The specter of a Ponzi scheme

A few days ago, police stormed into the office of China’s biggest peer-to-peer lending platform, Ezubao, and arrested 21 suspects - including the company’s head, Ding Ning, who also ran the legitimate Yucheng International Holdings Group - for orchestrating the country’s largest-ever Ponzi scheme, estimated at 50 billion yuan ($7.6 billion). The Internet lender promised investors returns as high as 15 percent but had actually been stealing money from 900,000 people over the last year. Financial crime has evolved to take an astronomical toll on the economy due to advances in information and financial technology.

Ponzi schemes work quite simply. Promoters offer a few investors high-yield - but ultimately nonexistent - investments. The investors are paid handsomely, and the fund expands as more investors are drawn by the payoffs. The system can then run on its own, with new investment paying the existing investors, until money stops coming in. Ezubao was the classic Ponzi case, conning people with high returns. When it could no longer pay investors the promised rate, the schemer dug into the funds for himself and his employees, and then watched as the system collapsed.

The scheme originated with Charles Ponzi, who developed his techniques in the 1920s. In just four months, he drew $450 million with offers of 50 percent returns in just 40 days. It was based on the arbitrage of international reply coupons for postage stamps. Over 17,000 people invested $1 billion in the nonexistent venture.

The scam gained international notoriety through Bernard Madoff, who had built a credible reputation on Wall Street since 1960. He even served as the chairman of the board of directors at Nasdaq. Until his scheme exploded in 2008, he had been swindling money for 48 years. Losses were estimated at $65 billion and involved over three million people.

He was skilled in working with the innate human weaknesses of fear and greed. His business flourished because people feared being rejected. His company was selective about its customers. Membership in Madoff’s club was exclusive and included stars like film director Steven Spielberg, the owner of the New York Mets baseball franchise, senators, congressmen and high-profile investment companies like HSBC.

He was sentenced to 150 years in prison, with the judge hoping no one would ever dream of mimicking such scheme.

But financial fraud won’t just disappear. Korea is a ripe market for schemers, with an increasingly aging population, low interest rates and a slowdown in its economy. In fact, we could soon see a boom. As the Ezubao case suggests, the damage could become colossal as fraud goes high-tech.

Lee Hyo-jin, head of 8 Percent, a pioneer among peer-to-peer lenders, has said he smells fishy deals in the burgeoning and unregulated fintech, or financial technology, industry. Peer-to-peer platforms have mushroomed in recent years to number over 200, but they remain beyond financial oversight and regulation. One senior official at the Financial Services Commission said if the sector comes under supervision, any scam and fallout could become the responsibility of the state.

But leaving it to expand into a Wild West is no solution. Authorities should encourage innovative financial technology, as well as prevent fraudulent and illicit practices. They must find a way to lure people into a registered system. They must further deregulate and liberalize while toughening punishment for any irregularities.

But the reality is quite the opposite. Regulations are multi-layered, yet punishment is light. If the country’s largest pyramid schemer, Cho Hee-pal, is still alive and caught, he would get a maximum jail sentence of 11 years under current law. We must think about why the U.S. court sentenced Madoff to 150 years in jail.

Once a major fraud blows up, the damage is fatal. All the money and effort put into creative finance or fintech could go down the drain. The specter of a Ponzi scheme may be looming closer and closer.

JoongAng Ilbo, Feb. 4, Page 30

*The author is an editorial writer for the JoongAng Ilbo.

by Yi Jung-jae