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

by: 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 for order flow took business away from the NYSE. 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. It was notable that Madoff and the firms he was trading for engaged in pay for flow with orders from unsuspecting retail investors, not those of institutional traders.

In 1990, the NASD empanelled a group of experts to study the subject. The committee was headed by former SEC chairman David Ruder, and included Mr Madoff. The so-called "Ruder committee" delivered a report in July 1991 dubbed, "Inducements for Order Flow".

The report found no legal basis for restricting the practice of payment for order flow, but recommended that the NASD require its members to disclose in advance the "factors that influence their order-routing and execution decisions".

The committee included the leading practitioner of the strategy in question?

If my memory serves, the SEC later required firms to disclose to customers that they may have received compensation for directing their order to a particular market or broker, or may have traded against the order themselves (a practice known as internalization). This disclosure was implemented by the firms as generic, boilerplate language on trade confirmations, with little if any effect.

In the 1990s, then SEC chairman Arthur Levitt criticised payment for order flow in speeches, but he never restricted the practice. Mr Levitt says he often asked his counsel for market regulation to figure out a way to ban the practice, but those requests went nowhere.

I think that merits more explanation; why did the requests go nowhere -- what happened?

The article goes on to explain how payment for order flow worked, and how immensely profitable it was for Madoff, until the introduction of decimalized stock prices shrunk spreads to as little as a penny. That meant it was no longer so profitable to pay for orders because the firm couldn't recoup that payoff (and then some) by capturing the spread on every trade.

This article got me wondering about other things as well.

Was Madoff's beginning as operating outside the established framework of markets the first indicator of future problems? In particular, was his treating trades as a commodity for his profit -- not that of the customer -- an early signal that regulators and investors should have heeded?

Given the NYSE's dominance of trading at the time, it is understandable that Madoff seemed like a David versus our Goliath, and I recognize that we needed competition. But in the name of fostering that competition, was Madoff given too much regulatory leeway? And did the SEC's allowing payment for order flow embolden Madoff to go on to bigger and worse things later? If he ends up on "60 Minutes," I think that would be a good question for him.

Similar ground is covered in "Rigged Games" (Forbes.com):

...Bernie led a group of Nasdaq marketmakers who wanted a piece of the NYSE’s very profitable game. They argued they could give investors a better deal by bypassing the established exchanges and matching buyers and sellers more rapidly on their own computers. There was only one problem: The marketmakers were gaming the system, too. Madoff paid brokers to steer orders to his computers--as long as they were from relatively ignorant retail customers who didn’t possess information that could move the market away from him too quickly. The marketmakers also kept spreads at 25 cents or more by refusing to post offer prices in “odd eighths,” or 12.5 cents off the bid, and refusing to deal with anybody who broke rank.

...Watching over all this misbehavior was the National Association of Securities Dealers, which ran Nasdaq and was controlled by executives in the securities industry. Madoff served as Nasdaq chairman from 1990 to 1993, and his brother Peter was NASD vice chairman in 1993.

Marketmakers “had a cushy existence in the Nineties,” says William Christie, a finance professor at Vanderbilt University who exposed the spread manipulation in an influential 1994 paper. That ended soon after Christie’s paper came out. Spreads collapsed literally overnight, and the Justice Department and class action lawyers extracted a consent decree and a $1 billion settlement a few years later.

The Forbes article underscores that the Madoff firm had a seat at the table of the self-regulatory organizations that made and enforced the policies and rules from which the firm stood to benefit. From what I gather in various news articles, prospective investors unfortunately took the leadership roles of Bernard Madoff and his family at Nasdaq and NASD as qualifying credentials for the firm as an investment manager, not warning signs or conflicts of interest that needed to be vigorously overseen.

From "Gaming in Dark Pools" (MarketBeat):

The rapid evolution of modern markets has caught securities regulators off guard in many instances this year, and they may be overlooking the scope of another problem in the rapidly growing alternative stock exchanges known as dark pools. One hedge fund manager says the only thing stopping him gouging clients of dark pools is his lawyer and his scruples. “It’s free money,” said Richard Gates, a portfolio chief at money manager TFS Capital. “It’s a neat inefficiency in the marketplace, and dark pools are growing tremendously in size.”

I take the MarketBeat post as a sign that the press is now going to be looking critically at little-noticed aspects of the markets, searching for nooks and crannies where the Next Big Problem might be brewing. That examination should be healthy for the development of markets and the protection of investors.

As the post points out, markets indeed have evolved rapidly. Dark pools are not the only such development. For example, internalized orders printed on the Finra-Nasdaq trade-reporting facility now account for more trading in NYSE-listed issues than Nasdaq does. Is that what policy makers intended when designing today's National Market System? Are such developments getting the appropriate level of regulatory attention, given their size and growth?

I don't know the answers, but I hope we're asking the right questions. There have been bigger changes in our markets in the last 10 years than in the previous 200 combined. Are we looking closely enough at the net effects? Conversely, are we stepping back far enough to take in what we've collectively created?

I'll try to mine these topics further. In the meantime, your thoughts are welcome in the comment box below.

Disclosure: Author is Vice President of Corporate Communications at NYSE Euronext.

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