Fooled By Randomness

No, not the Nicholas Taleb book – Madoff’s investors and the SEC. 

From Ashby Jones, two computer programmers for Madoff’s former operation were arrested and charged Friday with creating computer programs that helped Madoff hide his fraud from regulators (complaint here). 

From the SEC complaint against the two programmers:

51. Defendants knew that all of this data was, for all intents and purposes, randomly generated and assigned to purported trades by programs they created.

. . .

52. Defendants' extensive use of random selection arose from two related facts. First, there were no real trades from which to draw actual data. Second, Madoff and DiPascali were concerned that investor representatives and/or regulators would closely examine the data and notice implausible correlations (e.g. all fake trades with a certain counterparty were for a certain share volume, or were executed at uniform time intervals), which could lead to greater scrutiny. In fact, when Madoff, DiPascali, or Defendants reviewed the programs' results and found suspicious correlations and patterns, Defendants would have to make further revisions to the programs.

Paul Kedrosky has said since December that “Bernie Madoff’s results, far from being pulled from his hat, showed every sign of having been generated by a randomizing algorithm.”  From his original post:

The current party line is that this was an unsophisticated scam, something that would have been easy to spot, if not from the overly regular returns then from a fraud analysis of the numbers themselves. To that way of thinking, Bernie wasn't a very sophisticated crook.

[Kedrosky then provides his arguments and evidence against this theory, based on an analysis of Madoff's monthly returns from December of 1990 to May of 2005, as contained in a Fairfield Sentry performance data document]

Taking it one step further, it almost certainly means Madoff's numbers would have been generated algorithmically. He didn't pluck them from air at the end of each month. That is, I think, interesting in that it shows that this (alleged) con was at least somewhat more sophisticated than some of the noisier critics out there have been saying.

Having now been backed up by the SEC complaint, Kedrosky concludes: “I’m so clever.”  Judging from the SEC complaint, it seems that he is.