Rigged Games
Daniel Fisher Forbes Staff
I cover finance, the law, and how the two interact.
As nonexecutive chairman of Nasdaq in the early 1990s, Bernard L. Madoff raged against the arcane rules that prevented trading in New York Stock Exchange stocks from migrating to cheaper and faster computer networks like the one he was building in his midtown Manhattan offices.
Madoff was on the right side of history: Trading has since spread to a multitude of competing electronic exchanges. The NYSE specialists are fast becoming a historical oddity. But like many revolutionaries, Madoff likely was consumed by the changes he helped set in motion.
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.
Marketmakers were slow to react to the changes they'd helped initiate, says Daniel Weaver, a professor at Rutgers University who also wrote about marketmakers' tactics in the 1990s. "They had a model they learned to profit from," Weaver says. "Why change?" As prices shifted from fractions to decimals, volume increased, but spreads continued to shrink. "Decimalization probably made the marketmakers less important and less profitable," says Jake Zemansky, a New York securities lawyer who was involved in NASD litigation in the 1990s.
Madoff, who had a lock on a lucrative business that disappeared, survived and apparently found another way to pay his bills.
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I am a senior editor at Forbes, covering legal affairs, corporate finance, macroeconomics and the occasional sailing story. I was the Southwest Bureau manager for Forbes...