Madoff and Outsourcing

DQI Bureau
New Update

A lot has gone wrong with the world economy in 2008 but the Madoff fraud will

stand out as one of its worst moments. The fraud has come to light just a few

weeks ago and the true impact will not be clear for some more months. It is,

however, safe to say that it is a financial 9/11 event that will leave many

things changed forever.


The Outsourcing Ecosystem for Hedge Fund

My company services nearly 1,000 funds. And knowing hedge fund operations

intimately, at first I couldnt believe that such a fraud could have continued

for so long without being discovered.

If you look at normal hedge fund operations, there is a large cast of service

providers. At a minimum it will include the investment manager who manages the

funds assets; the prime broker who executes the trades and provides credit

lines; the custodian who holds all securities; the bank who provides cash

management services; the administrator who maintains independent books of

account and reports to Investors; and the auditors who audit annual accounts.

Most of the time, you have large, established entities providing these

services (indeed, many of these are global banks) and while there is no

guarantee that any of them may not make an occasional mistake, they do take

their fiduciary duties quite seriously and are regularly audited by the

jurisdictions that regulate them.


What this also represents is an elaborate outsourcing structure that is not

only highly specialized but is delivered by a set of service providers who are

accustomed to handling very complex transactions, high transaction volumes,

working under very stringent time lines and dealing with aggressive, demanding

Investment Managers. While no one will pretend this is easy, these service

providers are no shrinking violets and will push back strongly if they see

something they dont like.

This is the system of checks and balances that creates the Hedge Fund

ecosystem that for the last two decades, has delivered superior investor


The Madoff Scenario

Bernie Madoff side-stepped the whole outsourced service provider structure

by simply choosing NOT to outsource. He did his own administration, his own cash

management and his own investor reporting. He chose an audit firm that was run

by one accountant in his 70s, and two other people, one of which was his



It is important to remember that Madoff was not secretive and his entire web

of fraudulent record-keeping was aimed at one thing onlyto deceive. He staffed

key positions with his friends and relatives. His sons worked in the business.

His compliance officer was his brother. His chief attorney was his niece. His

nieces husband worked with SEC in-charge of compliance inspections. While it

does appear that they did not know the full extent of the fraud, even the most

charitable view possible suggests that they did not question his actions and

records too closely. But above all, Bernie Madoff outsourced nothing.

In an industry where outsourcing of certain functions is the norm, one has to

question why this did not raise huge red flags with institutional investors as

one has to question the regulatory framework of the SEC for domestic funds in

the US, that permits a fund to retain these functions in house.

In the Post Recession World

There are as many supporters of outsourcing as there are detractors. But

cost, politics and nationalistic sentiments apart, outsourcing is an essential

prerequisite that allows a system of checks and balances to operate effectively

in many industries. The world of hedge funds is one such.

Whether the current financial downturn is secular or cyclical is unimportant.

What is important is that the world learns from this experience and the

regulators and investors alike insist on the right level of transparency,

disclosure and oversight to ensure this does not happen again Intelligent

outsourcing must be a major component of the answer.

Akshaya Bhargava

The author is CEO, Butterfield Fulcrum Group