Madoff, 2008Easy

One firm made the investment decisions, held the assets and produced the statements. Nothing about the returns had to be checked by anybody outside it, because there was nobody outside it.

4 min read · 672 words

What happened

• The arrangement — an investment operation reported steady positive returns over many years, with unusually few losing months and a strategy described in terms that were, by design, hard to verify from the outside.
• The structure — the same firm made the investment decisions, acted as broker for the trades, held the assets, and produced the account statements that reported what those assets were worth.
• December 2008 — redemption requests during the financial crisis could not be met, and the operation was revealed as a Ponzi arrangement: returns paid from incoming money rather than from trading. A criminal conviction followed, which is a matter of public record.
• Afterwards — feeder funds that had invested on their clients' behalf were themselves wound up or sued, and a court-appointed trustee spent years recovering payments from those who had withdrawn more than they put in.

The mechanism

• Three roles, one party. A fund normally separates the manager who decides, the custodian who holds and the administrator who values — and here they were the same firm. Every check the structure provides is a check by one of those parties on another, so collapsing them does not weaken the checks; it removes them. How a fund is built sets out what each role is for.
• A statement is a claim until somebody independent confirms it. The reported holdings could not be reconciled against a third party's records because no third party held them. That reconciliation is the single most boring and most load-bearing control in fund operations.
• Consistency is a strange thing to find reassuring. A strategy exposed to markets produces losing periods. Returns that are smooth across regimes are evidence about the reporting process rather than about the strategy — and a smooth line is exactly what an unverified number looks like.
• Delegation does not transfer the obligation. Feeder funds passed money on and passed the diligence question on with it. The end investor's protection depended on somebody having asked who held the assets, and the chain assumed somebody further along had.
• Redemptions reveal, they do not cause. The arrangement failed when withdrawals exceeded incoming money, which is a property of every Ponzi structure and says nothing about the crisis that triggered it. The 2008 outflows were the test, not the reason.

What it teaches

• Ask who holds the assets, and get the answer from them. Not from the manager, and not from the statement the manager sends. This is one question, it is answerable in writing, and it is the one this episode is actually about.
• Ask who calculates the value. An administrator independent of the manager is the difference between a valuation and an assertion — the same distinction the fair-value hierarchy draws for a bank's trading book.
• Treat a strategy that cannot be explained as unexplained. Not as sophisticated. If a description does not let you say what would make it lose money, it is not a description.
• Diligence does not travel down a chain by itself. Each link either asked or assumed, and assuming is invisible until it is tested.
• The controls that matter are structural rather than analytical. No amount of return analysis substitutes for the fact that three roles belonged to one party — and that fact was available from the start, in the documents.

The mechanisms behind this

• How a fund is built — the six parties, and why the decider is never the valuer.
• Fund operations — the seat that runs the reconciliation this episode did without.
• Regulation and investor protection — client-asset segregation and what it is for.
• Reading a fund factsheet — where the administrator and depositary are named.