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FLASHBACK FRIDAY: Before the Fall
Traders Magazine Online News, December 7, 2018
Jingle Bells, jingle bells, jingle all the way…
December is usually festive and ushers in the holiday season of good cheer and good will towards men. But back in December 2008 there was a different type of jingle in the air – the sounds of handcuffs and chains as Bernard Madoff was arrested and eventually found guilty for conducting the largest Ponzi scheme in U.S history.
Madoff, now nearly 80 years old, plead guilty to fraud in December 2009 and is currently serving a 150-year sentence at a federal prison in North Carolina. Seven of his employees also plead guilty to associated crimes. Five former aides to Bernard Madoff who spent decades working for his firm were found guilty at the time on most counts in helping run the $17.5 billion fraud that was exposed by the 2008 financial crisis.
Hatched in the 1970s, Madoff’s fraud targeted thousands of wealthy investors, Jewish charities, celebrities and retirees. It unraveled in 2008 when the economic crisis led to more withdrawals than Madoff could afford to pay out. In addition to $17.5 billion in principal, it erased about $47 billion in fake profit that customers thought was being held in their accounts.
The multi-year dismantling of the Madoff event stretched into 2013 when the liquidation of Bernie Madoff’s defunct brokerage reached a total cost of $774.8 million, including lawyers’ and consultants’ fees and expenses of $737.1 million, the trustee for the firm reported.
The prosecutions lasted until March of 2014 when an 11-person jury on March 24 found five former colleagues of Madoff guilty on all counts, including claims they conspired to create fake trade confirmations and false account statements for thousands of clients of Madoff’s investment advisory unit. No trading took place in the business.
So, what’s the takeaway?
In the wake of the Madoff affair, the so-called “custody rule” Rule 206(4)-2 of the Investment Advisers Act saw extensive revision. The following are the highlights of the new custody rule:
Expanded Definition of Custody. The SEC has clarified that an advisor has custody of client funds when it physically possesses the funds or has authority to obtain possession, as well as when a "related person" of the advisor has such authority.
Surprise Exams. RIAs with custody of their client's assets or whose client assets are held by an affiliated custodian that is not "operationally independent" now must undergo an annual surprise examination by an independent public accountant to verify that the money claimed to be in customer accounts actually exists. If funds are discovered to have gone astray, the auditors are required to notify the SEC. When an adviser, or a related person, acts as the qualified custodian ("self-custody"), the surprise examination must be performed by a PCAOB-registered accountant. An adviser that does not "self-custody" can use any independent public accountant.
Custody Controls Reviews. In circumstances where the RIA, or a related person, acts as the qualified custodian--whether or not operationally independent--the RIA also will be subject to a custody controls review and will be required to obtain, at least annually, a written report, prepared by a PCAOB-registered auditor, that describes the internal controls in place at the custodian, tests the effectiveness of such controls and provide the results of those tests (typically, a "SAS-70 Report"). Advisers to pooled investment vehicles that "self-custody" must obtain such a report even if exempted from the surprise audit and the account statement requirements.
Direct Delivery of Account Statements. Qualified custodians maintaining client assets must now send account statements directly to advisory clients in all cases, even if the adviser itself sends account statements. The rule eliminates the current alternative that allows audited advisors to send account statements to clients in lieu of the qualified custodian. In addition, any account statements sent by an adviser now must "urge" clients to compare such statements with those from the qualified custodian.
Exemption for Advisers to Pooled Investment Vehicles. Advisers to hedge funds and other private funds that are subject to annual financial statement audits and that distribute those audited statements, prepared in accordance with U.S. GAAP, to its investors are deemed to have satisfied the surprise audit requirement. The audit must be performed by an independent PCAOB-registered accountant.
Exemption for RIAs Who Only Deduct Fees. RIAs whose managed assets are in the custody of an independent, third-party custodian, and either have no control over the funds or merely have authority to withdraw their agreed-upon advisory fees are exempted from the surprise audit requirement and the custody controls review.
The SEC also saw some changes. In September 2009, the regulator released a 477-page report on how it SEC missed the numerous reg flags that were raised by Madoff and identifies repeated opportunities for SEC examiners to find the fraud and how ineffective their efforts were. In response to the recommendations in that report, eight SEC employees were disciplined; none were fired.
As of February 2016, trustees reported that more than $11.079 billion of the $17.5 billion in principle investment has been recovered to date. U.S. judges ordered victims of the scheme could begin to receive payouts and individual distributions would range from $1,287 to $200.4 million. Bloomberg Business News also reported in 2016 that investors of approximately $2.5 billion of funds had made no effort to claim their lost funds. Analysts suspect that these parties have remained silent because their investments were from illegal activities such as drug dealing or tax evasion, or because they had civil liabilities in the United States and did not wish to subject themselves to the jurisdiction of the U.S. courts.
In September 2017 in a case before the Irish High Court, Thema International Fund agreed to pay $687 million to resolve a trustee lawsuit brought on behalf of the fraud victims resulting from Madoff's frauds.
The following article appeared in the December 2009 edition of Traders Magazine
Before the Fall
By Peter Chapman
The abrupt closure of Bernard L. Madoff Investment Securities in December marked an ignominious end for a firm that, after nearly 50 years in business, enjoyed near universal respect on Wall Street, as well as major financial success. That its founder could be charged with defrauding its customers out of billions of dollars, as two arms of the federal government have alleged, shocked and dismayed those who know the man.
He was considered a leader in the stock trading business who almost single-handedly created the modern-day Third Market for retail orders by attracting order flow destined for the New York Stock Exchange.
His ability to anticipate punishing regulatory changes designed to sideline market makers, coupled with a commitment to spending on technology and sophisticated inventory management techniques, enabled him to survive and prosper whilst many competitors fell by the wayside.
His knowledge of the intricacies of market structure and his openness with regulators, legislators, journalists, academics and industry executives served to boost his profile and influence. Those relationships also didn't hurt his market-making business.
In 1982, after more than 20 years in business, Madoff reported $5.5 million in net capital, making his the 153rd-largest brokerage house. He had 35 employees. By January 2007, he reported $613 million in net capital, making his firm one of the 40 largest. He employed 146 people.
His close ties to Nasdaq from its early days and their shared interest in wresting market share from the Big Board translated into a win-win for both parties as Madoff's Third Market business grew. His participation on NASD committees and his unwavering support for many of Nasdaq's often dealer-unfriendly initiatives through the years only cemented the bond.
By the 1990s, Bernie had become something of a senior statesman in the industry, serving on the NASD board, as non-executive chairman of Nasdaq and as head of the Securities Industry Association's influential trading committee. For a while, he was spending one-third of his time in Washington as an unofficial lobbyist for the dealer community. Madoff was often quoted in the press.
On a personal level, he was almost universally liked. He was open. He was helpful. He was willing to share his knowledge of market structure with almost anyone. The same could be said of all four Madoff principals, including Bernie's younger brother Peter (his number two) and sons Mark and Andy. "You couldn't say enough nice things about them," Jack Hughes, a former head of trading at Madoff customer Janney Montgomery Scott, said in a typical response. "They were just great, great people who would do anything for you. And if you had a question, they would always take the time to answer it."
Competitors' View
Not everyone saw eye to eye with the Madoffs. They championed regulatory initiatives that squashed bid-ask spreads and angered fellow market makers. Many are now quick to suggest that the profits Bernie generated through his alleged Ponzi activities made it easier to stomach those spread-narrowing changes. As Madoff's power grew, so did the resentment. His detractors said he was arrogant. Some said he could talk a good game but couldn't always deliver.
Through his attorney, Bernie declined to speak with Traders Magazine for this article. Peter, Mark and Andy also declined comment.
Bernie wasn't the whole show at BMIS. Peter had joined the firm in 1965 while still a student at Fordham Law School, from which he graduated in 1967. Peter was the firm's original computer whiz and eventually assumed responsibility for the trading operation. It was Peter, in fact, who saw the potential in trading securities listed on the New York Stock Exchange. And it was that decision that catapulted the firm into the big leagues of wholesaling.
The second generation-Bernie's sons, Mark and Andy-took control of the trading desks in the 1990s. As the years passed, the two MBA'd brothers largely replaced their father and uncle as the faces of the firm through their work on committees and appearances at industry conferences.
Mark and Andy were on the desk five years ago when it came time to usher in the black-box era-the use of computers to make markets, hit bids and lift offers. That forced the redundancy of a good swath of the firm's traders.
The decision was unavoidable but perhaps came too late. For all the firm's savvy, it was being out-traded by a new breed of algorithm-toting market maker. Madoff lost market share and profits. In the end, an investment bank could find no buyers for BMIS, and the firm was disbanded.
In the Beginning
Ironically, the circumstances behind the fall of Madoff's wholesale business were exactly the same as those behind its rise. The business crashed in the 2002-2008 period after the powers that be in Washington forced the industry to trade in penny increments. The firm got its foot in the door in the 1960s after the Securities and Exchange Commission forced the over-the-counter industry to automate its quotes.
Spurred on by a U.S. Congress upset by dirty dealings at the American Stock Exchange, the SEC spent two years analyzing the inner workings of the securities industry. In 1963, it produced the seminal "Special Study of the Securities Markets," which concluded that changes were needed.
One of its criticisms was directed at the sprawling over-the-counter market and its lack of transparency. Quotes were only published once a day in the Pink Sheets and typically out of date by the time they reached traders' desks in the morning.
To do a trade, a broker would have to telephone three market makers. The process was slow, inefficient and did not take into account all of the possibly 15 to 20 dealers bidding for or offering stock. Consequently, with no intraday transparency, bid-ask spreads were wide and market-maker profits flowed to just a few big New York wholesalers.
Displaying quotes once a day was insufficient, the SEC concluded. It believed computer technology was advanced enough to support widespread intraday quote dissemination. It urged the NASD to investigate the possibility.
At the time, BMIS was a small and struggling wholesaler, finding it difficult to make headway against larger and more established competitors. Eager to compete based on the quality of its quotations, the firm was often ignored by other dealers. Often as not, Madoff's firm did not get called when there was business to do.
The over-the-counter market in the 1960s was dominated by large New York-based wholesalers. These are brokerages that maintain inventories in securities and fill orders for other brokers. The top wholesalers of the day included Troster Singer, Singer & Mackie, New York Hanseatic, J.F. Reilly and Eastern Securities. Wirehouses such as Merrill Lynch did run OTC desks, but their presence was negligible.
So when the NASD was tasked with developing a quote display system that could be installed in dealing rooms around the country, Madoff saw the potential. "We felt, as a small market-making firm, it would level the playing field for us," Madoff told author Eric Weiner for his book "What Goes Up: The Uncensored History of Modern Wall Street." "So we pushed that concept, and I was not particularly popular with my competitors."
With all quotes displayed in one place throughout the day, market makers would have to do business with those displaying the best prices, no matter who they were. That would give a newcomer like Madoff a fighting chance. It would also cut into the business of the dominant players.
The NASD set up an automation committee in 1964, the year after the SEC report came out. It was chaired by Robert "Stretch" Gardiner, head of Reynolds Securities, and staffed with executives such as Johnny McCue, from Baird & Co., a regional broker, and Joe Fuller, from J.B. Maguire, a Boston wholesaler. Madoff was not on the committee.
Seven years later, after much kicking and screaming by traders, the National Association of Securities Dealers Automated Quotation system, or Nasdaq, finally launched. Credit is given to the now-deceased Gordon Macklin, Nasdaq's first president, for making it happen.
In the end, Nasdaq did what they thought it would. It brought quotes to the surface and competition to the market. Small wholesalers such as BMIS and J.B. Maguire and regional brokers such as Baird got a seat at the table. Spreads narrowed. Large wholesalers including Singer & Mackie saw their margins squeezed.
"Nasdaq gave those relative unknowns a sort of instant prominence," Singer & Mackie executive vice president Robert Mackie Jr. told Financial World magazine in 1973. "If they make the best market on that machine, people are bound to do business with them. Before Nasdaq, there was no way for the small firm, except through a strenuous effort, to get itself known as a market maker."
For Bernie, it was never a just one-way street. He got from the NASD, but he also gave back. The former head of trading from a large New York firm remembers Bernie "always made himself available in the early days of Nasdaq when it was hard to get volunteers. He was always willing to be involved in a committee or to help out somehow. After a while, he became a leading voice and was influential and valuable to Nasdaq."
Another ex-head of trading at a large New York firm who participated on NASD committees agreed. "Bernie's strategy was to get actively involved in all aspects of the industry," he said. "He had a much bigger presence than the size of his firm would naturally warrant. By being visible, he'd boost his business. They never said no. They volunteered for everything. It was a very smart move."
Third Market
Nasdaq brought scores of market makers out of the woodwork and onto the desktops of Wall Street. The transparency benefited Madoff, but his firm was now one of about 500 quoting prices in OTC stocks. The competition was fierce. Was there a way to set himself apart?
Sometime in the early or mid-1970s, Peter Madoff became enamored with the idea of trading NYSE-listed stocks. Because of the active market in these securities on the floor of the New York, they were much more liquid. That made them easier and safer to trade.
OTC names were much riskier. "That was pretty much one-way order flow," a trading executive noted. "If there were no more buyers and if you were a market maker, you became the buyer."
In addition to the stocks' lower risk profile, NYSE rules also lent appeal to Madoff's idea. NYSE Rule 390 prevented NYSE members from trading NYSE-listed securities on a principal basis away from the exchange. That eliminated many potential competitors to Madoff, as most firms of any size were Big Board members. The rule did allow them to send their NYSE orders to other exchanges or market makers. Most of Madoff's competition would come from NYSE and regional exchange specialists. Madoff was not, of course, a member of the New York.
The business of trading NYSE-listed securities outside the confines of the exchange was known as the Third Market. Until Madoff dived in, the business was largely institutional. It was dominated by firms such as Weeden & Co., First Boston and Blyth & Co. Some wholesalers did offer retail brokers a Third Market service in the 1960s, but with the exception of Weeden, none was especially large. Others were A.W. Benkert and American Securities.
Madoff started trading NYSE stocks on a small scale in the mid-1970s, at a time when the industry was embroiled in a contentious debate over regulatory changes that would make it easier for brokerages to compete with NYSE specialists. The SEC wanted to foster widespread trading of NYSE names outside the exchange's four walls. The U.S. Congress, via the 1975 Amendments to the Securities Exchange Act of 1934, gave them the authority to do so.
The SEC's dream was to break up the Big Board's monopoly in the trading of its securities by fostering the development of a central market system. The agency's original idea involved a consortium of OTC dealers and exchange specialists competing against each other for orders. As early as 1965, an SEC staff study concluded the NYSE's Rule 394 (later Rule 390) shielded Big Board specialists from competition.
The plan to construct a central, or national, market system boiled down to two competing ideas. The Cincinnati Stock Exchange was proposing a Composite Limit Order Book (CLOB) known as the Multiple Dealer Trading System, within which all trades would take place. The New York Stock Exchange was promoting the Intermarket Trading System (ITS), a routing and quoting network that would link all the exchanges.
The Cincinnati's CLOB, based on a trading platform designed by Weeden principals, was perhaps the more radical of the two ideas and eventually lost the SEC's endorsement. The ITS launched in 1978 with the participation of every exchange except the Cincinnati.
Cincy
The ITS was a godsend for Madoff if only he could plug into it. The network was a critical link to the New York Stock Exchange that would allow NYSE specialists to see and access the quotes of regional exchange specialists. In turn, it would allow regional specialists to access the New York to lay off their positions.
Madoff, however, was not a regional specialist. He was an NASD member. And when the ITS launched, there was no connection to Nasdaq. That was not for lack of trying on the part of the NASD. The New York fought hard to keep the NASD out. It wasn't until 1982 that the NASD was permitted to link to the ITS, and even then, market makers could only trade a limited number of (Rule 19c-3) stocks over it.
So in the late 1970s, the Madoff brothers started sniffing around the Cincinnati, hoping to become specialists. Although they were eventually allowed to purchase seats and Peter took a position on the board, they were initially treated with suspicion. Cincinnati executives were worried Bernie might be some kind of spy for the NASD, which was fighting hard to get full access to the ITS. In 1978, Bernie was a member of the NASD's National Market System Trading committee. In 1979, he was on the NASD's National Market System Design Committee. From 1981 to 1983, he was the head of the design committee. In 1983, he became chairman of the NASD's District 12 Committee, representing the New York area.
For the Cincy, the fear was very real. If the NASD did get full access to the ITS, and all those market makers started trading NYSE names, there would be little reason for regional stock exchanges to exist. Imparting precious technical information to the Madoffs could prove hazardous.
In any event, by 1980, the Madoffs were members. Peter joined the trading and technology committees, and the firm--along with other CSE specialists such as Merrill Lynch--had invested in an upgrade of the MDTS. That year, the Cincinnati closed its floor and opened for business as the country's first all-electronic stock exchange. In 1981, when the exchange finally won access to the ITS, Madoff could hang out his shingle as a full-fledged alternative to the New York Stock Exchange.
ITS Access
The ITS was terrific for Bernie," said Don Weeden, former CEO of Weeden & Co. "They were able to get their markets in and change them very quickly. They were very competitive with the New York and the other regional exchanges. He did very well doing that." (Weeden and Madoff are often considered in the same light, as both men took on the New York Stock Exchange in David-and-Goliath fashion and both invested heavily in technology to do so.)
While it never succeeded in becoming the central marketplace backers like Weeden and the SEC had hoped, the Cincinnati did retain a special standing in the eyes of the SEC.
One former Cincinnati specialist recalled that the rules of the exchange permitted maximum quote widths of 25 cents in the early 1990s, and so that was how he programmed his system. That got him a call from Peter Madoff, who asked the specialist to narrow his spreads. Madoff said the Cincinnati was always under scrutiny from the SEC and was held to a high standard. Tighter spreads would prove to the industry that the Cincinnati was "real" and its quotes accessible, Madoff explained.
Bernie would later tell Traders Magazine: "The Cincinnati has done a better job than the other regionals in keeping their market makers in a competitive mode. We set the standard at the Cincinnati."
The Customers
Now that Madoff had the ability to trade listed stocks, he set about the task of acquiring a steady stream of order flow from retail brokers. He won Charles Schwab & Co.'s business in short order, but the majority of brokers proved a tough slog. The business didn't really pick up until after the 1987 stock market crash.
During much of the 1980s, one source believes, the mainstay of Bernie's business was arbitraging the prices of OTC stocks with those of their attached warrants. Because the Black-Scholes options pricing model had yet to be fully understood by the Street, making money on the "optionality" of warrants was easy pickings. In those days, many speculative issuers, such as technology companies, would tack on a warrant to a new issue as a sweetener for the investor. The warrant was exchangeable into a certain number of shares at a certain price.
"The third market was almost a side business," this former trader said. "Bernie was very big in that [warrants] business, along with about four other firms. You could see. You would offer size, and Bernie would step up and buy it. Then he would be out there doing a contra trade in the common."
This source believes that the warrant trading operation was done under the aegis of Madoff's investment management operation, which allegedly eventually became a Ponzi scheme; and that losses in this warrant trading activity may have led to Madoff covering losses via the Ponzi scheme. "He had more share than you would expect a firm his size to have in those warrants," the source said.
Whatever the case, Madoff still had high hopes for his Third Market business. And because he had hopes of becoming a volume player, he decided he needed to automate the intake of orders. That way, brokers could send him flow at the push of a button and receive their trade reports just as quickly. This was a big and expensive project. One exec estimated it cost firms that chose to do this between 25 and 40 percent of a year's profit-and-loss account. Peter Madoff was put in charge.
In 1983, Madoff brought in TCAM Systems, a software vendor started in 1979 by the former chief information officer at Smith Barney, to build the system. TCAM had built a similar system a year earlier for Dean Witter Reynolds' OTC department.
The system TCAM would build for Madoff would read the quotes from the newly launched Consolidated Quotation System and quickly execute incoming orders at prices based on those quotes. The project took five years to complete. When it was finished, in 1988, it automatically filled orders of up to 3,000 shares at the national best bid or offer in less than 10 seconds. That was considerably faster than the New York Stock Exchange, which, by rule, had 90 seconds to handle the order.
"He was a pioneer," said Ken Pasternak, former chief executive of Knight Capital Group and a competitor to Madoff in the Third Market from the 1990s. "What helped him was the fact that he was the first to automate and provide [speedy] executions." Pasternak ran trading at Troster Singer in the late 1980s and early 1990s. Troster automated the intake of its OTC flow at roughly the same time Madoff automated the intake of his listed flow, Pasternak said.
Other industry execs also acknowledged Madoff's technology prowess. "They always had the best technology," Dennis Green, the former head trader at Legg Mason, remembered. "They always did. Even when none of us could afford that technology. It was expensive for us in the hinterlands. Maybe not in New York. But they always had the best systems."
Madoff's speedy fills involved trade-offs, though. An order sent to the New York might get filled at a price better than the NBBO, or within the spread. Madoff offered no such "price improvement." But, he argued, since he traded only the most liquid stocks, their spreads were as tight as they could be. Thus there was little chance they would get price improvement at the Big Board. Still, the criticism over Madoff's lack of price improvement would dog him throughout his career.
Madoff's business plan was simple: Accept orders only in the biggest, most liquid stocks from "uninformed" retail investors. Charge no fees. Guarantee fills on all orders up to 3,000 (later, 5,000) shares. Execute orders faster than the New York Stock Exchange.
Restricting his dealings to retail flow and the most liquid stocks would mitigate Madoff's risk. So-called uninformed investors-in contrast to professional traders-know less about a stock's immediate prospects than the dealer. And with the most liquid stocks, laying off positions would be easier.
Madoff got his new TCAM system installed just in time. The stock market had crashed the previous October, and the public had deserted the market. Retail brokers were hurting and looking for ways to cut costs.
Orders sent to the New York incurred both exchange fees and specialists' charges. Madoff, on the other hand, charged no fees. That was part of his appeal. Prior to the Crash of '87, NYSE member firms balked at sending their orders to Madoff out of loyalty to the exchange or fear of retribution. Afterward, those qualms vanished.
To sweeten the deal, Madoff started paying brokers for their flow. That made it even harder for cash-strapped brokers to resist the trader's entreaties.
"If you sent it to the floor of the New York, you got charged for it," Green explained. "If you sent it to Madoff, they paid you. For many, it was a no-brainer."
Hard Times
With hard times on Wall Street, the Third Market began to take off. According to a Wall Street Journal report, the share of trades in NYSE-listed securities under 1,100 shares done in the Third Market tripled between 1984 and 1989 to 6 percent. BMIS accounted for 70 percent of that figure, according to estimates of the exchanges. The surge left the New York Stock Exchange with only about 66 percent of all trades in its stocks, down from 87 percent in the late 1970s.
"The New York Stock Exchange looked at them as serious competitors," remembered Chris Keith, the Big Board's former chief technology officer and a member of the exchange's executive committee from 1980 to 1988. "The Madoff name was well known at the exchange and the firm was a not infrequent topic of discussion in meetings. He was highly regarded."
Meanwhile, over at the NASD, Bernie had reached the apogee of his relationship with the organization. In 1986, he was elected to the board of governors along with 39 others. He was also on the executive committee, the board surveillance committee and the long-range planning committee. He was chairman of the NASD's international committee, too, having recently opened an office in London to trade ADRs.
After more than 25 years in the business, everything was finally falling into place for Madoff. In 1989, the firm had 20 traders dealing in the top 250 NYSE-listed names. It was handling about 15,000 trades per day, totaling about 5 million shares. That gave it 2 percent of the share volume in NYSE-listed securities. By the end of the decade, BMIS boasted 100 customers including regionals such as A.G. Edwards, Dain Bosworth and Rauscher Pierce and discounters such as Schwab, Quick & Reilly and Fidelity.
For the most part, BMIS had the growing market to itself, but that would not last. In 1985, a veteran manager at several wholesalers started a small third-market dealer in White Plains, N.Y., called Trimark Securities. Steve Steinman, Trimark's founder, had held trading positions at a number of firms, including Troster Singer and M.H. Meyerson. Trimark was not much of a factor in the late 1980s, but was digging in. In 1990, the dealer signed an agreement with TCAM to build a trading system.
Madoff didn't have all the retail flow not going to the New York Stock Exchange. Discount brokers such as Schwab and Fidelity also operated specialist posts at various regional exchanges to internalize their NYSE-listed orders. Pershing, a large clearing firm, also operated specialist posts at regional exchanges.
Payment for Order Flow
Market making in those days was still a spread game. The minimum trading increment was a relatively fat 12.5 cents per share, allowing dealers to make a profit buying at the bid and selling at the offer. The wide spread also enabled them to pay for order flow. The practice had been around since the 1970s, when wholesalers were paying brokers about 2 cents a share for their OTC orders. Madoff extended the practice to NYSE-listed securities in 1988, paying brokers about a penny per share.
The move did not endear Madoff to the New York Stock Exchange and some of the regionals. As BMIS began to eat into their businesses, they complained bitterly to the SEC. They charged that Madoff's firm competed unfairly because it was not bound by the rules of exchanges. BMIS could pick and choose with whom it traded and which orders it would accept. Exchanges, on the other hand, had to take on all comers.
Others contended the SEC should abolish payment for order flow, as it constituted a perverse incentive for order-flow senders. Brokers should choose their trading venues based on best execution, not kickbacks, Madoff's detractors argued.
Madoff countered that the point was moot because his customers always got the best bid or offer. In addition, the brokerage could pass the savings on to its customers.
Ray Pellechia, an NYSE Euronext spokesperson for many years, still maintains that PFOF is harmful and that investors deserve a shot at price improvement. He recently blogged: "I also believed-and still do-that pay for flow deprived investors of the opportunity to get the best price; that is, the ability to trade at a price better than the published best bid or offer."
The SEC had long tolerated payment for order flow. But it was still concerned over possible conflicts of interest. In July 1989, the SEC convened a roundtable of industry leaders to discuss the issue. Bernie Madoff, the NYSE's Dick Grasso, Charles Schwab, Leslie Quick of Quick & Reilly, John Watson of the Security Traders Association, Peter DaPuzzo of Shearson Lehman and Buzzy Geduld of wholesalers Herzog Heine Geduld all sat down to offer their views on the subject.
After listening to all the arguments, the SEC still took no action. The sniping continued unabated for at least five years. Eventually, Congress waded in.
In the spring of 1993, Congress held hearings on the issue. NYSE chairman William Donaldson testified, asking Congress to ban the practice. So did NYSE president Dick Grasso. Bernie testified in defense of the practice, but said he would be open to brokerages having to disclose the practice. NASD president Joe Hardiman testified in support of the practice, defending the Madoff model.
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