Why in Russia financial pyramids grow like mushrooms after rain

In the first half of 2022, Europe and the United States experienced a significant increase in the number of computer crimes – significant even compared to the record 2021. Thus, in America, an increase in cybercrime by 62% was registered, and in the UK – by 40%. At the same time, the researchers noted that the complexity of cybercrime has significantly decreased. But the number of financial crimes, including those involving the use of computer technology, on the contrary, has increased significantly. In particular, the number of financial pyramids of various kinds fell by 21% compared to 2021, which is the lowest figure since 2008.

However, the problems of Western criminal activity, probably, in the current situation should not worry Russians too much. We are mostly disconnected from Western financial instruments – it makes no sense to offer “profitable financial investments.” For example, I would not even pay attention to these facts of changing the profile of international crime, if it were not for the following phenomenon: directly opposite trends are observed locally in Russia. The number of cybercrimes in our country over the past six months has decreased by 8% (according to the Ministry of Internal Affairs), but the number of pyramid schemes has increased by a factor of 6.5, according to the Central Bank of the Russian Federation. And this despite the fact that in 2021 the number of pyramid schemes has already increased by 4 times! This phenomenon is unexpected, since increased attention has recently been paid to teaching the financial literacy of the population. Without claiming to be the ultimate truth, let’s try to figure out what could lead to such consequences, and put forward some hypotheses.

Financial pyramids have been known for a very long time – at least since the end of the 18th century. The essence of a single-level pyramid is simple: it is an investment scheme with the promise of large returns, but the financing of these interests is carried out by attracting more and more new investors. Such a scheme enriches a small number of people at the top of the pyramid, but ruins the majority (85-90%) of the savers at the bottom. Even Charles Dickens described the schemes of such pyramids in his works – the novels “Little Dorrit” and “Martin Chuzzlewit”.

And in 1919, Charles Ponzi became famous at first glance for a rather sophisticated pyramid scheme, which made the name “Ponzi scheme” a household name in the United States. The promise of large profits in the Ponzi scheme was explained by the trade in international postal coupons, which, according to agreements concluded before the First World War, were accepted by the postal authorities of 60 countries at face value, but in fact, after the end of the war, they had a completely different real exchange rate in Europe and the United States. Conventionally, having bought a coupon for a cent in Italy, it could theoretically be exchanged in the USA for stamps worth 6 cents. The simultaneous buying and selling of an asset in different markets in order to profit from the difference in the value of an asset in these markets is called “arbitrage”. This is a legal practice – but always remember the Ponzi scheme when you are offered arbitrage on social networks. Since the postal coupons themselves were a rather useless thing in the everyday life of an ordinary person, they were not directly exchanged for money – only for postage stamps: investors were offered a secondary security of the scheme – an interest-bearing bill with a profit payment of 50% of the face value within 45 days and 100% of the profit within 90 days. The scheme quickly gained wild popularity – six months later it attracted 250 thousand dollars a day, special agents worked to attract new customers for a generous commission. Most of the scheme’s clients never even applied for payments, exchanging all “profits” for new bills.

The scheme did not last long. Quite quickly, the Wall Street Journal estimated that 160 million coupons would have to be bought and sold to keep the scheme running, compared to only 27,000 issued worldwide at the time. The investigation showed that in fact Ponzi did not invest anything anywhere, but simply spent money and paid interest to the first applicants, that is, the scheme was a simple pyramid scheme. Charles Ponzi was not a very successful swindler, but he was the first to come up with an explanation of future profits that was logical enough for a sophisticated investor. Since then, almost all pyramid schemes have used complex financial instruments as a basis to explain their “activities”.

It would seem that the pyramids have been known for hundreds of years, their signs are described in textbooks, and the practice of dealing with them has no less time. If in the 90s the spread of schemes in the post-socialist space could be explained by the naivety of the population, the underdevelopment of the financial market and the lack of legislation, now these explanations hang in the air. In our recent history, there was “MMM”, the collapse of which led to considerable unrest and required government intervention and a change in laws. There is an example of the whole Albanian civil war, when it turned out that most of the country’s national economy was involved in several pyramids, the collapse of which led to significant armed clashes, the death of 2000 people and the looting of the national treasury.

But these explanations are not very good. We have the example of Bernie Madoff’s 48-year pyramid scheme in the United States, defrauding 3 million highly sophisticated investors, including Hollywood stars, senators, fund managers, and stealing an unprecedented $64 billion. Despite the warnings of auditors and regulators, Madoff’s reputation was impeccable, in fact, until the arrest.

So why do people still continue to participate in the pyramid schemes? After all, the signs of a pyramid are obvious: the yield is significantly higher than bank deposits, the promise of guaranteed profitability, complex explanations of ways to make a profit such as “offshore investments in crypto-currency securized hedge funds”, lack of registration as a participant in the financial market, complex schemes for withdrawing “profits”. Nevertheless, professional investors fall into the pyramids in the same way as naive pensioners.

Science explains this phenomenon by the fact that a real person, unlike that described in economic theory, rarely acts rationally, since his decisions are always subject to cognitive distortions. Fraudsters usually play on these distortions. Both Madoff and Ponzi used, among other things, a “sampling error” scheme. Madoff was a well-known philanthropist who spent millions on charity, and a deeply religious man. Among his friends who made money on investments in Madoff’s company was Steven Spielberg himself. The essence of the sampling distortion is that if we look at the starry sky, we will see mainly giant stars, making the wrong conclusion that all stars are huge and bright, despite the fact that most stars in the Universe are dwarfs, and we simply do not have them. see. Attracting stars who have become even richer on the scheme convinces us of the correctness of the choice. The first clients to get rich in the Ponzi scheme were poor Italian migrants, which attracted a huge number of migrants from other diasporas to the scheme.

The second important distortion is that people do not calculate the probabilities of events badly, they are counterintuitive for a person. We also deal with risks poorly. Decisions, including investment decisions, are almost always made on the basis of optimism and self-confidence.

The next important factor is confirmation bias. Most people tend to seek confirmation of their point of view, beliefs, hypotheses, while discarding information that does not fit into their vision of the world. Despite the fact that all leading economists, central banks and regulators have always warned investors about the dangers of cryptocurrencies as a financial instrument – moreover, the cryptocurrency market has already collapsed more than once, ruining hundreds of thousands of people – the number of believers in a bright cryptocurrency future does not decrease. And finally, there is the framing effect. Information can be submitted (and, as a rule, is submitted) in a form that affects the perception of this information in the desired key. Modern propaganda is based on this effect. Loss information can be submitted as a gain; information about a gain can be submitted as a loss. Framing is a powerful tool for fraudsters and is used all the time to influence investors’ decisions.

Of course, the reasons for the growth of the pyramids in our country in recent years require a detailed scientific study, but I will allow myself to put forward a number of hypotheses. First, the gradual exclusion of professional Russian investment players from the international market forced them to look for highly profitable instruments in the domestic arena. At the same time, the domestic market, in turn, could not, by and large, offer these tools, unlike scammers who were ready to make such offers. Secondly, the new Internet reality gave rise to the “stars” of social networks, largely randomly giving money and influence to people who were not ready for this, which was used by numerous scammers, making new “stars” sometimes victims, and sometimes accomplices of schemes. . And, finally, the general negative information agenda of recent years is neuroticizing society, creating a crisis of confidence, increasing the number of wrong decisions, including financial ones.