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'Payment for Order Flow': Madoff's Earlier Days

Dec. 30, 2008 3:39 AM ET6 Comments
Ray Pellecchia profile picture
Ray Pellecchia

News articles about the Madoff scandal are beginning to focus on Madoff's earlier days in the business, when he and his firm were best known as the leading practitioners of "payment for order flow," and as driving forces behind the growth of the "third market" as well as Nasdaq. In this post I'll parse two articles on the topic that have appeared in the last few days, as well as a relevant blog post.

Excerpts, along with my own comments, from "SEC inaction that helped fuel scheme" (FT. com):

...It was the SEC's decision in the 1990s not to take a stand on the controversial issue of "payment for order flow" that helped fuel the rise of Bernard Madoff Investment Securities, the successful broker-dealer operation two floors above Mr Madoff's private fund operation in Manhattan.

According to regulators and competitors, Bernard Madoff Investment Securities enjoyed at least a decade of outsized growth in the 1990s because it paid brokers for business and exploited wide bid-offer spreads in the market.

By paying for order flow, Mr Madoff's firm siphoned roughly 10 per cent of the volume of trading on the New York Stock Exchange away from the specialist firms that dominated the Big Board's floor, creating what was known as a "third market". Then, according to competitors and regulators, Mr Madoff's firm thrived by trading within the bid-ask spreads, which could be sizeable.

The SEC had a longstanding rule regarding disclosure of any "remuneration" received in connection with stock transactions. But, as the practice of brokers paying for order flow became popular in the 1980s, concerns were raised about whether the brokers doing the paying were buying stocks at the best prices for investors.

There you have both the nut of the article and the disclosure of my own bias. Payment

This article was written by

Ray Pellecchia profile picture
Ray Pellecchia is vice president of Corporate Communications at NYSE Euronext. In addition to his work in Media Relations and Employee Communications, Ray oversees the company's blog, called Exchanges (http://exchanges.nyse.com/).

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Comments (6)

Ray Pellecchia profile picture
Thanks to all for the comments. This first-time contributor to Seeking Alpha is impressed with the response!

A couple thoughts on the last two comments:

mplaut: Agreed, we need to learn more before reaching any conclusions. My purpose was to raise questions. It will be interesting to learn the answers, just as I'm surpised to hear that you had brokers who passed along payments for order flow to customers. Also agreed: any system is susceptible to abuse; I think it's beneficial to discuss these issues so we can better understand how to prevent violations of trust and encourage compliance with the rules and the law.

capitalstructureman: All good questions: Where does the balance of competition versus fragmentation net out? Are we better off today? Do customers know enough about how their trades are handled? Can this new marketplace be regulated effectively? The answers will impact the public's confidence and participation in our financial markets.

The question is are we better off with a fragmented market or should we have a central market place?
With fragmented markets,dark pools, ECN, ATS,OMS,internalizatio... other exchanges that trade the same security can regulators oversee all these venues. One thing is certain that the upfront commissions which appear on customers confirmations have come down, but the question is do customers realize that other costs are incurred. How many customers know what payment for order flow means, even though the back of their confirmation acknowledges that fact.
I would hope that when the oversight committee meets that someone asks the SEC commissioner if he feels 100% confident that the regulators can regulate today's fragmented market. Additinally I would like to hear the SEC comment on the benefits of payment of order flow to investors.
M Plaut profile picture
It is rhetorically easy to smear Madoff's market activities with his clearly fraudulent money managing. But we will have to wait for more information to know if there really was a connection.

I had personal experience with several different brokers who passed on the order flow payments to their customers, and the firms themselves had computer systems that sought the best price, order flow payment or not (since anyway it did not go to them).

I think that the NYSE specialist system is pretty good overall, but it has also suffered from abuses from time to time to time again.
sheeples,its all ponzi & wall st does not want it cleaned up.the fleecing will continue & madoff is a piker compared to the whole thing.he should be made sec chairman with to clean it up or go to jail.this capitalistic system has fallen prey to scammers,scoundrels,li... & crooks.too big to fail,too many to jail is the new motto.but its ok the beer swillers are still filling the stadium.
Madoff's story is one of pride, plain and simple.At one time, he was a true leader in his industry, but his desire to be a "somebody" was uncontrollable and he deviated from the right path to feed his ego.

I don't care how great you are, anytime you add secrecy to big money, temptation will arrive.

Madoff proves once again that excess ego and too much pride are deadly. People in the clutches of those nasty twins can;t be trusted with OPM (other people's money).

If you want to know when Madoff went bad, just find out when he started using that rinky-dink accountant.
If a small hedge fund manager like Spiro Germenis, for example, can easily manage and steer investments to his pockets or at places that the money were not meant to be, what can really stop the big managers?
Swindler Spiro Germenis easily fends of prosecutors by threatening to expose much bigger scams. Therefore, there ARE much bigger scams.
Is the financial network a huge pyramid of swindlers?

In May 2008 President Bush responded to the “homeowner rescue plan’ saying “ Americans understand that we shouldn’t create a taxpayer funded bailout for lenders and speculators.” But after he realized that it was the tip of an iceberg, he started campaigning saying that a trillion dollar bailout is a must, because as bad as it appears, the alternative can be much worse.
I believe that he is now forcing disillusioned Americans to inject money into the big pyramid scheme in order to keep it going a little longer.
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