Financial pyramid scheme: is it always a fraud?
Surely everyone has heard of pyramid schemes at least once in his life. However, not everyone can explain what it is and how such scheme actually works. A trader, regardless of his education, simply must be financially literate, so today we will analyze two of the most popular pyramid schemes.
Financial Pyramid: Theory
From the point of view of economics, a pyramid scheme is a scheme that aims to make profits for its members. At the same time, the source of profit is funds coming from new members of this scheme.
In simple words, a pyramid scheme is when those who joined it today bring "profit" by their contributions to those who joined it yesterday and the day before.
It is a misconception that a pyramid scheme is inherently fraudulent. In principle, any company running a traditional business can turn into a pyramid scheme. It is enough for the company's management to estimate its profitability incorrectly. As a result, the company does not make a profit. Consequently, it cannot repay its credits, loans or investor contributions. To repay debts, the company takes new loans. Eventually, the repayments will still exceed the amount of funds raised, and the financial pyramid collapses - the company declares itself bankrupt.
There are two main types of pyramid schemes in finance:
- MLM - multilevel marketing (MLM);
- pyramid built according to the Ponzi scheme.
Let's look at each type in more detail.
MLM pyramid scheme
The point of an MLM pyramid is as follows: each new member of the structure contributes some initial amount of money. This money is distributed between the one who brought the new member of the pyramid and the chain of those who brought the invitee, so to speak.
If a new member of the pyramid brings the next participants, a part of their money will become his income. This chain operates at all levels.
It is worth noting that a fraudulent scheme based on the MLM scheme is 100% cases doomed. As you have already understood, there is a geometric progression in MLM pyramid scheme. But, since we are dealing not just with numbers, but with people, the number of levels of course - simply not enough people to create a new level. That is, the most recent levels remain without profit. As a result, the top levels, which have accumulated a tangible amount of money, are hidden, and the pyramid itself collapses.
A striking example of a pyramid scheme of this type is the notorious MMM, founded in 1989 by Sergei Mavrodi. Until 1994 it was engaged in trading activities. Since 1994, the JSC "MMM" turns into a classic financial pyramid MLM, the number of participants which, according to various estimates, has reached between 2 and 15 million people.
However, not all MLM pyramid schemes are scams. Many companies use this scheme in their business. For example, they include most network companies, such as Avon, Oriflame, etc.
Financial pyramid scheme Ponzi scheme
This scheme owes its name to its creator, Italian Charles Ponzi. When he moved to the United States, Ponzi lost all his money, leaving him with a few dollars in his pocket. After borrowing $200 from an acquaintance, in 1919 Charles Ponzi opened his own company, The Securities Exchange Company, in Boston, which was officially engaged in arbitrage transactions.
Ponzi's company raised funds from investors and in return was obligated to pay $1,500 for every $1,000 received after 90 days. After about a year of operation, the scheme collapsed after one of the investors filed a lawsuit. An audit showed that the company had $4 million in accounts, but $7 million in debts.
The Ponzi scheme was simple. By refusing to have each member of the scheme bring in new members, Ponzi paid off the first members with funds from the following members.
For a while this scheme works quite successfully. Investors put money into some "very profitable business. The new inflows of funds are used to enrich the manager and pay first-tier investors.
As you understand, apart from attracting investors' money, the company in the Ponzi scheme is not engaged in any "very profitable business". That is, the company cannot pay out more money than investors put into it physically, which leads to the logical result - the pyramid collapses, and the organizer of the scheme disappears with the investors' money.
In order to understand more clearly the differences between the two types of pyramid schemes, we have summarized them in a table.
Conclusion
For a literate person it becomes obvious that each of the types of pyramid scheme discussed above brings profit only to its organizer and members of the first levels. And it seems to be clear that it is not worth to mess with them. Nevertheless, given the constant development of the financial sphere, pyramids will exist for a long time to come. For example, MMM Global Republic of Bitcoin, which existed from 2014 to 2016, promised profitability of 100%, and funds were accepted in bitcoins.
You should always understand that any pyramid scheme is a bag where everyone throws money, but they take it out in order of how much they can carry. So be financially literate and don't let yourself be cheated.
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