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March 10, 2009

Before the Fall

By Peter Chapman

By the end of the 1990s, according to the NASD, Trimark was the largest off-board trader of NYSE-listed securities, with 46 percent of the third market. (The data include the institutional end of the third market.) In December 1999, Trimark traded about 53 million NYSE-listed shares per day, up from 11 million in January 1997.

The business of processing small orders in NYSE-listed securities had by now coalesced around three groups. The New York largely held onto the flow from its largest members, such as Merrill Lynch and Smith Barney. Trimark, Madoff and the Chicago Stock Exchange vigorously competed for the business of discount and regional brokers. Finally, a few of the retail brokers, including Schwab, Fidelity and Morgan Stanley Dean Witter, internalized their flow on various regional exchanges.

Stiff competition from Trimark and the Chicago kept BMIS on its toes. Trimark, for instance, turned up the heat in June 1999, when it became the first market maker to guarantee price improvement for orders in NYSE-listed securities. The move accompanied a similar offer from Knight for orders in Nasdaq securities. Madoff had offered price improvement on a best-efforts basis since the early '90s, but did not guarantee it. BMIS soon followed Trimark, though, guaranteeing to price-improve the order if the spread was greater than a sixteenth.

The rush to offer price-improvement guarantees was not strictly a competitive matter. Market makers were then coming under pressure from the SEC to provide investors with "best execution." The practice of simply matching the NBBO was being questioned.

Behind the SEC's concern was an upcoming proposal from the NYSE to rescind its Rule 390, which prevented NYSE members from internalizing their orders in NYSE stocks. After first proposing the rule's elimination more than 20 years ago, the SEC had finally prevailed over the exchange. Its removal would, in theory, create more competition for the NYSE specialist.

Despite its victory, the SEC still had concerns. If firms were permitted to internalize their flow, the market could fragment into potentially hundreds of competing marketplaces. That might eliminate the price competition that was the hallmark of the Big Board's auction model.

In early 2000, concurrent with the New York putting its Rule 390 proposal out for comment, the SEC issued a concept release regarding fragmentation. It asked for public comment on six possible regulatory initiatives intended to mitigate any downside to an increase in internalization.

One of them-an anti-internalization, price-improvement rule-came from the New York Stock Exchange. It would require brokers to price-improve their orders or ship them to the market center that first quoted the market's best price. In effect, such a rule could kill internalization and force market makers to ship most of their orders in NYSE-listed securities to the New York, as the exchange typically set the best price first.

Dealers opposed the New York's suggestion, of course. If they were forced to route their hard-won order flow to other execution centers, they said, they wouldn't compete as aggressively for those orders in the first place. "People want to be able to retain their order flow," Madoff told Traders Magazine at the time. "And they should, providing that their customers get the best price available. Matching [the NBBO] should solve that."