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March 10, 2009

Before the Fall

By Peter Chapman

In 1991, the ITS Operating Committee denied the NASD's request. Madoff petitioned the SEC to intervene, but to no avail. It would be another eight years before Nasdaq dealers would gain full access to the ITS.
   
Next Nasdaq
Despite Madoff's closeness to the NASD, the relationship had its limits. In the mid-'90s, Nasdaq made its first attempts to transform itself from a communications system for market makers into a quasi stock exchange. In swift succession, it proposed building three CLOB-like systems-N*Prove, Naqcess and Next Nasdaq.

Market makers hated the ideas. They complained the systems would come between them and their customers as they would permit brokers to post limit orders directly on a Nasdaq system. Nasdaq was trying to compete with them, they argued.
   The battle raged between the NASD and the dealer community from 1995 to 1998. Madoff was a key representative for the opposition after becoming one of two vice chairmen of the Securities Industry Association in 1996. He was to head the SIA's influential Trading Committee for the next two years, leading the negotiations with the NASD. N*Prove didn't pass SEC muster. Naqcess was shelved. Next Nasdaq went to the SEC for approval, but in the end, it too died, thanks partly to the effort by Madoff.

OTC dealers won the battle against Nasdaq's early CLOBs, but they were not destined to win the war. One year after defeating Next Nasdaq, the exchange-to-be introduced another CLOB called Supermontage. This one stuck.

Back in the mid-'90s, the tide was already turning for market makers. They incurred the wrath of the regulators after studies done by two academics implied they were colluding on prices. Both the SEC and the U.S. Department of Justice launched investigations into price collusion after two university professors discovered market makers did not quote in odd eighths. A settlement resulted in about two dozen market-making firms (excluding BMIS) paying $1 billion in fines. The industry also got a tough new rule requiring dealers to display their customers' limit orders.

The brokers quietly paid the fines but resisted the SEC's proposed Limit Order Display Rule. Market makers fretted that the competition it would introduce would cut spreads and profits. At least three wholesalers-Herzog Heine Geduld, Mayer & Schweitzer and Sherwood Securities-made a last-ditch appeal to Congress to block the SEC from passing the rules. The campaign failed, and in 1996, the rule was approved.

In contrast to many of his competitors, Madoff appeared unperturbed by the rule, part of a package of rules called the Order Handling Rules. He described it as a boon for the Nasdaq market. In a letter to the SEC dated Jan. 12, 1996, Bernie and Peter Madoff maintained the rule would help "achieve price discovery and fairness to investors." A year later the pair was still upbeat, telling Traders Magazine the rule would increase liquidity for Nasdaq securities.

Why was Madoff upbeat when many of the other dealers were pessimistic? Wouldn't smaller spreads cut into Madoff's profits as well? Apparently not. BMIS had moved beyond spreads.

Spreads were "a thing of the past," Bernie told Traders Magazine in January 1997. "You're making it today on trading," he said. "Everybody would love to sit there with a market 20 to 1/8 and buy at 20 and immediately sell that at 20 1/8. That almost never happens."