Ponzi: India’s problem isn't absence of legislation, it's lack of accountability, corruption, fraudsters using legal means

Charles Ponzi

By Moin Qazi*

In 1919 Charles (Carlo) Ponzi, a clerk in Boston, suckered Americans with a scheme that is now identified with his name. At a time when interest rates stood at 5 percent, Ponzi offered investors a 50 percent return in just 45 days. The pitch was to buy postal coupons -- used for buying foreign stamps, in a particular country, and then capitalize on exchange rate differences by redeeming them at a profit in the US. Ponzi only bought a handful of stamps. But he kept the scam going by robbing from Peter to pay Paul. Interest for early stage investors was paid out of funds from new investors and thus, he formed a cycle.
The Italian immigrant coaxed thousands of people into sinking millions of dollars .Ponzi fleeced investors worth at least $15 million — or about $190 million in today’s dollars — over the course of just eight months before his scheme finally crashed in 1920. Ponzi scams keep coming back because it is so lucrative and so easy to do in different forms. Almost a century later, this kind of con continues to haunt regulators across the globe.
India has always been a fertile ground for such scammers who have exploited the illiteracy of the poor to rob them of millions. There have been so many fraudulent operators in rural areas that the poor are now wary of investing money, even in credible organizations.
To check this menace, the government has approved a draft bill to tackle this menace of illicit deposit. This move will provide tighter regulation of financial industry and will bar several platforms from taking public deposits. The new Bill -- Banning of Unregulated Deposit Schemes Bill 2018 -- provides for complete prohibition of unregulated deposit-taking activity. It also provides for deterrent punishment for promoting or operating an unregulated deposit-taking scheme.
The law proposes to create three different types of offenses; running of unregulated deposit schemes, fraudulent default in regulated deposit schemes, and wrongful inducement in relation to unregulated deposit schemes. They will also set up competent authorities to ensure repayment of deposits in the event of default by a deposit-taking establishment. Heavy fines and punishments are also proposed. There are also provisions for repayment of deposits, attachment of properties and assets for repayment to depositors.
This law is necessary because there have been rising instances of people in various parts of the country being defrauded by illicit deposit-taking schemes. The leaders in the pack are Sahara, Sarada Group, Speak Asia, Rose Valley and Gold Sukh. They have between themselves duped investors of millions. India’s problem has never been the absence of legislation -- but the lack of accountability, corruption and ability of the fraudsters to use legal eagles to game the judicial system. This applies to bad loans and banking frauds, as much as it does to the thousands of illegitimate schemes that have gobbled up a staggering Rs 85,000 crore of hard-earned savings.
India does not have a unified regulatory regime to counter Ponzi or pyramid schemes whose operators typically grab new deposits to meet their promise of guaranteed returns to existing savers. These schemes can snowball but are eventually doomed to failure when the potential pool of new savers runs dry. This will occur when the scheme runs up against the natural limits of its strategy for recruiting investors.
A Ponzi scheme is a classic swindle, similar to a pyramid scheme in the sense that both are based on using new investors’ funds to pay the earlier investors. The promoters tout phenomenal returns for investors. One difference between the two schemes is that the Ponzi originator gathers funds from new investors and then distributes them. Pyramid schemes, on the other hand, allow each investor to directly benefit in proportion to the number of new investors recruited. Older members are allowed to withdraw money after a certain period of time and receive bonuses for encouraging new entrants to sign up. In this case, the person on the top of the pyramid does not at any point have access to all the money in the system.
The gullible investors are normally illiterate and do not understand the nuances of finance. They don’t realize that existing investors are paid money not than from genuine business profit. They believe their funds are used to finance a very profitable and legitimate business. The swindler parries questions about legitimacy wit huge dividends and creates an illusion of solvency by paying off early investors by acquiring the ever-increasing number of new investors. This scam actually yields the promised returns to early-stage investors, as long as new investors keep adding to the fold.
The liabilities actually exceed assets and the firm is permanently insolvent .The scheme moves seamlessly, without raising a faintest hint of suspicion, until a point when it is no longer able to attract new investors. The promoters even pay up the fanciful returns, perhaps even higher than the promised dividend, out of their personal funds, thus confirming the promoter’s credibility. A firm cannot keep on paying dividends out of capital contributions.
The whole structure collapses like a house of cards when the flow of fresh money dwindles, and the cash outflow exceeds the cash inflow. It simply means that the number of people in need of help outnumbers the number of people joining. The promoters try to siphon off as much of the money as they can before the scheme fails. Both schemes will inevitably collapse though Ponzi schemes may operate for longer periods than pyramid schemes.
Ponzi schemes have always risen phoenix-like when real estate looked shaky and the stock market was wild. The truth is that the regulators either know about these scams and do nothing or they completely overlook it on account of powerful promoters who have political links that bilk billions out of the investors.
While we should continue to make a case for strong regulations, we must remember that good financial literacy among citizens is the most effective antidote against these moral abuses in the financial system. To blunt the potential for risk, it’s more important than ever to arm customers with skills they need to borrow, save and move money prudently and to keep distance from unscrupulous and dubious investment schemes that have lacerated the financial lives of multitudes of them after they got into serious mess with them.
On account of lack of proper awareness and failure of institutions to properly guide them, people buy insurance policies without planning and give up midway because they don't have money to pay the premium. Aggressive selling prevents the agents from properly assessing the consistency in income streams of the buyers for servicing their policies. The customers end up losing heavily due to harsh penalties.
Persistency measures how long customers persist with their policies. The Insurance Regulatory and Development Authority of India (IRDAI), in its Handbook on Indian Insurance Statistics 2015-16, has provided persistency figures of the life insurance industry and the numbers are abysmal. For FY2016, the life insurance industry, on average, had a persistency rate of 61% in the 13th month, which means: 1 year after the sale, only 61 out of every 100 policies were renewed.By the 5th year of policy sale, 16 out of the 24 life insurance companies couldn't retain even a third of the policies. This shows the huge money customers are losing on account of bad financial planning.
People who have a strong grasp of financial principles are able to better understand and negotiate the financial landscape and avoid financial pitfalls. Conversely, people with a lower degree of financial literacy struggle to understand money matters and the potential impact on their financial well-being. Financial ignorance carries significant costs and results in people spending more on transaction fees, getting overextended with debts on account of them being ripe prospects for predatory practices. To blunt the potential for risk, it’s more important than ever to arm customers, especially the newly banked, with skills they need to borrow, save and move money prudently and to keep distance from unscrupulous and dubious investment schemes that are likely get them into serious trouble.
Financial knowledge is particularly important in times where increasingly complex financial products are easily available to a wide range of the population. To keep abreast even those who are financially literate need to brush up on financial skills.
*Contact: moinqazi123@gmail.com