Hedge Fund Scandals & How Smart Contracts Could Help Prevent Them — Part 1: Ponzi Schemes

In a world defined by its interconnectedness, any mistakes or malevolent activity taking place in the trillion dollar asset management industry will cause ripples of consequence across continents and societies. In the last 30 years, there have been several high profile hedge fund scandals that made it into the mainstream media. Billions of dollars in value has been lost or misappropriated, and the effects are often still being felt many years after the scandals conclusion.

This blog post is the first in a series where we intend to dissect the motivations, actions and fallout from these scandals. We’ll also investigate how in most cases, smart contract based asset management protocols like Melon, running on top of blockchain technologies like Ethereum, could have greatly mitigated the damage caused, or even prevented the underlying issues from arising in the first place.

Without further ado, let’s start at the top…

Ponzi Schemes

The largest Ponzi scheme of all time, and possibly the largest financial fraud in history is estimated to have cost investors up to $65bn, with over 4800 clients affected. What happened? For decades, Bernie Madoff took investments in his fund, and reported strong returns without ever making any actual investments… He simply posted “made up” returns, and spent the capital he was supposed to be investing with on yachts, jets and homes all over the world. As long as he was taking in more investors money than he had to pay back, the ruse could continue.

“F — k my victims. I carried them for twenty years, and now I’m doing 150 years.”
 — Madoff to an inmate who expressed concern for the defrauded investors
Photographers waiting outside the entrance to the apartment block where Bernie Madoff was under house arrest.

How did he get away with it for so long?

It is estimated that Madoff got away with taking investments and posting returns for as long as 30 years whilst the Ponzi scheme was in operation. There were never any real trades in the portfolio, but since Madoff also owned a broker dealer, he could generate “fake trade tickets“ on request. In over 30 years, no authority (eg. the SEC) decided to check whether the trades Madoff said he was completing really matched the assets his fund supposedly held. When asked to be audited by independent auditors, Madoff always said that only his brother was allowed to audit the fund’s performance in case his secret strategy leaked out to the world. When anyone asked for information about his returns, his answers were always vague and mysterious.

“It’s a proprietary strategy. I can’t go into it in great detail” -Bernie Madoff

People bought this false illusion for years and ignored a warning letter issued to the SEC by Harry Markopolos in 2005, which detailed every single red flag. An Assistant Director of the SEC at the time, Eric Swanson, was falling head over heels in love with and eventually got married to Madoff’s niece and compliance manager. It was quite the web of intertangled lies and conflicts of interest. Three years after the scheme came crashing down and Madoff was jailed, many are still paying the price of this scandal.

ABC News via Clusterstock: At a business roundtable meeting last year, Madoff boasted of his “very close” relationship with a SEC regulator, chuckling as he said, “in fact, my niece even married one.”

How could smart contracts have helped avoid this situation?

We can break up the issues into three broad buckets:

Conflict of Interest

In Madoff’s Ponzi scheme, two of the most notable “conflicts of interest” that arose (amongst many others) were that Madoff refused any auditor but his brother, and that the Chairman of the SEC at the time had a romantic relationship with Madoff’s niece and compliance manager. This must have at a minimum contributed to various parties feeling uncomfortable or reluctant to report or investigate for fear of being proven wrong. Fear! Fear of losing their job, losing their loved one or just being generally outcast in society.

By using smart contracts, we can pre-define the rules and parameters of a fund in immutable code. These rules are enforced by the underlying blockchain protocol which is in turn secured by many thousands of financially incentivised nodes across the world, all working to make sure the protocol rules remain unbroken. There is no room for fear to get in the way of standing up for what you believe may be fraud because of the element of pseudo-anonymity too.

In particular, the way that we address this in the Melon protocol is with Risk Management modules. The idea behind these is to give a set of rules to encourage sensible behaviour and limited losses in the event that the fund manager tries to act in a way which is not desired by investors. This gives the investors of a fund a level of security that until recently was next to impossible to achieve.

Everyone was fooled: BBC coverage of the Madoff scandal

Additionally, with the Melon protocol we are exploring new and innovative ways by which we can prevent conflicts of interest. Some methods which we are exploring include;

1- Having to pay a one-off spaming protection fee in MLN to set up a fund (the idea behind this would be to prevent spamming and the setting up of multiple funds which you claim to be yours)
2- Staking — the idea that you have to have skin in the game (possibility to take more risk as you stake more)

These methods will be explored in more detail in a future blog which we will publish centered purely around risk management.

Auditability and Transparency

Given how transparent and simple the accounting, auditing and checking process is on a blockchain, and since there is generally only one or two ledgers with all the information on — it would be almost impossible to say you owned something when you don’t without someone being able to find out very quickly. It’s relatively simple to prove whether you own assets on a blockchain or not. An inability to show ownership of tokenised blockchain assets can certainly be inferred by a lack of said proof. Investors could very easily and at any time audit the holdings of a smart contract based fund.

I was astonished. They never even looked at my stock records. If investigators had checked with The Depository Trust Company, a central securities depository, it would’ve been easy for them to see. If you’re looking at a Ponzi scheme, it’s the first thing you do. — Bernie Madoff

It’s worth noting here too that in the traditional world of hedge funds, settlement times can take 2–3 days or more, and you need several centralised parties in the middle to vouch for the fund’s activity. This makes the auditing process much more complicated, cumbersome and expensive than it needs to be. Blockchain based exchanges can settle in seconds at the click of a button for just a few cents.

Disappearing Funds/Theft

If you use smart-contracts to manage your fund, you could (and we hope investors come to demand such measures) pre-define the assets that your fund is allowed to invest in within a “Asset Universe” smart contract. You could also pre-define a sensible process by which new assets are added with various approvals fund stakeholders or from the investors themselves, this would likely take the form of a governance module. This is one of the most interesting features of the Melon protocol. The value proposition is that it attempts to puts guards in place so that it is close to impossible to use the funds for anything else but what the mandate of the portfolio allows you to do. More specifically, we have devised something we refer to as a Universe module which pre-defines:

1 A set of assets that a fund / fund-manager is allowed to invest in
2 A set of price feeds linked to those assets against which performance is calculated.
3 Pre-defines a set of exchanges linked to those assets

That concludes our first hedge fund scandal analysis. It is clear to us that smart contracts can and will play a vital part in protecting investors from and alerting regulators to potential fund manager malfeasance in the future, and that the Melon protocol will play a large part in that process. In part 2 of our hedge fund scandal series, we’ll investigate: How (too much) Leverage Led to the Fall of Bear Stearns, a Key Moment in the Largest Financial Recession in Recent History.

About the Author:

Mona El Isa

Former star-trader at Goldman Sachs, promoted to Vice President by the age of 26 and made the “top 30 under 30” list in Trader Magazine in 2008 and Forbes Magazine in 2011 after profitably trading the 2008 and 2011 crashes. Moved to Geneva-based macro fund Jabre Capital in 2011, before deciding in 2014 that the future of finance lay in blockchain technology. She studied Economics & Statistics at the University College London. Today, Mona is the CEO and Co-Founder of Melonport AG, the private company building the open-source Melon protocol.

Website: https://melonport.com/

Twitter: https://twitter.com/perham83

LinkedIn: https://www.linkedin.com/in/mona-el-isa-3a653526