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March 10, 2009

Before the Fall

By Peter Chapman

Another ex-head of trading at a large New York firm who participated on NASD committees agreed. "Bernie's strategy was to get actively involved in all aspects of the industry," he said. "He had a much bigger presence than the size of his firm would naturally warrant. By being visible, he'd boost his business. They never said no. They volunteered for everything. It was a very smart move."

Third Market
Nasdaq brought scores of market makers out of the woodwork and onto the desktops of Wall Street. The transparency benefited Madoff, but his firm was now one of about 500 quoting prices in OTC stocks. The competition was fierce. Was there a way to set himself apart?

Sometime in the early or mid-1970s, Peter Madoff became enamored with the idea of trading NYSE-listed stocks. Because of the active market in these securities on the floor of the New York, they were much more liquid. That made them easier and safer to trade.

OTC names were much riskier. "That was pretty much one-way order flow," a trading executive noted. "If there were no more buyers and if you were a market maker, you became the buyer."

In addition to the stocks' lower risk profile, NYSE rules also lent appeal to Madoff's idea. NYSE Rule 390 prevented NYSE members from trading NYSE-listed securities on a principal basis away from the exchange. That eliminated many potential competitors to Madoff, as most firms of any size were Big Board members. The rule did allow them to send their NYSE orders to other exchanges or market makers. Most of Madoff's competition would come from NYSE and regional exchange specialists. Madoff was not, of course, a member of the New York.

The business of trading NYSE-listed securities outside the confines of the exchange was known as the Third Market. Until Madoff dived in, the business was largely institutional. It was dominated by firms such as Weeden & Co., First Boston and Blyth & Co. Some wholesalers did offer retail brokers a Third Market service in the 1960s, but with the exception of Weeden, none was especially large. Others were A.W. Benkert and American Securities.

Madoff started trading NYSE stocks on a small scale in the mid-1970s, at a time when the industry was embroiled in a contentious debate over regulatory changes that would make it easier for brokerages to compete with NYSE specialists. The SEC wanted to foster widespread trading of NYSE names outside the exchange's four walls. The U.S. Congress, via the 1975 Amendments to the Securities Exchange Act of 1934, gave them the authority to do so.

The SEC's dream was to break up the Big Board's monopoly in the trading of its securities by fostering the development of a central market system. The agency's original idea involved a consortium of OTC dealers and exchange specialists competing against each other for orders. As early as 1965, an SEC staff study concluded the NYSE's Rule 394 (later Rule 390) shielded Big Board specialists from competition.