Clauss, Pierre and Roncalli, Thierry and Weisang, Guillaume (2009): Risk Management Lessons from Madoff Fraud. Published in: International Finance Review , Vol. Credit, No. 10 (2009)
Download (911Kb) | Preview
In December 2008, as the nancial and economic crisis continued on its devastating course, a new scandal erupted. After the 1998's failure of Long-Term Capital Management, Madoff's fraud once again discredits the hedge funds industry. This scandal is however of a dierent kind. Indeed, Madoff's rm is not a standard hedge fund but a developed Ponzi scheme. By explaining Madoff's system and exploring the reasons for its collapse, this paper draws risk management lessons from this fraud, especially for operational risk management. Present day risk management processes have partially failed to prevent the Madoff scandal. This paper presents the issues for risk capital requirements raised by the collapse of the Madoff scheme. Implications for due diligence processes, including the use of quantitative replication to assess the credibility of the performance of a hedge fund, are also considered. Finally, consideration is given to the regulatory and standardizing approaches of the hedge fund industry as a response to frauds similar to that of Madoff.
|Item Type:||MPRA Paper|
|Original Title:||Risk Management Lessons from Madoff Fraud|
|Keywords:||Madoff fraud, Ponzi scheme, operational risk, due diligence, supervision, hedge funds, bull spread strategy, split strike conversion|
|Subjects:||G - Financial Economics > G1 - General Financial Markets
G - Financial Economics > G2 - Financial Institutions and Services
|Depositing User:||Thierry Roncalli|
|Date Deposited:||18. Feb 2012 14:07|
|Last Modified:||11. Feb 2013 20:12|
AIMA. Guide to Sound Practices for European Hedge Fund Managers. Alternative Investment Management Association, April 2007.
Basel Committee on Banking Supervision. The new basel capital accord -- second consultative document, January 2001.
Basel Committee on Banking Supervision. Working paper on the regulatory treatment of operational risk, September 2001.
Basel Committee on Banking Supervision. The quantitative impact study for operational risk: Overview of individual loss data and lessons learned, January 2002.
Basel Committee on Banking Supervision. The 2002 loss data collection exercise for operational risk: Summary of the data collected, March 2003.
Carole Bernard and Phelim P. Boyle. Mr. Madoff's amazing returns: An analysis of the split-strike conversion strategy. March 2009. Available at SSRN: http://ssrn.com/paper=1371320.
Utpal Bhattacharya. The optimal design of ponzi schemes in nite economies. Journal of Financial Intermediation, 12(1):2-24, January 2003.
Stephen J. Brown, Thomas L. Fraser, and Bing Liang. Hedge fund due diligence: A source of alpha in a hedge fund portfolio strategy. January 2008. Available at http://ssrn.com/paper=1016904.
Stephen J. Brown, William N. Goetzmann, Bing Liang, and Christopher Schwarz. Mandatory disclosure and operational risk: Evidence from hedge fund registration. Journal of Finance, 63(6):2785-2815, December 2008.
Charles W. Calomiris and Richard J. Harring. The regulation of operational risk in investment management companies. Investment Company Institute Perspective, 8(2):1-19, September 2002.
Nicholas T. Chan, Mila Getmansky, Shane M. Haas, and Andrew W. Lo. Do hedge funds increase systemic risk? Economic Review - Federal Reserve Bank of Atlanta, 91(4):49-80, 2006.
Nicholas T. Chan, Mila Getmansky, Andrew W. Lo, and Shane M. Haas. Systemic risk and hedge funds. In M. Carey and R. Stulz (eds), The Risks of Financial Institutions and the Financial Sector, Chicago, IL, 2007. University of Chicago Press.
Economist Staff. Con of the century. The Economist, 389(8611):119-120, December 20, 2008.
Franklin R. Edwards. Hedge funds and the collapse of long-term capital management. Journal of Economic Perspectives, 13(2):189-210, Spring 1999.
Laurence Fletcher. Dollar compounds funds of hedge funds' Mado woes. Reuters, February 9, 2009. http://uk.reuters.com/article/americasHedgeFundsNews/ idUKLNE51904620090210.
Dean P. Foster and H. Peyton Young. The hedge fund game: Incentives, excess returns, and piggy-backing. Technical report, Economics Group, Nueld College, University of Oxford, March 2008.
Antoine Frachot, Pierre Georges, and Thierry Roncalli. Loss distribution approach for operational risk. Groupe de Recherche Opérationnelle, Crédit Lyonnais, Working Paper, March 2001. Available at SSRN: http://ssrn.com/paper=1032523.
Antoine Frachot, Olivier Moudoulaud, and Thierry Roncalli. Loss distribution approach in practice. In Michael Ong, editor, The Basel Handbook: A Guide for Financial Practitioners, chapter 15. Risk Books, December 2003.
Julian Franks, Colin Mayer, and Oxford Economic Research Associates. Risks and regulation in european asset management: Is there a role for capital requirements? Technical report, European Asset Management Association, January 2001.
William Fung and David A. Hsieh. Will hedge funds regress towards index-like products? Journal of Investment Management, 5(2), 2007.
Mila Getmansky, Andrew W. Lo, and Shauna X Mei. Sifting through the wreckage: Lessons from recent hedge-fund liquidations. Journal of Investment Management, 2:6-38, 2004.
Christian Gilles and Stephen F. LeRoy. Bubbles as payos at innity. Economic Theory, 9(2):261-281, June 1997.
Greg N. Gregoriou and François-Serge Lhabitant. Madoff: A riot of red ags. EDHEC Publications, January 2009.
Bernardo Guimarães. Good ponzi schemes and the price of debt. London School of Economics, Working Paper, March 2005.
HFWG. Hedge Fund Standards: Final Report. Hedge Fund Working Group & Hedge Fund Standards Board, January 2008. Available at http://www.hfsb.org/files/final_report.pdf.
Alexander Ineichen and Kurt Silberstein. Aima's roadmap to hedge funds, November 2008. Commissioned by AIMA's Investor Steering Committee, available at http://www.aima.org/en/knowledge_centre/education/aimas-roadmap-to-hedge-funds.cfm.
Katherine Burton John Helvar and Vernon Silver. Madoff's mayhem. Bloomberg Markets, 18(3):104-107, March 2009.
Philippe Jorion. Risk management lessons from long-term capital management. European Financial Management, 6(3):277-300, 2000.
Amir E. Khandani and Andrew W. Lo. What happened to the quants in august 2007?: Evidence from factors and transactions data. Available at SSRN: http://ssrn.com/paper= 1288988, October 2008.
Charles Kindleberger. Manias Panic, and Crashes, A History of Financial Crisis. Basicbook, New York, 2nd edition, 1989.
Andrew W. Lo. Risk management for hedge funds: Introduction and overview. Financial Analysts Journal, 57(6):16-33, November 2001.
Andrew W. Lo. Hedge funds, systemic risk, and the nancial crisis of 2007-2008. Written testimony prepared for the U.S. House of Representatives Committee on Oversight and Government Reform Novermber 13, 2008 Hearing on Hedge Funds, November 2008.
Paul Maidment. Naked swimming and macroprudence. Forbes.com, August 22, 2008.
Harry Markopolos. The world's largest hedge fund is a fraud. Letter to the SEC, November 7, 2005.
Marco Moscadelli. The modelling of operational risk: experience with the analysis of the data collected by the basel committee. Banca d'Italia, Temi di discussione del Servizio Studi, 217, July 2004.
Reiko Nahum and David Aldrich. Hedge fund operational risk: meeting the demand for higher transparency and best practices. Journal of Financial Transformation, 22:104107, 2008.
Dale A. Oesterle. Regulating hedge funds. Ohio State Public Law Working Paper No. 71; Center for Interdisciplinary Law and Policy Studies Working Paper No. 47, June 2006. Available at SSRN: http://ssrn.com/paper=913045.
Technical Committee of the International Organization of Securities Commissions. The regulatory environment for hedge funds: a survey and comparison, November 2006. Available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD226.pdf.
Technical Committee of the International Organization of Securities Commissions. Proposed elements of international regulatory standards on funds of hedge funds related issues based on best market practices, October 2008. Available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD281.pdf.
Technical Committee of the International Organization of Securities Commissions. Report on funds of hedge funds, June 2008. Available at http://www.iosco.org/library/ pubdocs/pdf/IOSCOPD276.pdf.
Thierry Roncalli and Guillaume Weisang. Tracking problems, hedge fund replication and alternative beta. January 2009. Available at SSRN: http://ssrn.com/paper=1325190.
Klarita Sadiraj and Arthur Schram. Informed and uninformed investors in an experimental ponzi scheme. University of Amsterdam, Working Paper, February 1999.
René M. Stulz. Hedge funds: Past, present and future. Journal of Economic Perspectives, 21(2):175-194, Spring 2007.
Jean Tirole. On the possibility of speculation under rational expectations. Econometrica, 50:1163-1181, 1982.
David Walker. Hedge-fund redemptions were $382 billion in 2008. wsj.com, January 21.