Financial pyramid — a common term that occasionally surfaces in conversations. Hearing it, many recall MMM, the Bernard Madoff scandal, and other examples. Nevertheless, these are just instances, while a general overview of what financial pyramids are and their varieties is rarely encountered.
There is no established universal definition of financial pyramids, and descriptions often resemble “uncontrolled investment schemes” or “unsustainable business models.” This article explains the nature of this “unsustainability” and why it occurs.
History records numerous financial pyramids presented under various guises, with seemingly diverse structures at first glance. However, all financial pyramids share a common principle that also accounts for their inevitable collapse.
Common Principle of Financial Pyramids — the “Bag Game”
The key feature of financial pyramids is that participants’ monetary contributions are simply redistributed during operation. In other words, the funds invested by participants do not go toward producing goods or services, so the total amount always equals the sum of investors’ contributions — only the owners change. This resembles collecting money in a bag and then distributing it sequentially to game participants according to certain rules. Clearly, not all participants in such a “bag game” can profit: at best, everyone breaks even, but typically pyramids are structured so early participants receive more than they invested, leaving nothing for the last ones. This clarifies why all financial pyramids eventually collapse — it’s impossible to enrich everyone by merely shuffling funds.
Organizing such “bag games” is considered fraud and illegal in most countries (including Russia and Ukraine). Yet financial pyramids emerge under various disguises despite legal restrictions — why? Most organizers lure players with promises of very high returns, and participants, due to gullibility, bite the bait without verifying legality, often unaware they’re joining a “bag game” with an inevitable end.
Two Main Types of Financial Pyramids
All financial pyramids fall into two types:
- multi-level pyramids;
- Ponzi schemes.
Multi-Level Pyramid
This scheme relies on each new participant, or newbie, first paying an entry fee. This fee is immediately split between the inviter and those who invited the inviter, i.e., earlier participants. After the entry fee, the newbie must recruit two or more people, whose entry fees benefit them and earlier participants. This continues level by level.
Depending on the pyramid‘s rules — entry fee amounts and required new recruits per newbie — promised returns vary but are usually substantial.
The entry fee amount and number of recruits differ by pyramid rules. For example, if rules require inviting 3 people with a 1000 rub. entry fee split equally between inviter and their inviter, simple math shows you spend 1000 rub. to enter and receive 6000 rub. (1500 from your three recruits and 4500 from their nine). Thus, the scheme yields 500% return, impressive compared to bank deposits.
However, as discussed earlier, any “bag game” ends. The reason multi-level pyramids collapse is the need for exponential participant growth. Such rapid rates often exhaust a country’s population within 10–15 levels. Not surprisingly, those who paid entry fees but couldn’t find recruits get nothing. Statistics show 80–90% of participants end up empty-handed.
Financial Pyramid – Ponzi Scheme
The scheme is named after American Charles Ponzi, who ran one in the US in the early 1920s. Though similar schemes existed before, Ponzi’s involved so many people it gained notoriety.
The essence of this “bag game” variant is the organizer invites participants to invest money, promising high, often “guaranteed” returns after a short period. No recruiting needed — just wait. The organizer pays initial few high returns from personal funds, then rumors of the “working” high-yield scheme spread, drawing new investors. Thereafter, the organizer pays old investors with new funds — the “bag game” runs. As early participants get paid, interest grows, and old ones reinvest, increasing inflows.
A financial pyramid as a Ponzi scheme ends simply: each investor expects more than invested, with no other income for the organizer. Thus, it’s doomed. The organizer usually knows this best, often absconding with funds when new inflows weaken.
Interestingly, well-known MMM and Bernard Madoff’s investment firm used Ponzi schemes.
Comparison of Ponzi Scheme and Multi-Level Pyramid
Both schemes fundamentally redistribute funds, differing only in rules and collapse speed. Here are the main differences:
A Parting Note
Financial pyramid organizers are inventive in disguising the “bag game” to entice participation. Multi-level pyramid creators often add “serious business” elements like selling goods or growing flowers.
The author knows of a curious Ponzi scheme where participants invested not in magic funds but in growing unique flowers. Presentations claimed scientists developed miraculous flowers aiding serious disease treatment. With few available, they were pricey. Participants could grow them at home.
Each bought seeds from the organizer firm for $500 each, planted them, and after 3 months, the firm bought back grown flowers for $1000. Word spread fast, creating queues for $500 seeds.
Obviously, the firm paid early participants from new seed sales. When the newbie boom faded and grown-flower returns loomed, organizers maximized profits and vanished.
Organizers of financial pyramids thus masquerade as legitimate network marketing, which provides goods distribution services and isn’t fraud. A clear sign of disguised financial pyramids using goods is that product value is far less than entry fees. Goods are mere “chips” in the “bag game.”
