The five big changes the Madoff scandal made to the financial world

The Madoff scandal was an enormous wake-up call, likely to shape the thinking of investors for years to come. Matthew Lynn outlines five of the big, long-term changes we can expect to see.

Not much in the financial markets can ever be stated with any real certainty. But here's one prediction you can take to the bank. Bernard Madoff isn't going to be back in the investment business any time soon. On Monday, a New York court sentenced the world's most accomplished fraudster to 150 years in jail. It is safe to say that he won't ever be released.

That, at least, is some measure of justice. The full scale of Madoff's fraud may never finally be known. At its peak, his firm had $65bn under management. In the court hearings, some allowance was made for redemptions, but it was estimated that between $10bn and $20bn went missing. Since many of his investors came via discreet Swiss private banks, and are unlikely ever to go public with their losses, we may never know exactly how much money disappeared.

His legacy won't just be felt by his unfortunate investors. The Madoff affair has exposed whole swathes of the financial services industry as being built on the flimsiest of foundations, surfing on hype, promises and hot air. It has revealed often shockingly lax standards of checking and breathtaking naivety. It was the greatest Ponzi scheme in history. But it was also the greatest wake-up call, an event that is likely to shape the thinking of investors for years to come. Here are five of the big, long-term changes we can expect to see.

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1. Life is harder for hedge funds

Madoff, of course, wasn't really a hedge-fund manager. He just banked all the money and occasionally paid some back to people who asked for it. But that was how he described himself, and there is little question that he rode the boom in hedge funds over the past decade.

Very few hedge-fund managers are fraudsters like Madoff. Most are perfectly capable of losing their clients money while sticking scrupulously to the letter of every law. But many use similar marketing techniques. They wrap up their strategies in an air of mystery, as Madoff did. They trade on contacts and social cachet to raise funds, just as he did.

There is nothing fair about tarring them with the same brush but nobody ever claimed business was fair. The fall of Madoff will make it very hard for anyone to go around claiming some secret but brilliant system for beating the markets. And that will make life much harder for the whole hedge-fund industry.

2. Private banks will lose out to DIY

It's probably no accident that much of Madoff's money came from the private banks and the wealth management industry. For the last decade, private banking has been one of the most lucrative corners of the financial markets. Managing money for the wealthy has been an easy way for banks to lift their profits: rich people have more assets to play with and are a lot less likely to complain about fees.

The pitch from private banks was that they could steer their clients through the minefields of the financial markets. That looks a fairly ridiculous boast right now. Many steered their clients straight into Madoff's fund, despite numerous warning signs. In the light of that, many wealthy people are likely to decide that they can do without the fancy cheque book that comes with a private bank account. Instead, they'll stick with the Bognor Regis Provident Mutual for their current account, and manage their investments themselves they aren't likely to make as much of a hash of it as their private banker did.

3. A regulatory overhaul

The Securities & Exchange Commission in New York looks the most exposed over the Madoff scandal. It was warned about his firm, but failed to act. But regulators around the world will be asking how they missed the greatest fraud of all time for so long. The problem is clear: too much box-ticking, and not enough looking under the bonnet by people who actually know how markets work. If that lesson is learned admittedly a big if the scandal could pave the way for an overhaul of financial market regulation.

4. Buyers will be more wary

Nobody likes being ripped off. After the Madoff affair, anyone putting money into a fund will ask much harder questions. They'll want to know where it's being invested and why. Any kind of too good to be true' promise isn't going to work. The lesson that investors are likely to learn is that if you don't understand it, don't invest in it. That's going to make any complex financial instrument a very hard sell.

5. We will learn to doubt everything

Across the markets, Madoff's overall legacy is likely to be greater scepticism. He traded on a sense of sophistication, of giving people access to a closed world, and deflected hard questions with a sense that it was improper to ask too closely how the money was made. Across the industry, everyone will be probing for weakness and looking for frauds. Whether a firm is honest or dishonest, there will be far fewer places to hide.

And both investors and regulators are going to be a lot more dubious about the claims of money managers. That is no doubt a good thing. But at $65bn, it was an expensive way to learn what should have been a pretty simple lesson.

Matthew Lynn

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years. 

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.