IMF UNHAPPY WITH UNREGULATED CARIBBEAN

FROM THE JAMAICA OBSERVER

reprinted as fair use

By Al Edwards

The rise of the unregulated financial organisations (UFOs) between 2006 and 2008 in Jamaica, led by the likes of David Smith's Olint and Carlos Hill's Cash Plus, threatened to both undermine and destabalise the country's legitimate financial sector. The demise of these schemes has marked a return to a semblance of the status quo and a time to reflect on why these organisations became so popular. To that end, the IMF has recently published a working paper entitled Ponzi Schemes in the Caribbean by Ana Carvajal, Hunter Monroe, Catherine Pattillo and Jamaica's very own Brian Wynter.

The IMF notes that in several Caribbean states, unregulated investment schemes grew quickly by claiming unusally high monthly returns and through a system of referrals by existing members. It posits that such high returns are usually associated with Ponzi Schemes.

"Such schemes are pervasive and persistent phenomena and emerge on a regular basis even in developed countries with strong regulatory frameworks as shown by the recent experience in the United States with US$50 billion alleged Ponzi scheme run by Bernard Madoff. However, their impact has been greater in countries with weaker regulatory frameworks. This is illustrated by the well-known case of Albania and by more recent and ongoing cases in the Caribbean and Colombia," reads the working paper.

In the case of Ponzi schemes, returns may be paid to investors out of the money paid in by subsequent investors rather than from genuine profits. These schemes usually offer higher returns than any legitimate business activity could plausibly sustain, in order to lure investors. Ponzi schemes usually have to attract new investments at an exponentially growing rate to sustain payments to existing investors and inevitably collapse when the new investment needed exceeds the size of the target market.

"Ponzi schemes are insolvent from the moment that they take in money from investors. Their liabilities to investors exceed their assets as the value of liabilities increases at the inflated rate of return, while assets may be depleted by the running costs of the schemes or possibly suffer from other depredations.

"As the experience of different countries has shown, the "business opportunity" advertised to lure investors into putting their money in a Ponzi scheme can vary in nature, from straightforward investments in stocks or bonds, to less traditional financial sector products such as currency trading, to investments in non-financial assets, such as real estate and cars. These business opportunities are only limited by the imagination of the perpetrator and the gullibility of the investor," says the IMF.

As far as Jamaica is concerned, many of the schemes purported to make their returns from foreign currencies trading, but nowhere in this world has this form of trading made consistent returns of above 10 per cent per month. Jamaica's main regulatory body, the Financial Services Commission has yet to unequivocally determine whether the likes of Olint, Cash Plus and World Wise were either Ponzi or pyramid schemes. The lead principal of Olint, David Smith, still maintains that his operation was not a duplicitous scheme which saw him taking investors' money to pay out high returns.

The labels Ponzi scheme and pyramid scheme are often used interchangeably to describe specific forms of investment fraud where sustainability depends on the influx of new "investors" to the scheme. However, from a technical perspective, there are differences in the way the two types of schemes operate. Pyramid schemes are a form of fraud where the expected benefit to members depends primarily on the number of individuals they recruit, which is not necessarily the case in a Ponzi scheme. Ponzi schemes often grow larger than pyramid schemes as they can take in unlimited amounts from an individual and can continue to operate indefinitely, as long as payments demanded by investors from the scheme do not exceed payments by investors into the scheme.

"There are a number of similarities between the life-cycles of pyramid schemes and Ponzi schemes. Both types of schemes typically proceed through the following stages: initiation; validation, when large and easy rewards earned by initial members generate strong word of mouth publicity; expansion, when a large number of people join or massive investments are received; and collapse when defaults occur, the inflows of new funds or members stops, and the promoters may seek to abscond with money. The schemes are inherently likely to collapse and default on most members. Pyramid schemes grow exponentially for a given rate of recruitment until they exhaust the pool of potential members. Inflows in a Ponzi scheme must also grow exponentially, if investors do not reinvest all earnings," noted the IMF working paper.

The collapse of the Stanford Group of Companies and its ramifications for Antigua has placed the spotlight on the Caribbean and the proliferation of unregulated investment schemes in the region. Such types of schemes can undermine investor confidence in financial institutions and may explain why leading commercial banks like Jamaica's National Commercial Bank took measures to ensure that these schemes would not gather into epidemic proportions with the potential to destabilise entire financial sectors.

"The longer that these schemes operate, the more damage they are able to inflict. Thus, the main policy lesson that can be extracted from countries' experiences with Ponzi schemes is the need for a rapid and early response from financial regulators and law enforcement authorities, to identify and stop the schemes and protect investors' interests. However, responding swiftly has proven to be a challenge in many countries.

"Other policy lessons involve tackling the social dimensions of the phenomenon by means of programmes to enhance financial litereacy and personal financial responsibility amongst members of the public. In the case of Ponzi schemes operated by regulated entities such as offshore banks, the lessons point more simply towards the dangers of weak regulatory frameworks and inadequate supervision.

The recent Caribbean experience has heightened the awareness of regulators and potential investors to the risks associated with UFOs. However, awareness alone will not prevent a recurrence and the experience shows that fraudulent schemes will emerge on a regular basis, even in financial markets with strong regulatory frameworks.

Thus it is necessary that countries work together in enhancing their legal and regulatory frameworks," suggested the IMF.

The working paper on Ponzi Schemes in the Caribbean poses two questions that are yet to be answered by Caribbean institutions set up to keep UFOs in check; namely what are the key conditions that need to be in place for regulatory agencies to be able to take adequate actions against the schemes, and second, what are the key actions that authorities should take?