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March 10, 2009

Before the Fall

By Peter Chapman

Madoff didn't have all the retail flow not going to the New York Stock Exchange. Discount brokers such as Schwab and Fidelity also operated specialist posts at various regional exchanges to internalize their NYSE-listed orders. Pershing, a large clearing firm, also operated specialist posts at regional exchanges. 
Payment for Order Flow
Market making in those days was still a spread game. The minimum trading increment was a relatively fat 12.5 cents per share, allowing dealers to make a profit buying at the bid and selling at the offer. The wide spread also enabled them to pay for order flow. The practice had been around since the 1970s, when wholesalers were paying brokers about 2 cents a share for their OTC orders. Madoff extended the practice to NYSE-listed securities in 1988, paying brokers about a penny per share.

The move did not endear Madoff to the New York Stock Exchange and some of the regionals. As BMIS began to eat into their businesses, they complained bitterly to the SEC. They charged that Madoff's firm competed unfairly because it was not bound by the rules of exchanges. BMIS could pick and choose with whom it traded and which orders it would accept. Exchanges, on the other hand, had to take on all comers.

Others contended the SEC should abolish payment for order flow, as it constituted a perverse incentive for order-flow senders. Brokers should choose their trading venues based on best execution, not kickbacks, Madoff's detractors argued.

Madoff countered that the point was moot because his customers always got the best bid or offer. In addition, the brokerage could pass the savings on to its customers.

Ray Pellechia, an NYSE Euronext spokesperson for many years, still maintains that PFOF is harmful and that investors deserve a shot at price improvement. He recently blogged: "I also believed-and still do-that pay for flow deprived investors of the opportunity to get the best price; that is, the ability to trade at a price better than the published best bid or offer."

The SEC had long tolerated payment for order flow. But it was still concerned over possible conflicts of interest. In July 1989, the SEC convened a roundtable of industry leaders to discuss the issue. Bernie Madoff, the NYSE's Dick Grasso, Charles Schwab, Leslie Quick of Quick & Reilly, John Watson of the Security Traders Association, Peter DaPuzzo of Shearson Lehman and Buzzy Geduld of wholesalers Herzog Heine Geduld all sat down to offer their views on the subject.

After listening to all the arguments, the SEC still took no action. The sniping continued unabated for at least five years. Eventually, Congress waded in.

In the spring of 1993, Congress held hearings on the issue. NYSE chairman William Donaldson testified, asking Congress to ban the practice. So did NYSE president Dick Grasso. Bernie testified in defense of the practice, but said he would be open to brokerages having to disclose the practice. NASD president Joe Hardiman testified in support of the practice, defending the Madoff model.