Vanderbilt Law Review

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Temptation. It lies at the heart of financial swindles. The promise of 50% returns in three months can lure thousands of investors-so too can a stock that soars 500% in three years. But those who are tempted are often skeptical. Before they invest, they want to know how one can enjoy such supracompetitive returns. The answer usually is a facially plausible story, though with a bit of mystery attached. The mystery is often touted as the reason that the investment opportunity is exclusive to the entrepreneur who discovered it. It is what ensures that the gains are not competed away. The classic case remains that of Charles Ponzi. While not a very adept con artist-he was caught several times-in a six-month period in 1920, Ponzi convinced ten thousand investors to part with an aggregate of $9.5 million. He promised amazing returns-50% in ninety days. As a testament to his financial wizardry, Ponzi often paid off his investors in half the time he had initially promised. How could he work such financial magic? Allegedly, Ponzi had discovered a lucrative arbitrage opportunity in postal reply coupons. Postal reply coupons allowed the sender of a letter to ensure that the recipient in another country would be able to obtain sufficient postage to respond. For example, a letter writer in America would purchase a reply coupon here and send it along with a letter to a relative in another country, say, Spain. The Spanish relative could then redeem the coupon for Spanish stamps sufficient to send a reply.

Ponzi noticed a pricing discrepancy in the postal reply coupons. One could buy a coupon in one country for, say, one penny, and redeem it in another for six cents worth of stamps. This opportunity existed because exchange rates had been set in a postal convention in 1906, well before the outbreak of the Great War. The Great War changed the relative value of many currencies, but the rates for postal exchange coupons remained fixed. The failure to adjust the exchange rates on postal reply coupons meant that a trader could buy a postal reply coupon in a country where the relative value of the currency had declined, redeem it in a country where the relative value of the currency had increased, and turn a profit. There were, in theory, gains to be had by exploiting government inertia.

But transaction costs limit any opportunity to profit from arbitrage. Consider the steps necessary to exploit this state of affairs. Money would be gathered in the United States. This money then had to be converted into a foreign currency and put in the hands of an agent in the appropriate foreign country. The agent would have to buy the postal reply coupons in large quantity, although there were limits on the number of coupons that could be bought at one time. The agent then had to send the coupons back to the United States. Another agent would have to redeem them. Given these elaborate requirements, it is hard to imagine how anyone could purchase a sufficient number of reply coupons to support the millions of dollars that Ponzi collected.

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