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March 10, 2009

Before the Fall

By Peter Chapman

Whatever the case, Madoff still had high hopes for his Third Market business. And because he had hopes of becoming a volume player, he decided he needed to automate the intake of orders. That way, brokers could send him flow at the push of a button and receive their trade reports just as quickly. This was a big and expensive project. One exec estimated it cost firms that chose to do this between 25 and 40 percent of a year's profit-and-loss account. Peter Madoff was put in charge.

In 1983, Madoff brought in TCAM Systems, a software vendor started in 1979 by the former chief information officer at Smith Barney, to build the system. TCAM had built a similar system a year earlier for Dean Witter Reynolds' OTC department.

The system TCAM would build for Madoff would read the quotes from the newly launched Consolidated Quotation System and quickly execute incoming orders at prices based on those quotes. The project took five years to complete. When it was finished, in 1988, it automatically filled orders of up to 3,000 shares at the national best bid or offer in less than 10 seconds. That was considerably faster than the New York Stock Exchange, which, by rule, had 90 seconds to handle the order.

"He was a pioneer," said Ken Pasternak, former chief executive of Knight Capital Group and a competitor to Madoff in the Third Market from the 1990s. "What helped him was the fact that he was the first to automate and provide [speedy] executions." Pasternak ran trading at Troster Singer in the late 1980s and early 1990s. Troster automated the intake of its OTC flow at roughly the same time Madoff automated the intake of his listed flow, Pasternak said.

Other industry execs also acknowledged Madoff's technology prowess. "They always had the best technology," Dennis Green, the former head trader at Legg Mason, remembered. "They always did. Even when none of us could afford that technology. It was expensive for us in the hinterlands. Maybe not in New York. But they always had the best systems."

Madoff's speedy fills involved trade-offs, though. An order sent to the New York might get filled at a price better than the NBBO, or within the spread. Madoff offered no such "price improvement." But, he argued, since he traded only the most liquid stocks, their spreads were as tight as they could be. Thus there was little chance they would get price improvement at the Big Board. Still, the criticism over Madoff's lack of price improvement would dog him throughout his career.

Madoff's business plan was simple: Accept orders only in the biggest, most liquid stocks from "uninformed" retail investors. Charge no fees. Guarantee fills on all orders up to 3,000 (later, 5,000) shares. Execute orders faster than the New York Stock Exchange.

Restricting his dealings to retail flow and the most liquid stocks would mitigate Madoff's risk. So-called uninformed investors-in contrast to professional traders-know less about a stock's immediate prospects than the dealer. And with the most liquid stocks, laying off positions would be easier.

Madoff got his new TCAM system installed just in time. The stock market had crashed the previous October, and the public had deserted the market. Retail brokers were hurting and looking for ways to cut costs.