ponzi schemes

Continuing my ramblings about commission, I refer you, gentle reader, to my earlier posts about Bernard Madoff.

Madoff operated a classic Ponzi scheme, and in my earlier post I postulated that the market as a whole had done the same to its participants, largely as a result of commission.

A classic, or simple, Ponzi scheme, is an investment product producing above-average returns to early adopters by siphoning-off the deposits made by new investors. So long as the scheme continues to attract new depositors, investors get a good return; but it is as fraudulent as a chain letter. It is, of course, exactly the same thing, but less honest. At least with a chain letter you are told how it works, but the inexorable arithmetic is the same in both cases. Madoff made his scheme last for so long by providing only slightly above-average returns, which both made it seem more credible and extended the time-scale of the inexorable arithmetic.

I think that in addition to the simple Ponzi scheme used by Ponzi, Madoff and many others, it is possible to conceive of complex Ponzi schemes. A simple scheme is implemented in a self-contained financial instrument, whereas a complex scheme does the same thing using multiple instruments where the value flows between them; but from the outside, the effect is the same.  A complex scheme could then be either contrived or emergent. In a contrived complex Ponzi scheme, the operators of the various instruments deliberately set out to achieve the Ponzi effect and design them to do so. I think that some of the housing/buy-to-let/mortgage frauds may be contrived complex Ponzi schemes; estate agents, solicitors and mortgage brokers are typically implicated in a conspiracy to defraud.

Much more disturbing, however, is the case of the emergent complex Ponzi scheme. In this case, it is the interaction of various financial instruments, each of which is itself entirely legitimate, which leads to a Ponzi effect. One such instrument might be broker’s commission. Indeed, I suspect it is the main villain in my very strong hunch  that most of the financial services sector has been operating for much of the last quarter-century as a very large emergent complex Ponzi scheme. Not a deliberate, criminal enterprise, but one nevertheless where the operators have benefitted enormously as punters have lost.  I suspect that it is a property of commission-based sales in savings products that a complex emergent Ponzi scheme is inevitable.

Perhaps there is evidence for this, but I think that first I need an adequate algebra to make the case and then to derive relations which can be tested against available metrics.