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

An allocator discovers that a manager acts as investment adviser, executes all trades through its own affiliated broker-dealer, and also holds custody of client securities, with no independent third party in any role. Which risk does this structure most directly create, as illustrated by Madoff?

The main risk is the lack of independent checks and balances. When one firm advises, trades and holds custody, no outside party verifies trades or assets, so fabricated statements can persist undetected, which is exactly how Madoff's fraud operated for decades.

  1. AAbsence of independent checks and balances, enabling fabrication of trades and holdings to go undetectedCorrect
  2. BHigher transaction costs from using an affiliated broker
  3. CGreater interest rate risk in the portfolio
  4. DReduced tax efficiency for investors

Explanation

Madoff concentrated advisory, brokerage and custody functions in one entity, so no outside party could confirm trades or assets. This removes segregation of duties and allows fictitious records. Costs or tax issues may exist but are not the central risk of the structure.

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