A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This is similar to a pyramid scheme in that both are based on using new investors’ funds to pay the earlier backers. For both Ponzi schemes and pyramid schemes, eventually there isn’t enough money to go around, and the schemes unravel.
The scheme is named after Charles Ponzi, who became notorious for using the technique in the 1920s. The idea, present in novels (for example, Charles Dickens’ 1844 novel Martin Chuzzlewit and 1857 novel Little Dorrit each described such a scheme), was performed in real life by Ponzi, and became well known throughout the United States because of the huge amount of money he took in.
With the constant fluctuation of postage prices, it was common for stamps to be more expensive in one country than another. Ponzi hired agents to purchase cheap international reply coupons in other countries and send them to him. He would then exchange those coupons for stamps that were more expensive than the coupon was originally purchased for. The stamps were then sold as a profit.
This type of exchange is known as an arbitrage, which is not an illegal practice. Ponzi became greedy and expanded his efforts. Under the heading of his company, Securities Exchange Company, he promised returns of 50% in 45 days or 100% in 90 days. Due to his success in the postage stamp scheme, investors were immediately attracted. Instead of actually investing the money, Ponzi just redistributed it and told the investors they made a profit. The scheme lasted until 1920, when an investigation into the Securities Exchange Company was conducted.