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March 10, 2009

Before the Fall

By Peter Chapman

"We determined the best thing for us to do was basically to take the human being out of the equation," Bernie said at a forum on Wall Street held in New York last year. By automating the process, the trader added, a team of seven people was able to process the 300,000 trades per day that previously required 40 or 50. "This is what all market-making firms do today," Madoff said. "That's the way they operate."

With fewer traders needed, BMIS' employee roster began to shrink. From a high-water mark of 179 employees in January 2003, BMIS' staff shrunk to 146 by January 2006.
New Ballgame
Despite the boost the SEC's Dash-5 stats gave his business, Madoff's euphoria over the quality of his numbers would be short-lived. The firm went into decline after 2002 as sophisticated new players entered the wholesaling business and NYSE members began to internalize more of their flow in the wake of Regulation NMS. Revenues from the market-making operation were $42 million in 2002. They fell to as low as $13 million in 2007, before rebounding to $32 million last year.

Competition from two newcomers from the hedge fund space-ATD and Citadel-played a big role in Madoff's decline.

Automated Trading Desk, or ATD, now a part of Citigroup, had been making a quiet living using advanced trading algorithms to manage money for a small group of private investors. In 2002, it turned its attention to the market-making business and quickly started beating Madoff at his own game. ATD employed no traders, relying on computers to do all the work.

By 2005, ATD had grabbed a good chunk of the retail orders in NYSE stocks from TD Ameritrade, Piper Jaffray, Southwest Securities and Morgan Stanley. By 2008, it had 29 percent of the business, according to data compiled by Barclays Capital.

ATD was joined in 2005 by the broker-dealer unit of the giant hedge fund Citadel. Like ATD, it too employed sophisticated algorithmic trading strategies to both predict the direction of stock prices and make its markets. Citadel now commands about 30 percent of the market, according to Barclays.

The more traditional players, such as Knight and UBS, which entered the business through its purchase of Schwab Capital Markets, were determined to stay in the game. Both retooled their trading operations, replacing hundreds of traders with computers. Knight now controls a third of the business.

The customer was king. Prodded by the SEC, order senders started taking the Dash-5 reports seriously in the 2003-04 period, sources say. They were constantly comparing one wholesaler's numbers against another. Janney Montgomery Scott was one Madoff customer to reduce the amount of listed flow it sent to the broker. "The rules started to change," said Hughes, a former Janney executive. "We instituted regular and rigorous reviews, so we were constantly monitoring the execution data. That's why ATD came along, There were times when ATD was much better than Madoff on a certain stock. So you'd send the order to ATD."

The upshot was that Madoff saw its customer base dwindle to less than 100 from its high-water mark of 350 during the boom years of the 1990s. Its share of the wholesaling business was 19 percent before it shut its doors last year. According to published reports, the business accounted for no more than 10 percent of BMIS' revenues in 2007.