Understanding Pyramid Schemes
A pyramid scheme is a deceitful financial scam where profits for participants are mainly derived from enrolling others into the program, rather than from genuine business ventures.
While technology and terminology may have shifted, from outdated stock scams to modern crypto assets and from complex algorithms to intricate smart contracts, the core dishonesty remains. This kind of trickery is reminiscent of the 1920s when Charles Ponzi purported to possess a unique arbitrage system using international postal coupons. Early investors are then compensated by funds from new sign-ups. This generates an unsustainable cycle that will inevitably fail.
Key Points
- Pyramid schemes circulate funds from those at the bottom, upward to those at the peak of the structure.
- In the United States, it’s a criminal offense to enlist individuals into pyramid schemes.
- These fraudulent programs depend upon recruitment fees, rather than genuine sales of goods or services, despite what most contributors assume.
- Multilevel marketing companies (MLMs) are legitimate business models where distributors make money from the sale of genuine products and commissions related to the purchases and sales generated by their recruits.
- Pyramid schemes often pose as MLMs, but their primary focus remains on recruitment fees, rather than genuine product sales.
A Real-World Pyramid Scheme Example
Between 2023 and 2024, offers emerged promising returns as high as 13.5% per month, through investments in a cryptocurrency trading bot. This pitch was highly attractive. It boasted the capabilities of cutting-edge AI (artificial intelligence) to make profits from crypto assets. However, the U.S. Securities and Exchange Commission (SEC) determined this was untrue, and that yearly returns as high as 354% were too good to be factual.
In August 2024, the SEC blocked the assets of two brothers accused of orchestrating the $60 million scheme, using the promise of massive profits with cryptocurrency arbitrage trading. There was no trading bot, no trading activity, and no genuine business. One of the brothers had already been found guilty of security fraud. The entire program was simply a carefully structured pyramid scheme, using money from new investors to fund luxury condominiums and recreational vehicles.
Important Note
Some sources differentiate Ponzi schemes from pyramid schemes, sometimes implying that the latter may be legal. However, Investopedia, along with the SEC and federal law enforcement, uses the term “scheme” only in reference to unlawful activities.
How Pyramid Schemes Function
Pyramid schemes operate on a deceptively simple principle: Participants pay a fee to join what they think is a legitimate investment, but profits are produced by recruiting new members, and not actual business or real investments. The schemes fail when recruitment becomes difficult or impossible.
Modern schemes often include sophisticated aspects to appear lawful. Operators have defrauded investors of significant sums by boasting about sophisticated AI, special algorithms, private trading platforms, or exclusive high-yield investments. These features are designed to mask the underlying scheme.
These deceptive operations have become increasingly advanced, often disguised as advanced investment possibilities relating to cryptocurrency, AI, and other modern technologies. The SEC has cautioned investors about the rise in these cases, and crypto-related pyramid schemes are now the fastest-growing type of fraud under investigation.
Justin C. Jeffries, Associate Director of Enforcement at the SEC’s Atlanta Regional Office stated that “The SEC will make use of all methods available to halt those taking advantage of excitement around new technologies to cheat investors.”
Warning
The concerning part about modern pyramid schemes is not simply their scale, but their speed. Through social media, they may collect millions within days, rather than months or years. The money is often gone before anybody recognizes the fraud.
Pyramid Scheme Stages
A pyramid scheme generally happens in five stages.
1. The Beginning
Operators promote an investment that promises outstanding returns, frequently at least 10% monthly. They can claim the yields originate from trading cryptocurrency, foreign exchange, real estate, or other complicated investments.
2. Early Wins
Initial investors typically receive their promised profits, paid using the funds from new members. These early “winners” turn into advocates for the scheme, sharing their success with loved ones. Social media is utilized to improve the impact of this advertising, attracting additional victims.
Fast Fact
The pyramid schemes of the 2020s exploit the public’s perception of modern technology. Individuals know certain investors are profiting from AI and crypto but do not understand the specifics. Targets are likely to trust in the potential for earnings. Operators do not require a comprehensive expertise of the technology, only sufficient knowledge to make their story seem credible.
3. Warning Signs Emerge
Even thriving pyramid schemes have warning signs ahead of their eventual collapse. The first sign is a change in how money is handled. Withdrawal requests are consistently delayed, with operators typically blaming technical issues, financial institution problems, or regulatory compliance.
There is a noticeable shift in communication. Operators, previously accessible, become harder to reach. Updates become less frequent and contain changes to service terms or new requirements for withdrawals.
4. Desperate Measures
Operators use common tactics like requiring “holding periods” or raising minimum investments. Some schemes encourage existing investors to commit their resources for longer periods in exchange for increased yields.
The biggest sign is increased recruitment. Operators emphasize recruiting new members as the pool of potential investors gets smaller. They may add bonuses or generate artificial urgency through limited-time offers. Some schemes even gamify the process, developing reward systems or recruitment contests to keep motivation.
5. The End
As the pool of new investors shrinks, schemes cannot sustain payments to earlier contributors. The structure fails when recruitment slows or stops. Operators have usually withdrawn millions in funds, leaving most individuals with substantial losses.
Origin of the Term: Pyramid Schemes
The expression “pyramid scheme” originates from the exponential growth needed to maintain these frauds. Each level of individuals must recruit several new members, creating a pyramid that ensures collapse.
The pyramid will quickly become unsustainable if each participant needs to recruit five new individuals to gain yields:
- Level 1 (Top): 1 operator
- Level 2: 5 investors
- Level 3: 25 investors
- Level 4: 125 investors
- Level 5: 625 investors
- Level 6: 3,125 investors
- Level 7: 15,625 investors
- Level 8: 78,125 investors
- Level 9: 390,625 investors
- Level 10: 1,953,125 investors
The scheme would require a larger pool of investors than the entire United States population by level 13. It would exceed the global population by level 15. This explains why pyramid schemes are unsustainable because they eventually use all potential recruits.
If a person recruits just two individuals, not five, the chart below explains how the scheme works:
Ponzidemia and Modern Pyramid Schemes
Research into pyramid schemes worldwide shows how these scams adjust to local economic conditions. Argentina has been undergoing a “Ponzidemia” in the mid-2020s, an outbreak of pyramid schemes targeting people suffering with high inflation and recession, as a result of government austerity and growing social desperation.
One instance in Argentina involved scammers hiring Polish actors to portray American executives, when promoting a false crypto investment app called RainbowEx. They were able to successfully lure in victims from all over Argentina, especially in San Pedro, a town of 70,000.
The program assured yields of 2% per day paid in cryptocurrency, an attractive guarantee in a nation where a large part of the population lives in poverty and lacks confidence in the local currency. About one-third of the town’s residents invested, losing about $49 million when the scheme failed.
Warning
Cases show that defrauders are building false platforms and apps to generate credibility, making their schemes more believable.
Argentina’s “Ponzidemia” has links to Argentina’s president, Javier Milei. Milei promoted the CoinX platform across his social media, claiming that investors would gain 8% per month, with yields paid in U.S. dollars.
The CoinX platform is under scrutiny for fraud.
Bernie Madoff and Pyramid Schemes
Bernie Madoff ran what remains the largest and most well-known pyramid scheme. He guaranteed steady 10% to 12% returns regardless of market conditions, which attracted wealthy people, charities, and investment organizations.
Madoff helped build the Nasdaq exchange. He exploited his status as a Wall Street pioneer to extend his fraud for decades, claiming a complicated “split-strike conversion strategy.”
The financial crisis of 2008 caused the scheme’s demise, and in December that year it collapsed. The scale was about $64.8 billion in paper wealth vanished, devastating investors, charities and foundations. Madoff faced a 150-year prison sentence.
How to Detect Pyramid Schemes
The SEC and Argentine examples reveal familiar characteristics among pyramid schemes. The warning signs have remained remarkably reliable even as schemes have evolved from postal coupons to cryptocurrency trading bots.
- No real product or service: Operators will claim advanced trading algorithms or special investment strategies but cannot explain generating returns. The strategy is not even tried in most instances.
- Guaranteed high returns: Promises of high returns like “13.5% monthly” are classic signs. Lawful investments highlight market risks. Only defrauders guarantee profits.
- Emphasis on recruitment: If earnings rely more on recruiting individuals than on sales or returns, you are likely involved in a pyramid scheme. Schemes disguise this element as “network expansion.”
- Complex commission structures: Lawful companies have revenue models. Pyramid schemes are known for elaborate payment structures that obscure their true nature.
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Pressure to “act fast”: Defrauders generate urgency by stating limited openings. This pressures victims from completing background checks.
Pyramid Schemes Compared to Multilevel Marketing
Multilevel marketing (MLM) is a lawful business model, involving real products or services being sold by distributors. Distributors are paid for what they sell, while also gaining income from sales created by their recruits.
Some pyramid schemes disguise themselves as MLMs. The Federal Trade Commission warns people to avoid MLM promoters who do the following:
- Share extraordinary claims of earning potential.
- Persuade individuals that recruitment is where the real money lies.
- Pressure individuals to get involved without learning about the company.
- State that opportunities will be lost unless individuals get in immediately.
Another sign is distributors continuously buying products they cannot sell to qualify for a reward.
Are Pyramid Schemes Illegal in the United States?
Yes. Enrolling an individual to take part in a pyramid scheme in the United States is a felony, and penalties may include prison, fines, and disgorgement.
How Do Pyramid Schemes Succeed?
Pyramid schemes are successful due to quick monetary rewards. Early investors recruit new members to generate revenue and continue the cycle.
Pyramid Schemes Versus Multilevel Marketing Programs?
MLMs are lawful businesses where distributors make money selling items and by commissions. Pyramid schemes may pose as MLMs to attract individuals.
Conclusion
Pyramid schemes have been around for a long time, yet are continuing to evolve and take advantage of current trends and technology, by always relying on a chain of new investors. From Ponzi to Madoff to crypto scams, early investors are paid with new investors until inevitable collapse.
Knowing the red flags and math involved with schemes is critical for protection. If someone guarantees high returns through complicated techniques, remember that technology can’t overcome math. Protecting yourself requires background research and the prudence to know that if it sounds too good to be real, it may not be.