The abrupt closure last month of Bernard L. Madoff Investment Securities, charged with running a Ponzi scheme, left some of its retail broker-dealer customers with losses and proved a windfall for the wholesaler’s competitors.
Madoff Investment Securities was closed last month for allegedly bilking money management clients out of an estimated $50 billion. The Securities and Exchange Commission has charged firm founder Bernard Madoff and the firm with a crime that has touched investors and traders far and wide-in the U.S. and abroad.
The asset management area was run on a separate floor from the wholesaling unit, which was operated by Bernard Madoff’s sons, Andrew and Mark, who have not been charged.
Madoff’s wholesale customers did not incur losses on trades the firm handled through Thursday, Dec. 11, its final day of operation, according to sources. But some experienced losses on limit orders held by the firm on the next day’s open-Friday, Dec. 12.
Madoff employees advised their customers before the market opened on Friday not to send any new orders. But, as late as 30 minutes before the opening, they also told them not to cancel their sitting limit orders.
At one minute before the bell, Madoff unilaterally canceled all sitting limit orders. The move forced agency desk executives to scramble to route these orders to other trading houses.
The surprise reversal by Madoff caused problems for brokers whose limit orders would have executed during early trading. They had to honor their customers’ instructions to trade at the limit prices.
At least one retail brokerage, D.A. Davidson & Co., based in Montana, reports losing $50,000 making good on its customers’ limit orders. Madoff canceled 1,200 limit orders, Patrick Fay, Davidson’s director of equity trading, told Traders Magazine. “At one minute to the opening, they kicked out all our orders,” he said. “And it wasn’t just us.”
It is unclear how many other brokerage firms lost money on their unexecuted limit orders. But Madoff has described its customer base as including “scores of leading securities firms, banks and financial institutions.” Based on regulatory filings, they ranged from small firms such as Davidson to larger ones such as Morgan Keegan.
Another Madoff customer confirms the last minute snafu, but did not describe losses. “The cancellation process was cumbersome,” the operations executive said, “because you had to look at them, find out who is close to the market and then get them delivered to another party.” His firm uses Thomson’s Beta back-office system, which “did wide-scale cancels and then put them back in the system for routing to another party.”
Madoff executives did not return telephone calls.
Sources reported no losses on trades completed by Madoff in the three-day period between Tuesday and Thursday, partly because the National Securities Clearing Corporation “locks in” the trades and guarantees they will clear and settle.
Most sources reported it was very easy to transfer their new orders to Madoff’s competitors. “There are plenty of fish in the sea,” said Dan McMahon, co-head of equity trading at Madoff customer Raymond James Financial.
Most firms have contingency plans in place to route orders to other wholesalers if their primary venue is experiencing problems. Thomson’s Beta system makes that easy, they say.
Bernard Madoff and his firm have been accused of using money from new investors to pay off existing clients-the classic Ponzi scheme. Even though the alleged fraud occurred within the money management arm, the entire firm is being liquidated by Irving H. Picard, at the behest of the Securities Investor Protection Corporation.
Madoff was best known as a wholesaler, a trading house that handles the orders of retail brokerages. Many of its clients were regional brokerages such as Raymond James, Wells Fargo Investments, Morgan Keegan and A.G. Edwards.
It operated in a highly competitive sector of the securities industry where large computer-driven firms have come to dominate. Chief competitors are Citi/ATD, Citadel Derivatives Group, Knight Capital Markets and UBS. Madoff was actually one of the smaller firms in the group.
Some or all of these firms are expected to benefit from Madoff’s demise. On the first day Madoff was closed, Knight’s stock shot up 6 percent on a day the S&P 500 Index rose 1 percent. Analysts at Barclays Capital interpret the move as “driven by investors’ evaluation of potential opportunities for Knight to pick up market share from wholesale competitor” Madoff.
Despite its stature as one of the industry’s smaller wholesalers, Madoff was held in high regard by order senders. Davidson’s Fay says his firm had few problems with them and that they were always quick to fix any situation.
An executive from a clearing firm who has known Madoff executives for many years called them “straight shooters and the most honest people in the business.”
Indeed, equity pros used words like “shocked,” “shaken” and “disbelief” when describing their reaction to the news that Bernard Madoff ran an elaborate scam that bilked investors out of a staggering $50 billion. Other traders declined commenting on what might be the biggest Ponzi scheme in the history of the U.S. securities business.
“This is a major shock,” said legendary trader E. E. “Buzzy” Geduld, who served on a number of industry committees with Bernard Madoff. Geduld sold his Nasdaq market making firm-Herzog Heine Geduld-to Merrill Lynch in 2000 and now runs his own firm, Cougar Trading. Geduld said he has known Bernard Madoff for 35 years and “has the highest regard” for him and his family. Geduld was not an investor in Madoff’s hedge fund, where the alleged fraud occurred, and has not seen him in three years, he said.
Brothers Bernard and Peter Madoff built their business trading New York Stock Exchange stocks by beating the NYSE specialists at their own game. The firm championed technology when other market makers were still in manual mode. This burnished the firm’s reputation for being progressive. In fact, Madoff championed the SEC’s 1997 Order Handling Rules, which forced dealers to post their customers’ bids and offers for public display.
Although the Madoffs were active in Nasdaq-Bernard Madoff was Nasdaq chairman for three years-the firm did not start trading the Nasdaq 100 for clients until the mid-1990s. It was also among the last of the odd-lot brokers and did a nice business in that space until 2000, according to one NYSE source. The firm exited the business when the NYSE changed the rules and put the business in the hands of the specialists.
To put the alleged fraud into context, the $50 billion that disappeared from investors accounts is 7.1 percent of the size of the government’s $700 billion bailout of the financial system.
“I am still in shock,” said Art Pacheco, who also sat on numerous Nasdaq and Security Traders Association committees with Bernard Madoff. Pacheco, a longtime sales trader who now works for a foreign firm, Raffameel Structured Finance, says this is the last news he would have expected about the people and firm.
“I’ve always known him as a good guy-an industry leader,” Pacheco said. “I’ve known Bernie Madoff for over 30 years, and I’m just dumbfounded. I just don’t know what to say. It’s terrible.”
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