Trader’s Narrative

Due diligence has many meanings depending on context. If you pressed me for a definition within finance, I would say it is:

The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship.

If you suffered losses as a result of Madoff’s fraud, then this lesson is extremely expensive. If not, it is probably the biggest gift Madoff has given the world.

As an investor or trader, you have to perform due diligence not on just trades or investments, but also on your broker or prop firm, your bank, your accountant, etc. Each link in the chain is vital. Never assume anything. Check and verify every little detail. As this most recent event has shown beyond a shadow of a doubt, you have to take personal responsibility and can not have the SEC or FBI do it for you.

Madoff’s Ponzi scheme has snared not just wealthy individuals but very large instititutions like Nomura, BNP Paribas, Neue Privat Bank, Santander, UniCredit, Lombard Odier, Royal Bank of Scotland as well as dozens and dozens of fund of funds that allocated portions of their assets under management to Madoff. These institutions supposedly have whole departments full of lawyers and accountants who are given the task of due diligence. Each and everyone of them failed their fiduciary responsibility and will probably be sued by those who experienced losses.

Just out of curiosity, I looked the website for Optimal Investment Services, the hedge fund arm of Banco Santander. Here is a snippet:

Optimal clients were exposed to the tune of 2.33 billion euros or $3 billion US dollars, according to a report from Bloomberg.

What sort of due diligence did they perform exactly? one that didn’t flag a potential problem with Madoff being the broker, custodian and investment manager, all rolled into one? one which missed the fact that a tiny one person accounting firm did their annual audit?

A lot of heads in “due diligence” and “risk management” departments are going to roll.