Pyramid Schemes: Beware Of Crafty Marketers Posing As Respected Persons To Lure Customers
By W.A. Wijewardena -September 10, 2012 |
Dr. W.A. Wijewardena
A salutary reader interest on share market regulation
A reader of the previous week’s My View titled “SEC: Not a mere watchdog, but a bloodhound mandated to bite” has raised an important issue with this writer. He has asked the question why it is necessary to have a regulator to police the financial markets and why can’t the market system punish the miscreants. Such a public interest on an important issue like the one in hand is a welcome development.
Market can fix the problems but it takes time
The answer to the reader’s query is ‘yes, the market system could punish the miscreants, and it would do so eventually, but since the miscreants use distorted information to gain profits at the expense of others, it takes time for the market system to pass the information to all. Hence, by the time the market would have punished the miscreants, it would have been preceded by a catastrophe that had killed everyone on sight – the participants, the national economy and even the bystanders’.
This can be explained by taking the ‘pyramid scheme market’ or known in a more respectable way as the ‘multi-level marketing market’ as an example.
Charles Ponzi: Offering secret to quick richness
Pyramid schemes are not novel developments and even in mid 19th century, as illustrated by Charles Dickens in some of his novels, they had been present sporadically in England. But in modern times, the major financial scandals involving a pyramid scheme started in USA in early 20th century with an unknown Italian migrant, Charles Ponzi, coming up with a super-profit scheme to lure investors. Having noted the price differences in International Reply Coupons or IRCs in USA and the rest of the world, he suggested to his investors that they could make super-profits – 50 per cent in 45 days and 100 per cent in 90 days, by buying from the low-priced market and selling at the high priced market. Economists call this arbitraging.
IRCs are a system of facilitating postal replies to trade inquiries. For instance, a trader in Sri Lanka could buy an IRC from local postal authorities and send it to a customer in USA so that he could use IRC to buy the required postal stamps from USA to reply the trader in Sri Lanka. The coupons are valued at the postage cost in the respective country. For instance, in our example, suppose an ordinary airmail letter costs in Sri Lanka Rs 50. If the exchange rate of the rupee to US dollar is, say, Rs 100, by spending one US dollar, a US citizen can buy two IRCs in Sri Lanka. If an airmail letter in USA costs $ 5, the two IRCs could be exchanged in USA for stamps to a value of $ 10. Ponzi told his investors that by selling those stamps in USA, one can make a huge profit. According to our example, it is a profit of $ 9 or just 900 per cent which no sane person can resist if offered as a profit opportunity.
