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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

A feeder fund invests all assets with a single manager who also acts as broker-dealer, custodian of the securities, and executor of all trades, with no independent administrator. Which is the primary governance concern?

The main concern is the lack of segregation of duties. When the manager trades, custodies assets and issues statements, no independent party can verify that assets exist or are valued correctly, which enables fabrication of results to go undetected.

  1. AConcentration of counterparty risk in a single legal entity
  2. BLack of segregation of duties removes independent checks on existence and pricing of assetsCorrect
  3. CExcessive diversification across strategies
  4. DHigher management fees due to bundled services

Explanation

When one entity trades, holds assets, and produces statements, nobody independent can confirm that positions exist or are priced correctly. This lack of segregation allows fabricated statements to go undetected. Counterparty concentration is a related but secondary issue, and fees are not the core concern.

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