Why Bernie Madoff’s Scheme Proves We Must Abolish The SEC

In the wake of the largest swindle Wall Street has even known, everyone is questioning how this could have happened. How could anyone run a 50 billion dollar Ponzi scheme right under the SEC’s nose? The SEC, with virtually limitless resources, has the power to do essentially whatever it wants when investigating fraud. So how could they miss this? Is this just a failure of the free market, an example that those hedge funds just have too much freedom, and government regulators need more power and resources? Not at all – in fact, quite the opposite.

This is a wake up call for investors and the public. Where the SEC failed to spot a problem, the free market saw it. Eighteen months ago, a firm named Aksia run by Jim Vos and Jake Waltour, warned clients not to do business with Bernard Madoff’s investment fund. Aksia is what’s called a due-diligence firm, and they’re an example of what regulation would look like in a true free market.

Because of the lack of government regulation in hedge funds, these due-diligence firms emerged. Investors wanted to be assured that their money was going to a reputable fund, so these companies thoroughly investigate hedge funds for a fee.

Since these firms are operating in the free market and competing with one another (as opposed to the SEC, which has a monopoly on the business of regulation), they have incentives to do the best job so that they gain the best reputation in the business, thus increasing their customers and their wealth.

And Aksia was thorough; they found a number of red flags in Madoff’s fund during it’s investigation, including:

1. The Madoff investment strategy, called “split-strike conversion,” is known to be very volatile; it involves trading huge positions around options expirations. Despite that volatility, its returns over the past decade were an amazingly stable 8-10 percent.

2. Aksia discovered a 2005 letter to the Securities and Exchange Commission from a financial advisor who supposedly studied Madoff’s operations. That letter asserted Madoff was running a Ponzi scheme. There was also a Wall Street Journal story at the time about one of the Madoff’s associated “feeder funds” getting shut down in 1992.

3. Madoff’s strategy was bizarre: He said he would move $13 billion in various trades at once, yet Aksia couldn’t find traders who saw his trades. There were also no regulatory filings. And family members were running the firm.

4. The comptroller of the firm was based in Bermuda. Most mainstream hedge fund investment advisers have their comptroller in-house. Madoff’s so-called feeder funds, meanwhile, were audited by respectable auditors. That gave the impression that Madoff had a professional operation. But the central investment action wasn’t with the feeder funds, but in Madoff’s New York City headquarters. And those activities were audited by a smaller, lesser known firm.

5. Madoff sent out accounting statements by mail. Most hedge funds email statements and allowed them to be downloaded via computer for easier analysis by investors.

6. Aksia wasn’t the first firm to check out Madoff’s activities. A two-man shop (not counting the secretary) which operated out of a small office in Muncie, N.Y., was also looking into Madoff’s activities.

So whats the moral of this story? The SEC simply cannot protect investors as well as free market systems can. The SEC failed to protect investors from mortgage-backed securities and credit default swaps and collateralized debt obligations – and now it failed to notice a $50 billion dollar Ponzi scheme masquerading as a hedge fund. Unfortunately, some people will see those facts and come to the conclusion that we just need more regulation and the SEC needs more resources.

The SEC failed because it’s a centralized monopoly, it’s that simple. And Bernie Madoff’s scheme succeeded because investors had a false sense of security in that bad system and it’s regulations. Take away that monopolistic regulatory giant, and a system of due-diligence firms would spring up to take it’s place. That type of decentralized system of competing firms is many orders of magnitude better at finding fraud and protecting investors; and it’s been proven so. It would be less expensive and more efficient than the SEC, and it would lower taxes and place the financial burden on the actual investors instead of the entire US population, including non-investors.

It’s just common sense.