By 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.
Charles Ponzi: It is a crime not to exploit those willing to be exploited
In effect, what Ponzi did was not buying IRCs in foreign countries where the postal rates were lower but using the money he got from subsequent investors to pay preceding investors, while keeping a big part for his use. Pretty soon, his company became bankrupt because he could not go on recruiting a sufficient number of new investors to pay the previous ones and enjoy his lavish life style.
He was jailed in 1920 and deported to Italy since he was not a US citizen. Later he migrated to Brazil where he died. When he was questioned by US authorities why he misled gullible investors, his answer had been quite simple and to the point. He is reported to have said that if the world wants to be deceived, let it be deceived, meaning that it would be a sin not to exploit people who wish to be exploited.
Since then, all pyramid schemes or schemes similar to pyramid schemes are known as Ponzi schemes. For instance, if a commercial bank or a finance company pays its original depositors using the moneys mobilised from new depositors because it has a chronic liquidity problem, that financial operation too is known today as a Ponzi business.
Greed creates demand for pyramid schemes
But, as Ponzi himself had elaborated to US authorities, the demand for pyramid type of schemes arises out of the greed of people. That greed in turn fuels the desire to make quick money and become rich without labouring too much. The pyramid operators make use of this boiling desire in people to trap them to their nets by using super-marketing strategies.
The claimed good side of pyramid schemes
Pyramid operators always justify their operations saying that they are superb multi-level marketing schemes that enable people to become richer quickly. They also claim that their schemes have eliminated the middlemen and thereby connected the producers direct with the buyers. Thus, a part of the money the participants would get is what the middlemen would have got earlier. Hence, they are schemes that help a country to make everyone richer rather than a few selected middlemen who are also accused of exploiting both the producers and the consumers. Thus in economists’ jargon, they help a country to attain the objective of ‘inclusive growth’. Besides, they also claim that pyramid schemes help young people to become innovative marketers and entrepreneurs, a development which a country can reject hardly. These schemes, they further argue, teach people to take risks and by taking high risks, make super profits. In their opinion, no business is business, unless there is willingness to take risks. If people are prepared to take risks, the government should not intervene and stunt their risk taking spirits.
If they are so beneficial, then, why should a country ban pyramid schemes as has been done in many countries including Sri Lanka?
The tragic experiences of Albania
The answer comes from the tragic experience of Albania in 1990s. When Albania embraced free market economy system in 1991 after shedding the previously followed socialist type policies, everybody wanted to get richer quickly. This desire was satiated by the new government itself by promoting pyramid schemes as a way to get richer quickly and create wealth in the country. In fact, the very first pyramid scheme was started by an economic advisor of the Prime Minister himself. All senior government officials who had been blessed by politicians started pyramid schemes competing with each other. Within two years, there were more than 25 such pyramid schemes offering interest incomes at rates ranging from 10 to 25 per cent. Some Albanians sold their houses to put money in to schemes and other Albanians who were working in countries likeItalyandGreeceused their hard earned money to get richer quickly through these schemes. Like any pyramid scheme, they pretty soon ran to their limit when no more new recruits could be made from within the country. Consequently, by 1997, all the 25 schemes became bankrupt making participants lose some $ 1.5 billion dollars. In a country where the average monthly income amounted to just $ 80, this was a substantial amount. People demanded the government to pay back because they had been promoted by the government officials. When the government failed to honour the demand, flash riots sprang up throughout the country. The end result was the toppling of the Albanian government and some 2000 people losing their lives. It took another 10 years forAlbaniato recover from the man-made catastrophe.
Social costs outweigh claimed benefits
Thus, the risks these schemes entail on the financial system and the social costs they inflict on the economy outweigh the so called benefits of the pyramid schemes and, therefore, they have been made illegal in a majority of countries. Today, they have an international dimension too because the pyramid operators function as global networks and if a scheme fails in one country, it has repercussions in other countries as well. For instance, the Albanian Pyramid Rebellion of 1997 had repercussions in bothItalyandGreecewhere a majority of the victims had been working and losing their life-long savings. Hence, preventing the upsurge of pyramid schemes has become a global issue.
Pyramid scheme combating in Sri Lanka
Sri Lanka had had its own share of pyramid schemes since 1998 when a Hong Kong based pyramid scheme operator started his business in the guise of a multi-level marketing or MLM scheme in the country. He had the benefit of promoting his scheme without running into legal problems since the country did not have anti-pyramid scheme laws at that time. Any action had to be taken against the scheme under the common law in which fraud had been made a criminal activity. This was no sufficient deterrent and the scheme proliferated without a major challenge. When the problem became wide-spread threatening the stability of the financial system, the Central Bank started to take action against the pyramid operators. At the request of the Central Bank, the Ministry of Finance took action in 2005 to amend the Banking Act making the operation of pyramid schemes illegal. Anyone found guilty of operating a pyramid scheme was to be imposed a punishment of a fine of up to Rs 1 million or a prison sentence of up to 3 years or both.
The writer’s involvement in anti-pyramid operations
The writer recalls his involvement in the anti-pyramid operations in the Central Bank as its Deputy Governor during 2004 to the middle of 2006. A special unit was set up in the Central Bank to conduct the operations supported by three detectives released full time from the Criminal Investigations Department. The unit reported to the Governor of the Bank through the writer during this period.
According to the findings of the unit, the operator had used ingenious marketing strategies to lure gullible participants. His modus operandi was as follows.
The pyramid operators had impersonated the writer
The prospective participants were assembled to a hotel in the night under the guise of providing entrepreneurial training. They were addressed by many people who had been specifically trained in the art of effective public speaking. To show that they had the backing of the authorities, imposters were planted at the training sessions posing as very senior officers of the Central Bank. One such person they had impersonated in one of the meetings inAnuradhapurahad been the writer himself as the Deputy Governor of the Central Bank. According to reports, the person who had impersonated the writer had introduced himself as the Deputy Governor and explained to the audience the many benefits which one could get by joining the so called multi-level marketing scheme. He had explained to the gullible audience who had been cushioned mentally by that time by other speakers that the scheme had the blessings of the Central Bank. In their eagerness to join the scheme and make quick money, nobody had bothered to check on the true identity of the person who had impersonated the writer there. Since it was night and the hall had been kept deliberately in semi-darkness, even if there was anyone in the audience who had known the writer personally, he could not correctly identify the impersonator. So, for all practical purposes, to the enchanted audience present, it was the Deputy Governor of the Central Bank that had addressed the gathering there atAnuradhapuraand signed off the multi-level marketing scheme being promoted by the pyramid operator.
The use of asymmetric information
This is indeed an ingenious marketing strategy. What the promoters had used is what economists call today, the asymmetry of information and irrationality in decision making when people are guided by emotions. The asymmetry of information means that the marketer knows everything about the product being offered for sale, but the buyer does not know. Before an audience that is not familiar with the senior officers of the Central Bank, anyone could pose himself as the Deputy Governor of the Central Bank. There, the asymmetry of information occurs because the audience does not know the Deputy Governor and only the promoters know him. Thus, the ignorance of the audience is used by the promoters to gain unwarranted credibility for the scheme.
Emotions kill rationality
The irrationality of decision making occurs because through enchanting public talks, the emotions of the audience are aroused to such a high level making them blind even to the most obvious things around them. They are there to believe in toto whatever that is passed under their noses. Hence, the promoters are in a position to spread any distorted or misleading information to benefit from their enraptured state of mind. They do so without any sense of guilt. It simply proves that they have been following to the letter what Charles Ponzi had told the US authorities: ‘If the world wants to be deceived, let it be deceived’. But, that willingness to be deceived has been planted in them through crafty marketing strategies, including the planting of imposters posing as famous people to lure them without the knowledge of such celebrities.
Disabusing the minds of people misguided
The writer recalls that when it was learned that he was being impersonated by the promoters of the scheme, it became necessary to disabuse the minds of the people who had been misled. To do so, the writer had to appear regularly on the television and speak of the ills of the pyramid schemes. He had to give interviews to newspapers, both Sinhala and English, on the same lines. He addressed many meetings and public lectures conveying the message of the Central Bank that the Bank means it business when it comes to combating pyramid menace. However, this made the writer a target by the pyramid promoters which necessitated him to seek protection from the police.
Impersonation occurs even today
Thus, the public should be cautious about when public figures known to them only by name are introduced to them for promoting illegal businesses. It happened in the past, is happening now and will happen tomorrow. The objective of those who do so is to take advantage of the ignorance of the gullible people who cannot see beyond their noses because of the enormous profit opportunities shown to them by means of enchanted public lectures. It is the duty of the Police, when they come to know of such instances, to nab such imposters and deal with them severely, since such imposters do a greater harm to the nation than those who directly rob from people by encouraging young people to earn without labouring. They also plant distorted career ambitions in their minds.
Regulator needed when a market is not there
The free market system cannot effectively check on them quickly enough because one of the fundamental prerequisites for the operation of a market is not present there. That prerequisite is rational thinking and rational thinking is killed here by intoxicating greedy people with emotions.
Hence, a financial market regulator is needed in order to prevent the system from being hit by bigger catastrophes. The public should at the same time beware of the so called high profile people who are brought before them for promoting illegal trading activities. Those high profile people are imposters who work for the promoters for cash gains and not the actual people.
(Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT – W.A. Wijewardena can be reached at firstname.lastname@example.org )