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

An allocator reviewing a hedge fund that reports steady monthly returns of about 1% with almost no down months learns that the fund's entire trading, custody, and brokerage function is handled by the manager's own affiliated broker-dealer. Which concern is the most direct operational red flag from this structure?

The key concern is the lack of independent verification. When one affiliated firm manages, executes and holds custody of assets, no outside party can confirm trades or holdings, so fabricated statements can go undetected. This was central to the Madoff fraud.

  1. AThe affiliated broker-dealer will charge lower commissions, which reduces the fund's net returns
  2. BAbsence of independent third-party verification of trades and assets, weakening checks and balancesCorrect
  3. CThe fund will be unable to use leverage because of regulatory limits on affiliated brokers
  4. DThe fund's returns will be too volatile to match its stated strategy

Explanation

In the Madoff case, the adviser, broker-dealer and custodian were all the same firm, so no independent party confirmed trades or holdings. This removes segregation of duties and lets fabricated statements go undetected. Lower commissions and leverage limits are not the core issue.

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