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August 31, 1999

Another Stab AtThe Third Market: Madoff's Brave New Trading World

By Peter Chapman

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  • Another Stab AtThe Third Market: Madoff's Brave New Trading World

Electronic trading systems have not always been viewed as a market maker's best friend. That could change next year, though, when a pioneer of the third market, Bernard L. Madoff Investment Securities, launches Primex Trading NA.

The new electronic trading system is billed as a superior version of the floor of the New York Stock Exchange - a system that could help the firm maintain its crucial inflow of retail orders.

Madoff, long a competitor of the Big Board, is in essence conceding the superiority of the exchange's auction model to achieve price improvement for the firms retail customers' listed and Nasdaq orders. "This new trading platform is an improvement over our existing system," said Bernard Madoff, a principal at the firm.

The Design

Primex, which was designed for listed and Nasdaq trading, was purchased by Madoff late last year. Chris Keith, a former chief technology officer at the Big Board co-conceived the trading system. (The system is based on software he created.) Madoff controls the new venture, but is partnering with Street behemoths Goldman, Sachs & Co. and Merrill Lynch & Co. among others.

Madoff says the introduction of Primex is driven by demand from the market maker's customers for price improvement, or executions at prices better than the national best bid and offer (NBBO).

"If the spread is greater than a teeny we have pledged to price improve. But current conditions make it difficult, if not impossible, to do this," said Peter Madoff, senior managing director of trading and market operations at Madoff. (He is the most active member of the mainly family-run firm on the Primex project.)

Narrower spreads have hampered all dealers' abilities to buy or sell stocks at prices inside the NBBO. Trading in decimals, slated for implementation next year, is expected to reduce spreads and exacerbate the problem.

(Spreads of one-sixteenth are typical on the 800 listed and Nasdaq issues the firm trades, according to Bernard Madoff.)

To solve that problem, Madoff says it is counting heavily on Primex. By eliminating the physical confines of the trading floor the market maker hopes Primex will attract a crowd of brokers, creating a huge pool of liquidity. In theory, their competing bids will lead to price improvement.

Madoff and its partners will profit by charging "a nominal amount" per trade, according to Peter Madoff. That amount may be less than a penny, he said.

Brokers that enter order flow into the system will not be charged while those that take liquidity out of the system will be charged. (That strategy, incidentally, is used by an electronic communications network operated by one of the industry's largest trade-order management vendors.)

Madoff must continue to offer its customers price improvement in order to keep their orders coming. Unlike some dealers that count on affiliated broker dealers and equity partners for order flow, Madoff is an independent partnership that relies on the quality of its executions and industry reputation for business.

The changing environment, however, is most likely hurting other third market players that cannot offset declining profit margins with revenue streams from other larger affiliated brokerages.