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March 10, 2009

Before the Fall

By Peter Chapman

The plan to construct a central, or national, market system boiled down to two competing ideas. The Cincinnati Stock Exchange was proposing a Composite Limit Order Book (CLOB) known as the Multiple Dealer Trading System, within which all trades would take place. The New York Stock Exchange was promoting the Intermarket Trading System (ITS), a routing and quoting network that would link all the exchanges.

The Cincinnati's CLOB, based on a trading platform designed by Weeden principals, was perhaps the more radical of the two ideas and eventually lost the SEC's endorsement. The ITS launched in 1978 with the participation of every exchange except the Cincinnati.

The ITS was a godsend for Madoff if only he could plug into it. The network was a critical link to the New York Stock Exchange that would allow NYSE specialists to see and access the quotes of regional exchange specialists. In turn, it would allow regional specialists to access the New York to lay off their positions.

Madoff, however, was not a regional specialist. He was an NASD member. And when the ITS launched, there was no connection to Nasdaq. That was not for lack of trying on the part of the NASD. The New York fought hard to keep the NASD out. It wasn't until 1982 that the NASD was permitted to link to the ITS, and even then, market makers could only trade a limited number of (Rule 19c-3) stocks over it.

So in the late 1970s, the Madoff brothers started sniffing around the Cincinnati, hoping to become specialists. Although they were eventually allowed to purchase seats and Peter took a position on the board, they were initially treated with suspicion. Cincinnati executives were worried Bernie might be some kind of spy for the NASD, which was fighting hard to get full access to the ITS. In 1978, Bernie was a member of the NASD's National Market System Trading committee. In 1979, he was on the NASD's National Market System Design Committee. From 1981 to 1983, he was the head of the design committee. In 1983, he became chairman of the NASD's District 12 Committee, representing the New York area.

For the Cincy, the fear was very real. If the NASD did get full access to the ITS, and all those market makers started trading NYSE names, there would be little reason for regional stock exchanges to exist. Imparting precious technical information to the Madoffs could prove hazardous.

In any event, by 1980, the Madoffs were members. Peter joined the trading and technology committees, and the firm--along with other CSE specialists such as Merrill Lynch--had invested in an upgrade of the MDTS. That year, the Cincinnati closed its floor and opened for business as the country's first all-electronic stock exchange. In 1981, when the exchange finally won access to the ITS, Madoff could hang out his shingle as a full-fledged alternative to the New York Stock Exchange.