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

After Madoff, a fund of funds revises its due diligence policy. Which revision would most directly address the structural weakness that regulators and investors both overlooked?

The most direct fix is requiring segregation of advisory, brokerage and custody functions, with a reputable independent administrator and auditor verifying holdings and trades. Madoff's concentration of roles and a tiny auditor let him fabricate statements unchecked, so independent verification of assets is the key control.

  1. ARely on a manager's reputation and long track record as the primary screen
  2. BRequire that the manager's investment, brokerage, and custody functions be separated, with an independent, reputable administrator and auditor verifying holdings and tradesCorrect
  3. CAccept performance consistency as evidence of low risk and reduce monitoring frequency
  4. DDelegate all verification to the regulator's published examination results

Explanation

Madoff acted as adviser, broker-dealer and custodian, with a tiny auditor, so no independent party checked trades. Separating functions and using independent reputable service providers closes this gap. The other options repeat reliance on reputation, smooth returns or regulators, which failed.

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