Not too long ago, one of my friend asked me whether am I interested to distribute a certain product. The return was more than 20% per annum GUARANTEED. I immediately scolded my friend for getting involved in a scam. They were shocked at my swift and rude response. I felt bad about being rude but a true friend is one who tells the truth even if the truth hurts friendship itself.
A product that gives this kind of guarantee is obviously a scam. Most people get themselves into a scam without understanding and just because they received the returns do not mean that the investment is legitimate. The most common type of scam these days that give such guaranteed outrageous gains is through a ponzi scheme in which the returns are taken from the investments of new investors’ monies. Also a scam can take a very long time to be exposed. Take for example it is believe Bernard Madoff ran a ponzi scheme as early as 1980s only to have been uncovered through his own confession in December 2008 making it two decades of fraud! The amount in missing money including fabricated gains were US$65 billion! To think about it, if he did not confess to his own sons, he might still be running the world’s largest ponzi scheme.
How does a ponzi scheme actually works? Let’s say the return is 10% per annum. You invested $100 and expect to receive a gain of $10 by end of the year. In order to give you this $10, it will have to come from investments of the next investor. For simplicity let’s say the each investor will only invest $100. Therefore, each investor is able to provide the gain for the previous 10 investors (because $100/$10 = 10). Because of greed, most investors will “rollover” their principal and allow their gains to compound. For the scheme to work, the ponzi scheme must manage their cash flow properly by ensuring that there are more money flowing into the company than going out of the company.
For Ponzi to work: Company’s Cash Inflow > Cash Outflow.
Since very few people will be withdrawing their capital and gains, their wealth increase “virtually” through a paper gains. The problem starts when Cash Outflow exceeds Cash Inflow. Since there is no underlying assets to liquidate and gains are mere paper gains, the operation will just collapse. But of course, prior to the collapse the operators would have fled the country with investors’ monies.
These days, it is easy to spot a ponzi scheme. So people have come up with distracters. I cannot give specific example of distracters because these operators are well known to use famous and big gun lawyers to sue bloggers. But distracters are basically collaterals. Let’s say you as an investor invest $100 into the ponzi scheme to “buy” a 1 ton Uranium rod (for illustration only). In this case, the Uranium rod is a collateral. They will tell you that you cannot open the wrapping paper but even if you would to open the wrapper, you will find that the collateral is a genuine Uranium rod. So you think you got a genuine investment and you would tell others about it. But I mentioned that ponzi can only work if the Cash Inflow is greater than Cash Outflow. How can there be any positive Cash Inflow for the company if the company is required to provide a collateral? The answer to the mystery is that the price of the collateral is markup. So the investor is paying $100 for a collateral that is only worth $90. In this scenario, the company receives a Cash Inflow of net $10. Many unsavvy and uninformed investors who think are smart will start saying that they are actually exposed to the market value of the collateral and that is why I say the collateral is merely a distracter. The “guarantee” return promised has nothing to do with the market price of the collateral because the investor is given a free put option which is in-the-money since day 1.
Confused already? Many people fall into a scam without understanding and even with much explanation, yet continue to be confused.
There is another way in which scammers can provide such high guaranteed return without resorting to a ponzi scheme. This method is even more dangerous. It is when the promised gains come from “dirty money” or money laundering. Money laundering is a big problem in the world’s financial market. Because terrorists and drug lords are using the sophisticated banking system and financial centers to launder their money, such dirty money could actually end up in such “too good to be true” schemes. Participates who invest in such a schemes could end up becoming part of the money laundering network and get themselves implicated with terrorist groups. I do not think it is wise to have any association with such groups. So far, I have not heard of any company running “guaranteed high return” scheme being investigated for money laundering. I believe such companies exist but it is unlikely they will go bust anytime. Unlike the ponzi scheme which will eventually collapse due to cash flow problems, a company laundering drug lords and terrorists’ money will not go bust since terrorism and drugs will remain in our global village for a very long time. In the meantime, investors who participates in their too-good-to-be-true products become implicated with such global terrorist network.
The wonderful part of the entire story is that the Monetary Authority of Singapore does not regulate many of such investments schemes simply because these innovative products are not defined under the Securities and Futures Act (SFA). Those selling these products are also not regulated under the Financial Advisers Act (FAA) because the focus is on the wrong area – it only regulates salesmen selling products defined under the SFA.
Unfortunately, most scams are sold by friends. See: Turning to friends for advice turn out to be a bad advice
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