Stepping Stones to Fraud

Fraud is a persistent obstacle in the functioning of the financial sector in all countries. Certain themes like defrauding of ignorant investors, sale of securities based on false disclosure, market manipulation, abuse of settlement procedures, trades at unusual prices in order to do transfer pricing, and cartel formation, recur again and again across countries and across the years.

In this article, we will examine a stylised set of `stepping stones' in financial fraud. Many major frauds in recorded history go through some or all of these steps. Knowing these steps will help us understand and anticipate fraud. From a policy perspective, these steps focus regulatory attention on weak links in the financial system. From an individual perspective, awareness of these steps will help avoid being defrauded.

The `canonical fraud' goes through six steps:

I. Promises of high return with low risk
One common starting point of a great deal of fraud are promises of high rates of return. Such promises were present in the case of CRB and in the famous real estate fraud of Prudential-Bache in the US.
II. High risk investments
The only way any financial company can give such high returns is by taking high risks. Hence many firms which have collected funds based on unrealistic promises are tempted to take massive bets of obtaining supernormal returns by taking high risks. High leverage (i.e. purchases of assets financed by borrowings) is a common feature of almost every financial crisis.
III. Failure of high risk investments
Most high risk investments fail to generate the desired returns. Even if these poorly thought out strategies work for a month or two, they do not continue to work for long. Some of the most dangerous investments here are in real estate, financed by bank loans, where the pressure of daily valuation (as in the stock market) is absent, and where the illiquidity of the assets inhibits counteraction.
IV. Ponzi Schemes, or Pyramiding
At this point, many scamsters embark on pyramiding, where investors of last week are paid high returns out of fresh capital obtained from the investors of this week. The original Ponzi scheme, of 1920, consisted of promising investors 50% returns in 45 days. This works well in the early phases, attracting investors by the dozen who are impressed by the success stories that are visible. As intelligent a man as Isaac Newton lost 20,000 pounds in the South Sea bubble. This is obviously not a sustainable state of affairs - after two or three iterations, a ponzi scheme requires a massive scale of interest to sustain itself. Showmanship and high publicity are used in every ponzi scheme, but new avenues for fund raising are soon imperative.
V. Crime
Criminal alternatives are vigorously explored at this stage. A fair amount of opportunism is displayed here; criminals are rational in the sense of investing their efforts where the regulatory apparatus is the weakest. Financial markets where anonymity is lacking are often easy targets of crime.
VI. Exposure
Every scam breaks at some point; some take longer than others. The fixed income scam in India seems to have started in 1985 or so but was exposed in 1992. Exposure has been associated with catastrophic consequences for key personnel of the scandal, including escape to foreign countries, imprisonment and suicide. Charles Blunt, insider to the South Sea Company, cut his own throat in 1720 following exposure.

Steps I - VI are a commonly observed sequence, but the script varies with many scandals. Some scams start off directly into criminal activities. However, it may be useful to point out that many scams originate with fairly honest people who make promises of returns which cannot be met; this leads to pyramiding and/or crime.

What can investors and regulators do to combat these rungs of the ladder of fraud?

A gentleman from the World Bank once commented to me that India has fared better than many east asian countries on the subject of financial fraud thanks to the fear of the free press, and thanks to the greater success at obtaining prison sentences in India for white collar crime as compared to that seen in many countries. Similarly, the US has a very good track record of imprisoning individuals exposed in financial scandals, e.g. Ivan Boesky, Michael Milken, etc. These institutions - a strong and competent media, and a high probability of imprisonment deriving from exposure - are the foundation of a well functioning financial sector.

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