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January 13, 2009

Madoff Closure Disrupts Trading

By Peter Chapman & Michael Scotti

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  • Madoff Closure Disrupts Trading

The abrupt closure last month of Bernard L. Madoff Investment Securities, charged with running a Ponzi scheme, left some of its retail broker-dealer customers with losses and proved a windfall for the wholesaler's competitors.

Madoff Investment Securities was closed last month for allegedly bilking money management clients out of an estimated $50 billion. The Securities and Exchange Commission has charged firm founder Bernard Madoff and the firm with a crime that has touched investors and traders far and wide-in the U.S. and abroad.

The asset management area was run on a separate floor from the wholesaling unit, which was operated by Bernard Madoff's sons, Andrew and Mark, who have not been charged.

Madoff's wholesale customers did not incur losses on trades the firm handled through Thursday, Dec. 11, its final day of operation, according to sources. But some experienced losses on limit orders held by the firm on the next day's open-Friday, Dec. 12.

Madoff employees advised their customers before the market opened on Friday not to send any new orders. But, as late as 30 minutes before the opening, they also told them not to cancel their sitting limit orders.

At one minute before the bell, Madoff unilaterally canceled all sitting limit orders. The move forced agency desk executives to scramble to route these orders to other trading houses.

The surprise reversal by Madoff caused problems for brokers whose limit orders would have executed during early trading. They had to honor their customers' instructions to trade at the limit prices.

At least one retail brokerage, D.A. Davidson & Co., based in Montana, reports losing $50,000 making good on its customers' limit orders. Madoff canceled 1,200 limit orders, Patrick Fay, Davidson's director of equity trading, told Traders Magazine. "At one minute to the opening, they kicked out all our orders," he said. "And it wasn't just us."

It is unclear how many other brokerage firms lost money on their unexecuted limit orders. But Madoff has described its customer base as including "scores of leading securities firms, banks and financial institutions." Based on regulatory filings, they ranged from small firms such as Davidson to larger ones such as Morgan Keegan.

Another Madoff customer confirms the last minute snafu, but did not describe losses. "The cancellation process was cumbersome," the operations executive said, "because you had to look at them, find out who is close to the market and then get them delivered to another party." His firm uses Thomson's Beta back-office system, which "did wide-scale cancels and then put them back in the system for routing to another party."

Madoff executives did not return telephone calls.

Sources reported no losses on trades completed by Madoff in the three-day period between Tuesday and Thursday, partly because the National Securities Clearing Corporation "locks in" the trades and guarantees they will clear and settle.

Most sources reported it was very easy to transfer their new orders to Madoff's competitors. "There are plenty of fish in the sea," said Dan McMahon, co-head of equity trading at Madoff customer Raymond James Financial.

Most firms have contingency plans in place to route orders to other wholesalers if their primary venue is experiencing problems. Thomson's Beta system makes that easy, they say.