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March 10, 2009

Before the Fall

By Peter Chapman

Not all of the problem can be attributed to the entrance into the business of sharp-penciled hedge funds. Regulation NMS, the New York's hybrid market and the NYSE's decision to demutualize have all led to greater levels of internalization by NYSE members. It took five years, but the elimination of NYSE Rule 390 finally had its desired effect.

The Madoffs saw it coming as early as 2004. "Brokers are starting to look at [internalization]," Andy Madoff told Traders Magazine. "Reg NMS is a big deal. Once it is more defined, firms will make more of a move." Citigroup is a prime example. In 2003, the giant retail broker was sending Madoff 14 percent of its small orders in NYSE-listed securities. At the end of last year, it sent them nothing, opting to internalize more than half of the flow.

In the end, Madoff's wholesaling operation was undone by the very same forces that set the firm in motion back in the 1960s. Regulatory changes put Madoff on the map. Regulatory changes nearly drove him off of it.

Perhaps more than any brokerage on Wall Street, Bernie's wholesaling operation was a shaped by the agenda in Washington. From Nasdaq to the National Market System to decimalization to Reg NMS, BMIS both influenced and was affected by all of the major regulatory mandates. It adapted. It thrived. It ultimately declined.

-Michael Scotti provided additional reporting for the story