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March 10, 2009

Before the Fall

By Peter Chapman

Competitors' View
Not everyone saw eye to eye with the Madoffs. They championed regulatory initiatives that squashed bid-ask spreads and angered fellow market makers. Many are now quick to suggest that the profits Bernie generated through his alleged Ponzi activities made it easier to stomach those spread-narrowing changes. As Madoff's power grew, so did the resentment. His detractors said he was arrogant. Some said he could talk a good game but couldn't always deliver.

Through his attorney, Bernie declined to speak with Traders Magazine for this article. Peter, Mark and Andy also declined comment.

Bernie wasn't the whole show at BMIS. Peter had joined the firm in 1965 while still a student at Fordham Law School, from which he graduated in 1967. Peter was the firm's original computer whiz and eventually assumed responsibility for the trading operation. It was Peter, in fact, who saw the potential in trading securities listed on the New York Stock Exchange. And it was that decision that catapulted the firm into the big leagues of wholesaling.

The second generation-Bernie's sons, Mark and Andy-took control of the trading desks in the 1990s. As the years passed, the two MBA'd brothers largely replaced their father and uncle as the faces of the firm through their work on committees and appearances at industry conferences.

Mark and Andy were on the desk five years ago when it came time to usher in the black-box era-the use of computers to make markets, hit bids and lift offers. That forced the redundancy of a good swath of the firm's traders.

The decision was unavoidable but perhaps came too late. For all the firm's savvy, it was being out-traded by a new breed of algorithm-toting market maker. Madoff lost market share and profits. In the end, an investment bank could find no buyers for BMIS, and the firm was disbanded.


In the Beginning
Ironically, the circumstances behind the fall of Madoff's wholesale business were exactly the same as those behind its rise. The business crashed in the 2002-2008 period after the powers that be in Washington forced the industry to trade in penny increments. The firm got its foot in the door in the 1960s after the Securities and Exchange Commission forced the over-the-counter industry to automate its quotes.

Spurred on by a U.S. Congress upset by dirty dealings at the American Stock Exchange, the SEC spent two years analyzing the inner workings of the securities industry. In 1963, it produced the seminal "Special Study of the Securities Markets," which concluded that changes were needed.

One of its criticisms was directed at the sprawling over-the-counter market and its lack of transparency. Quotes were only published once a day in the Pink Sheets and typically out of date by the time they reached traders' desks in the morning.

To do a trade, a broker would have to telephone three market makers. The process was slow, inefficient and did not take into account all of the possibly 15 to 20 dealers bidding for or offering stock. Consequently, with no intraday transparency, bid-ask spreads were wide and market-maker profits flowed to just a few big New York wholesalers.

Displaying quotes once a day was insufficient, the SEC concluded. It believed computer technology was advanced enough to support widespread intraday quote dissemination. It urged the NASD to investigate the possibility.