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March 10, 2009

Before the Fall

By Peter Chapman

Actually, the rise in 2002 was the first time in at least four years the third market had notched up any further gains in market share. Trading in the third had exploded in the aftermath of the Crash of '87, but stalled 11 years later. In June 1998, Nasdaq's share of the volume was 8 percent, no different than it was in June 2001. Its share of the trades was 11 percent.

With the rescission of NYSE Rule 390 seemingly a non-event, and the advent of the Dash-5 regime a shot in the arm for a stagnating third market, the early years of the new century looked good for Madoff from a regulatory standpoint. Any questions that his firm might not be offering its customers best execution were laid to rest by the statistics he published every month. Any concern that orders might stop coming in the front door were also relieved.

Actually, around this time, with decimalization just around the corner, it was the back door that was Madoff's biggest worry. Once an order came in the front door, it often created a position that had to be unloaded into the marketplace through Madoff's back door, or trading room. Madoff employed about 40 people in that trading room, a significant expense. With decimalization likely to crush spreads on the stocks Madoff traded by up to 84 percent, the costs associated with that trading room would suddenly loom much larger.

Decimalization hit in 2001, reducing the minimum trading increment from 6.25 cents to a penny, an 84 percent reduction. Firms knew it was coming, of course, and had made their plans. Still, it had a tremendous impact on every trading desk on Wall Street. BMIS' desk was no exception.

As early as 1999, BMIS began preparing for the surge in orders it expected to accompany penny ticks by upgrading its automatic execution system. For this, BMIS turned to the former TCAM technologists who had built its original system back in the 1980s.

It was the trading operation, however, that would get the most drastic overhaul. Madoff, like most trading chiefs on Wall Street, set out to replace his human traders with robots, or algorithms.

Although known as a technology-savvy operator, Madoff still employed humans to make markets. Humans sat in front of quote montages and changed their prices in reaction to or ahead of changes in their inventories. The heart of market making was adjusting the firm's prices, and at BMIS, as at most firms, humans still performed that function.

That was about to change.

Shortly after decimalization took effect, Madoff hired Josh Stampfli to automate the market-making operation. Stampfli, a former hedge fund trader, had been chief executive of Gale Technologies, a start-up birthed by brokerage A.B. Watley to commercialize a product called the Liquidity Engine. The technology had been used by Watley, an online brokerage, to automatically fill incoming orders. Gale was set up to sell the system to other brokers interested in internalization.

Gale, though, ran out of cash during the market downturn between 2000 and 2002. Stampfli was looking for his next assignment. Mark and Andy Madoff offered the trader/technologist a home. His job was to automate market making at BMIS.