Proactive Investors Editor Ian Lyall is the author of the Street-Smart Trader, an insider?s guide to the City. Here in an extract from his book he looks at the Ponzi scheme, named after the Charles Ponzi, the 1920s fraudster, and used to devastating effect by Bernard Madoff.
Charles Ponzi gave us the blue-print for fraud on a grand scale. He discovered an apparently risk-free way of making a profit in the market for postal vouchers, and used it as the basis of a fund that guaranteed an impossibly high return.
It wasn?t long before he was overwhelmed by the interest in this innovative means of making money.
And so he started using his latest deposits to pay off the original investors in his enterprise.
It was a recipe for disaster that left thousands of investors out of pocket, while creating financial mayhem.
It even precipitated a run on the local banks in his native Boston. No surprise then that when the authorities caught up with Ponzi, he was tried and jailed for five years (of which he served three and half).
Now fast forward to June 2009, and the sentencing of Bernard Lawrence Madoff to 150 years in prison for the world?s biggest Ponzi scheme. It was a scam of breath-taking audacity.
In total it is estimated around $65 billion of clients cash went missing from the accounts of Bernard L Madoff Investment Securities ? his limited liability company set up by the ?investment guru? in 1960.
Investigators reckon in all $18 billion of that will never ever be recovered.
Madoff started out quite modestly in the early 1960s trading penny shares on the unregulated pink sheet market with seed capital of just $5,000.
But he was a wily operator and with the help of his accountant father-in-law Saul Alpern, Madoff built up the business investing on behalf of close friends and their families.
Where Ponzi fleeced wealthy Bostonians, Madoff targeted the affluent New York Jewish community in those early days.
This gave him an invaluable leg up. But in order to compete with the big time firms on Wall Street, Madoff was forced out of necessity to create his own electronic dealing system that eventually became the backbone of the Nasdaq exchange in the US.
This gave him two things: respectability (Madoff went on to become chairman of Nasdaq and pillar of the financial community) and the means to perpetrate his gargantuan fraud.
The technology allowed him to create his own team of share traders known as market makers who dealt on behalf of the fund.
It meant the Madoff fund was unique on Wall Street in that it didn?t rely on outside broker dealers to execute trades, which meant it was subject to little or no outside surveillance and interference.
Ironically, some of Madoff?s sophisticated institutional investors suspected the hedge fund tycoon was bent. However they thought the stellar returns were the result not of a giant pyramid investment scheme, but because Madoff?s market makers were investing on the back of inside information.
Bernard L Madoff Investment Securities styled itself as a hedge fund. But that?s where the similarities ended ? though the mystique of the business was always maintained.
Nobody could ever determine how month after month the fund returned 1-2 per cent with never a down month, quarter, or year.
Goldman Sachs once dispatched bankers to discover how Madoff performed his alchemy. A week later they returned as baffled as they set off. Not only was Goldman not allowed to see the books, but was fed a cock-and-bull story about the sophisticated mechanics of the fund that nobody concerned understood or believed.
From that day on, Bernard L Madoff Investment Securities was blacklisted and Goldman?s brokers were told they couldn?t do business with the New Yorker.
But how did Madoff get away with it for so long? Well the answer is he relied on a degree of cunning, a lot of luck and the sheer incompetence of the regulatory authorities.
Madoff himself makes some damning observations of the Securities and Exchange Commission, which had numerous opportunities to unravel the giant deceit.
In a jailhouse interview with the SEC?s Inspector General, David Kotz, he likened the Commission?s investigative efforts to those of the bumbling TV detective Lieutenant Columbo.
Madoff?s was one of a handful of frauds and alleged rip-offs to come to light all at the same.
It is possible if you look in microscopic detail at these scams to discern a number of common threads.
The first and most obvious is that each offered too-good-to-be-true rates of return. Yet this still did not trigger the alarm bells as greed blinds the even the most savvy investors.
Of course with Madoff there was the ?halo effect?. Bernie Madoff was a legendary investors, a reputed billionaire and philanthropist.
He was well connected in New York society - sitting on the boards of a number of the major charitable trusts, while rubbing shoulders with actors and politicians.
Incredibly he was even close friends with the then SEC chairman, Mary Schapiro, and the organisation?s Commissioner, Elisse Walter.
Madoff was particularly cunning in that he didn?t actively solicit for new clients. This made would-be investors all the more determined to break into this exclusive club that boasted celebrity investors such as film director Steven Spielberg, the actors John Malkovich and Kevin Bacon and the singer songwriter John Denver as well as a handful of billionaires.
What Madoff knew also was that he should keep the management of the company in the family.
So his ex-wife and sons at various points worked for Bernard L Madoff Investment Securities.
At the start his younger brother Peter was the firm?s senior managing director and chief compliance officer, while Peter's daughter, Shana, was the compliance attorney. Finally, Madoff?s nephew Charles Weiner worked in the trading section.
The analyst Harry Markopolos raised concerns in 1999 and again in 2005 and 2007, pointing out it was simply not possible to post the sort of returns Madoff was filing year in year out irrespective of the state of the markets.
But like the Goldman investigations, the Markopolos warnings went unheeded. Perhaps that was down to greed or stupidity.
?Lots of Bernie Madoff's investors, including institutional investors and banks, thought Madoff Securities was running a scam ? they just didn?t realise he was scamming them,? says Henry Blodget, the Wall Street commentator.*
?The scam everyone thought he was running was basically having his hedge fund operation front-run the trades from his electronic market making operation.
?As the saying goes, you can't cheat an honest man...but cheating those who are dishonest is all too easy.?