Risk Management Lessons from Madoff Fraud

Abstract

In December 2008, as the financial and economic crisis continued on its devastating course, a new scandal bursts. After the 1998's failure of Long-Term Capital Management, Madoff's fraud brings once again the discredit on the hedge funds industry. This one is however of a different kind. Indeed, Madoff's firm is not a standard hedge fund but a developed Ponzi scheme. By explaining Madoff's system and exploring the reasons to its collapse, this paper draws risk management lessons from this fraud, especially for operational risk management. Risk management rules as applied nowadays partially failed to prevent Madoff's scandal. This paper presents the issues for risk capital requirements raised by Madoff collapse. Implications for due diligence processes, including the use of quantitative replication to assess hedge fund performance's credibility, are also considered. Finally, consideration is given to the regulatory and standardizing approaches of the hedge fund industry as an answer to frauds of Madoff's kind.

Keywords: Madoff fraud, Ponzi scheme, operational risk, due diligence, supervision, hedge funds, bull spread strategy, split strike conversion

JEL Classification: G1, G3