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March 10, 2009

Before the Fall

By Peter Chapman

Somewhere along the way, Madoff's firm had moved from "flipping for eighths"-as the dealers used to call it-to holding positions for longer periods. The trader was incorporating more risk into his operations. "We're a position trading firm," Bernie would later tell Traders Magazine. "We've always traded with a large inventory. It is larger, I believe, than most, if not all, of our competitors'. We have the ability to hedge our risks."

He explained: "In order for us to provide a better execution than our competitors, we must expose ourselves to greater risk by carrying inventory and being willing to provide liquidity."

By 1997, it had become obvious (to Madoff, anyway) that the old market-making model was not sustainable. Making a profit by buying at the bid and selling at the offer only worked if the minimum trading increment was wide enough. Decimalization was on the horizon, and the future of the bid-ask spread was not promising.

A former competitor notes that Madoff was always preparing for the future. "We were on a lot of committees over the years," ex-Knight CEO Pasternak said. "We always thought market transparency, Manning (limit order) protection and decimal pricing were inevitable. The real secret to success was to figure out where the market was going and position yourself."

For 200 years, the minimum increment had been one-eighth of a dollar, but the days of that custom were numbered. As early as 1991, the SEC was mulling a move to penny ticks. In 1994, the SEC's Division of Market Regulation recommended the industry move to sixteenths as soon as possible. Spreads were headed in only one direction: down.

In December 1996, Nasdaq's Quality of Markets Committee voted to cut the minimum spread by half and move to sixteenths. It also voted to study trading in decimals. In March of the following year, the Nasdaq board voted to quote in sixteenths. In May 1997, both Trimark Securities and BMIS started quoting NYSE names in sixteenths, a month before the New York Stock Exchange. Spreads did indeed collapse in June 1997.

That same month, the New York announced it would move to quoting in pennies by 2000. Decimalization, Madoff told Bloomberg News in 1997, didn't necessarily mean brokerage profits would suffer. "Decimals will encourage more trading," he said, "and the greater volume could more than compensate for narrowing spreads." Decimal trading would debut in 2001.
   Narrower spreads weren't the only challenge Madoff faced in the late 1990s. Trimark Securities, previously a bit player in the Third Market, was coming on strong. Carried by the bull market of the 1990s, partly fueled by America's newfound passion for online trading, Trimark would eventually pass Madoff in market share terms.

In 1994, the suburban New York dealer was taken over by a trio of brokerages and executives from wholesaler Troster Singer. The following year, the firm's chief executive, Steve Steinman, became one of the four founders of Roundtable Partners, from which the formidable Knight/Trimark wholesaler would emerge. The firm would come to dominate the wholesaling business, thanks to order-flow arrangements with about two dozen retail brokerages that invested in Roundtable. In contrast to Madoff, Trimark traded all 2,500 or so NYSE-listed securities, not just the biggest, and welcomed flow from informed traders as well.