The Real Take-Away from the Madoff Scandal

Shocked? Yes. Surprised? No. This “stuff” (scandals so shocking that they practically take your breath away) can and does happen for a variety of reasons. The Madoff scandal is so interesting not for the classic reasons – abhorrent due diligence practices by fiduciaries, basing enormous financial decisions on the word of friends, wanting to be part of an “exclusive” club, etc. – but for the gaps it highlights in our regulatory apparatus.

Hedge funds, the purported touchstone of the unregulated entity, are far more regulated and subject to many more checks and balances than Madoff ever was. I’ve long made the argument that hedge funds are actually heavily regulated, not directly but indirectly through their relationships with the heavily regulated prime brokers. Forget about the negative PR and spin – it’s true. Prime brokers have full transparency into the books of hedge funds, contribute data to the reporting of Net Asset Value (NAV), which is generally pumped out by the hedge funds’ administrator. There is a further layer of protection offered by the hedge fund’s auditor. Unless everyone is in cahoots it is pretty hard to see how a hedge fund is systematically mis-reporting NAV (except with respect to illiquid assets, but this is another issue entirely).

Some of the biggest non-market risks of hedge funds include style drift (veering from the strategy outlined in the prospectus, such as when Amaranth’s natural gas trades ceased to make it a multi-strategy fund), creeping illiquidy (taking advantage of the illiquid asset carve-out in the prospectus only to see the value of the liquid assets fall, resulting in a prospectus-breaching concentration in illiquids), overuse of side pockets (concentrated, balky public positions that don’t fall under the rubric of illiquids yet result in a similar risk profile) and manager fatigue (“If I’m down 50% and it will take me years to dig out from under my high water mark, I’ll just shut down”). Note that these risks have to do with the character of the manager, things that a good due diligence process should ferret out. But they really don’t have to do with the veracity of the firm’s positions, books and records, as third-party involvement together with the regulatory oversight of the prime brokers makes the Madoff kind of fraud highly unlikely.

But Madoff is a completely different kind of firm. It is a broker/dealer with an asset management division, enabling it to rely entirely on itself for trading and settlement. Further, it used a no-name, three-person accounting firm, unheard of for a firm of Madoff’s size, scope and complexity. A purely rational trader of Madoff’s stature would have set up a hedge fund business to extract 2/20 from his clients. I guess we now understand why; it would have subjected his portfolio to the unwanted scrutiny of his prime brokers. By keeping his game completely in-house and on the down low, it essentially fell through the cracks of our regulatory structure. Will this cause the SEC to redouble its efforts in regulating broker/dealers? Force changes in transparency, similar to what I’ve pushed for in the OTC derivatives market to the broker/dealer community? Or is it simply a matter of creating rules that ensure credible third-party involvement in the validation of assets under management/NAV in order that Madoff’s brand self-dealing couldn’t be sustained?

When it comes to client funds, I believe the involvement of multiple third-parties in the validation of positions and NAV is critical. Checks and balances have to be built into the system, and by employing a structural approach to regulation as opposed to simply adding more regulations, I believe we can minimize the friction in the system while providing the necessary protections to individuals and institutions. The lack of trust so pervasive in today’s financial markets just took another hit. But let’s take a moment to think of the right way to address the issue (better due diligence, higher standards for fiduciaries, imposition of checks and balances with broker/dealers and asset managers working under the same roof), rather than the way that plays best for PR purposes.

Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!

About Roger Ehrenberg 94 Articles

Roger is an active early-stage investor, having seeded or invested in over 20 companies in asset management, financial technology and digital media since 2004. Prior to his venture days Roger spent 18 years on Wall Street in M&A, Derivatives and proprietary trading.

Throughout his career he has held numerous executive positions, including:

President and CEO of DB Advisors LLC, a wholly-owned subsidiary of Deutsche Bank AG. His 130-person team managed over $6 billion in capital through a twenty-strategy hedge fund platform with offices in New York, London and Hong Kong.

Managing Director and Co-head of Deutsche Bank’s Global Strategic Equity Transactions Group. In 2000, his team won Institutional Investor magazine’s “Derivatives Deal of the Year” award.

As an Investment Banker and Managing Director at Citibank, he held a variety of roles and responsibilities in the Global Derivatives, Capital Markets, Mergers & Acquisitions and Capital Structuring groups.

Roger sits on the Boards of BlogTalkRadio; Buddy Media; Clear Asset Management; Global Bay Mobile Technologies and Monitor110. He is currently Managing Partner of IA Capital Partners, LLC.

He holds an MBA in Finance, Accounting and Management from Columbia Business School and a BBA in Finance, Economics and Organizational Psychology from the University of Michigan.

Visit: Information Arbitrage

Be the first to comment

Leave a Reply

Your email address will not be published.


This site uses Akismet to reduce spam. Learn how your comment data is processed.