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  • Writer's pictureCarlos Pinto

How do Pyramid Schemes​ Work?

The old adage “if it’s too good to be true, it probably isn’t” is not always right, but in the case of a pyramid scheme, it certainly is. Although pyramid schemes can seem like unmissable opportunities, their other name - pyramid scams - is a more accurate representation of them. Recently, I myself was invited to join a pyramid scam by a friend who has unknowingly been made a victim of one. Therefore, I hope to spread knowledge about this type of fraud as an effort to prevent more from falling victim to them. Pyramid scams have this name because a “pyramid” is exactly the shape that best depicts their business model. Basically, pyramid scams work by members recruiting new members, new members recruiting newer members, and those newer members recruiting even newer members... Hence rather than earning money by producing and selling something, top-level members earn money from the payments new members make to join the scam. This, however, is obviously unsustainable, as once the list of potential members dries up, no more money is put into the scam, leaving those at the top rich and those at the bottom empty-handed (and, in many cases, in debt). For example, if members of a pyramid scheme had to recruit six more members to turn a profit, by the 13th layer, a population greater than that of Earth would be necessary to maintain the scam, as a consequence of the exponential growth. Pyramid scams can sound very tempting. They may promise great returns from little to no work and no risk, as well as wondrous perks, such expensive cars and trips. They may also attribute “cool” titles, such as “Triple Diamond” or “Ruby”, to the members in higher layers and with the most people below them. Be wary, nonetheless: “there is no such thing as a free lunch.” That is, if you are invited to join a business, question what it is about it that makes it viable and profitable. Is the product it sells priced reasonably, and does it have a wide consumer base or is its main source of revenue the money paid for by new members? It is also common for pyramid scams to sell “high-tech” products and have complex commission systems in an attempt to camouflage their true nature. Pyramid scams are not just limited to consumer businesses, however. Ponzi schemes, which are a version of pyramid schemes adapted to the financial market, also rely on attracting new investors to make profit. In Ponzi Schemes, instead of the money from investors being, in fact, invested, their capital is used to repay investors who joined the scheme earlier. Similarly to pyramid scams, they often offer high returns at, supposedly, low to no risk.

On December 10, 2008, what is probably the largest and most famous Ponzi scheme of all time was dismantled by the fraudster’s own sons. Bernie Madoff, a man many considered to be one of the most intelligent investors in the world, confessed to his sons that the wealth management arm of Bernard L. Madoff Investment Securities, was in reality a Ponzi scheme. His sons, in turn, told federal authorities about their father’s crimes, resulting in Bernie Maddof’s arrest on the day following his confession. In the end of his trial, Bernie Maddof pleaded guilty to fraud and was sentenced to 150 years in prison as well as forfeiture of US$17.179 billion, some of his victims included the Royal Bank of Scotland, the Royal Bank of Canada, HSBC, and Kevin Bacon. Bernie Maddof differed from most Ponzi scammers because, rather than openly courting potential investors, he would fend them off as if their investment wasn’t necessary. That is, he would play hard to get. This resulted in investors becoming more eager to join in and less concerned with how it worked in reality. As evidenced by the list of Maddof’s victims, many amazingly smart people fell for his scam, which means pyramid scams can be incredibly deceiving. Hence, whenever a financial opportunity seems unmissable ask yourself whether you are really that lucky or whether there might be more to it than meets the eye (or ear). Don’t forget to always do your research and think logically when dealing with money.

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