FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags
After the Madoff scandal, an allocator rewrites its due diligence policy. Which of the following changes best addresses a structural weakness that regulators also overlooked?
Requiring independent administrators, custodians and reputable auditors addresses the structural weakness. Madoff controlled trading, custody and reporting himself and used an obscure auditor, so no one verified the assets. Separation of functions creates independent checks that neither the regulator nor investors had in practice.
- AAllow the manager to act as its own broker-dealer, custodian and executor provided its returns are consistent and low in volatility
- BRequire independent administrators, custodians and reputable auditors, so that no single party controls the trading, custody and reporting of fund assetsCorrect
- CTreat low volatility and steady positive returns as evidence of strong risk controls and raise the allocation limit accordingly
- DReplace on-site operational reviews with reliance on the manager's regulatory filings
Explanation
Madoff combined advisory, brokerage and custody under one roof and used an obscure auditor, which removed independent checks and which examiners did not challenge. Separation of functions with reputable independent service providers restores checks and balances. The other options either accept or reward the structure and returns that were red flags.
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