Ponzi Schemes
The growth and perpetuation of Ponzi schemes are grounded heavily in information cascades. Many of the most distinctive properties of information cascades are embedded in Ponzi schemes. Ponzi schemes, like cascades, are unstable and based on little information. They are also built on incorrect/incomplete knowledge. Information about a fund’s investments and returns are passed from investor to investor, with personal knowledge about the fund being diluted each time until the information passed is hearsay or second-hand. For example, several clients of Madoff’s report never being able to speak to Madoff himself after having invested their money with him.
The paper written by Sadiraj et al. in 1999 explores the players and their roles in the information cascade involved in Ponzi schemes. Ponzi schemes build initial power by paying out substantial dividends to initial investors, which consist of only a portion of the investors’ money. The supposed high payoff combined with good word of mouth allow for potential investors to choose the Ponzi scheme over their personal choice for funds, and eventually allows for a cascade to begin. There are two types of investors involved in Ponzi schemes: informed and uninformed. Although the informed investors are required to provide initial momentum to the Ponzi scheme, the uninformed investors are necessary for the cascade to begin in earnest. The informed investors’ opinions are often public and highly regarded, and strongly influence uninformed investors. Because Ponzi schemes fail when amount of investment is less than the amount of owed dividends, a large number of investors is necessary for them to succeed. This would require an initial “guarantee of authenticity” by informed investors to boost uninformed investors’ confidence in the fund. Then, even with the loss of informed investors, the information cascade would have begun via the uninformed investors and allowed for the growth of a scam.
Sources:
(1) “Bernard Madoff: More Trouble on Wallstreet”
(2) “Informed and Uninformed Investors in an Experimental Ponzi Scheme”