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March 10, 2009

Before the Fall

By Peter Chapman

In the end, the SEC settled for the least drastic recommendation on its list: disclosure. It approved Rule 11Ac1-5, which required market centers to publish uniform execution-quality statistics. That way, their customers could compare one trading venue against another. From 2001, dealers would have to make available to their customers such data as effective spreads, execution speeds and levels of price improvement.

The SEC did not let the order-sending firms off the hook. It approved Rule 11Ac1-6, which required brokers to document which market centers they sent their orders to and in what quantities. Both rules applied only to orders of fewer than 10,000 shares.

Meanwhile, the New York's proposal to eliminate Rule 390 was approved by the SEC, to no one's surprise. It was the end of an era, but its absence left the future of stock trading an open question. Would the marketplace fragment into a collection of dark pools? Or would the status quo prevail?

The passing of Rule 390 had potentially devastating effects for Madoff. Many of his customers were brokerages with trading operations. They were now free to trade as principal against their NYSE flow. They might decide not to outsource that trading to Madoff.

In the end, however, the rescission of Rule 390 was a non-event. Business carried on as usual. The major wirehouses continued to send their retail orders to the New York. The regionals and the discounters stuck with their outsourcing arrangements. Madoff stayed in business.

The institution of Rule 11Ac1-5 was another matter. Despite being the least disruptive change of the six possibilities, Rule 11Ac1-5, or "Dash-5," had a major impact on the business of filling small orders. Some older firms shut down their trading operations, as they were unable to beat their competitors' numbers. Some new firms with highly automated trading operations entered the business.

For Madoff, initially, the Dash-5 stats were good news. His numbers outshone those of many of his peers. "We were number one in every category," Bernie told Traders Magazine. "That's the way we've always executed these trades. It was no surprise to us. Our execution quality is certainly better than the primary markets', as well as that of our competitors. We're thrilled with the stats. They confirm what we have always told our customers."

Based on numbers coming out of Nasdaq and the NYSE at the time, Madoff's comments about the primary market seemed to ring true. In April 2002, 10 months after the Dash 5 regime kicked in, the Nasdaq InterMarket, its venue for dealer trading of listed names, recorded an all-time-high market share.

Nasdaq now accounted for 11 percent of all trading in NYSE-listed shares, up from 8 percent in June 2001, when Rule 11Ac1-5 went into effect. During the same period, the New York's market share dropped to 81 percent from 85 percent. When asked by Traders Magazine, the NYSE shrugged off the dip, attributing it to normal ebb and flow.

Mark Madoff, in charge of NYSE-listed trading at the time, had a different view. "The new rules have demonstrated that third-market players have done a better job than the primary markets," he told Traders in 2002. "For the first time, you are able to quantifiably define best execution. Because of that, our volume has increased."