Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Madoff, Markopolos and the SEC

The Wall Street Journal has a bland
story
(subscription required) about the efforts made by a rival
hedge fund manager named Markopolos to convince the SEC back in 2005
that Madoff was running a Ponzi scheme. Much more interesting are two
documents that the WSJ has put up on its public pages (no subscription
required) on this subject: Markopolos’ nineteen page submission
to the SEC describing all the red flags about the Madoff operation and
extracts
from the SEC’s Case Opening Report and Case Closing
Recommendation.

I found the Markopolos submission extremely persuasive and well
argued. It appears to me to be a good example of forensic economics
– the difference being that this is done not by academics (like
the Nasdaq market making study) but by one of Madoff’s
rivals.

Markopolos’ theoretical argument that Madoff’s
alleged option trading strategy would deliver T-bill like returns is
absolutely correct. This is what we teach in all derivative courses.

Markopolos also makes a valid argument about the open interest in
the exchange traded options being too small to support Madoff’s
alleged strategy given the large funds under management. He also
points out that OTC option trades on this scale would breach
counterparty limits and therefore explicitly requests the SEC to seek
trade confirmation directly from the trading and operations teams at
the counterparty.

What I found most interesting is Markopolos’s analysis of why
Madoff did not set up a hedge fund himself but instead chose to be a
white label agent for hedge fund of funds. Markopolos argues that it
does not make sense for Madoff to give up the attractive 2/20 fees of
a hedge fund unless he has something to hide. He also argues that the
arrangement is best described as Madoff borrowing money at 16%
interest. It is worthwhile understanding this part of the submission
in detail, because the moment one accepts this analysis, it becomes
clear that it can only be a Ponzi scheme.

Why then did the SEC miss all this? I could not get away from the
feeling that the SEC bungled this investigation very badly. But I also
suspect that regulators are much more geared towards dealing with
complaints from whistleblowers or other complaints with a
“smoking gun” proof rather than some forensic economics
that most regulators probably do not understand. Perhaps also the fact
that a complaint comes from a rival automatically devalues its
credibility in the eyes of many regulators.

I believe that in financial regulation, both these attitudes are
completely mistaken. Forensic economics is usually more valuable than
“smoking guns” and complaints by rivals and other
interested parties are the best leads that a regulator can
get. Regulators should perhaps hire some PhDs in market microstructure
and derivative pricing in their surveillance and enforcement
departments. Under normal times, PhDs in these fields would probably
not want to work in these departments of a regulator, but these are
unusual times.

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