Justin Fox: Bernie Madoff's Other Legacy
[Justin Fox is the economics and business columnist for Time magazine.]
One day in fall 2007, I found myself on the 19th floor of the Manhattan skyscraper known as the Lipstick Building, listening to Bernie Madoff explain to me how he made money. This was in preparation for a discussion called the Future of the Stock Market that I was moderating; Madoff was a participant. (It's a big hit on YouTube — just Google "Madoff video.") Sadly, he didn't happen to mention the now infamous Ponzi scheme he was running two floors below us. At issue was his legit business, a brokerage that had long been one of the biggest marketmakers (the firms responsible for keeping trading going) on the Nasdaq exchange.
"You've heard of payment for order flow, right?" Madoff asked. "Huh?" I responded. Madoff explained that Bernard L. Madoff Investment Securities had pioneered the practice of paying customers to trade through it, thereby siphoning business away from the New York Stock Exchange (NYSE). The firm was able to use its sophisticated computer systems and trading algorithms to earn enough off the spreads between what it bought and sold stocks for to more than offset the amount it paid customers.
This was my first glimpse into the strange modern methods of making money from making markets in stocks. Madoff's version of it was actually outdated by the time he explained it to me. With the government-ordered advent of decimalization in 2000 (stocks were previously traded in eighths of a dollar) and the rise of nimble competitors, the big spreads that Madoff Securities once feasted on were already a thing of the past.
Since 2007, the evolution has accelerated. Less than a third of the trading in NYSE-listed stocks is now done through the NYSE — and only a tiny fraction of that by the floor traders, who now function mainly as a colorful backdrop for CNBC broadcasts. Virtually all stock-trading is electronic, and somewhere from 45% to 70% of trading volume is done by high-frequency traders who make their money by the millisecond...
...The fear may be justified, the loathing less so. Stock-trading in the U.S. was long dominated by a cartel (the NYSE) that charged exorbitant fees and stifled competition. That cozy arrangement began to fall apart in the early 1970s with the birth of the Nasdaq electronic exchange for small stocks. The rapid growth of Nasdaq companies like Intel and Microsoft, coupled with Madoff's poaching of orders from the NYSE in the 1980s and '90s, brought more direct competition. Now things have broken wide open. Nasdaq and the NYSE are still the biggest players, but they must do daily battle with upstarts such as BATS and Direct Edge. Both exchanges have also gone from member cooperatives to for-profit companies — the NYSE by merging with electronic competitor Archipelago.
The cartel is dead and has been replaced by a brutally competitive environment in which the price of trading has plunged. It's a market in which exchanges do constant battle over trading volume. The biggest volume generators at the moment are high-frequency trading firms you've never heard of — GETCO, founded a whopping 10 years ago, is the granddaddy — that try to get ahead of millisecond-by-millisecond price movements and take advantage of rebates paid by exchanges to those who create liquidity (that is, offer to buy or sell stock at a certain price and assume the market risk). Not surprisingly, the exchanges cater to these firms — with flash orders and "co-location" arrangements that put traders' computers right next to their own, giving the firms a profitable millisecond-or-so edge in trade execution...
Read entire article at Time
One day in fall 2007, I found myself on the 19th floor of the Manhattan skyscraper known as the Lipstick Building, listening to Bernie Madoff explain to me how he made money. This was in preparation for a discussion called the Future of the Stock Market that I was moderating; Madoff was a participant. (It's a big hit on YouTube — just Google "Madoff video.") Sadly, he didn't happen to mention the now infamous Ponzi scheme he was running two floors below us. At issue was his legit business, a brokerage that had long been one of the biggest marketmakers (the firms responsible for keeping trading going) on the Nasdaq exchange.
"You've heard of payment for order flow, right?" Madoff asked. "Huh?" I responded. Madoff explained that Bernard L. Madoff Investment Securities had pioneered the practice of paying customers to trade through it, thereby siphoning business away from the New York Stock Exchange (NYSE). The firm was able to use its sophisticated computer systems and trading algorithms to earn enough off the spreads between what it bought and sold stocks for to more than offset the amount it paid customers.
This was my first glimpse into the strange modern methods of making money from making markets in stocks. Madoff's version of it was actually outdated by the time he explained it to me. With the government-ordered advent of decimalization in 2000 (stocks were previously traded in eighths of a dollar) and the rise of nimble competitors, the big spreads that Madoff Securities once feasted on were already a thing of the past.
Since 2007, the evolution has accelerated. Less than a third of the trading in NYSE-listed stocks is now done through the NYSE — and only a tiny fraction of that by the floor traders, who now function mainly as a colorful backdrop for CNBC broadcasts. Virtually all stock-trading is electronic, and somewhere from 45% to 70% of trading volume is done by high-frequency traders who make their money by the millisecond...
...The fear may be justified, the loathing less so. Stock-trading in the U.S. was long dominated by a cartel (the NYSE) that charged exorbitant fees and stifled competition. That cozy arrangement began to fall apart in the early 1970s with the birth of the Nasdaq electronic exchange for small stocks. The rapid growth of Nasdaq companies like Intel and Microsoft, coupled with Madoff's poaching of orders from the NYSE in the 1980s and '90s, brought more direct competition. Now things have broken wide open. Nasdaq and the NYSE are still the biggest players, but they must do daily battle with upstarts such as BATS and Direct Edge. Both exchanges have also gone from member cooperatives to for-profit companies — the NYSE by merging with electronic competitor Archipelago.
The cartel is dead and has been replaced by a brutally competitive environment in which the price of trading has plunged. It's a market in which exchanges do constant battle over trading volume. The biggest volume generators at the moment are high-frequency trading firms you've never heard of — GETCO, founded a whopping 10 years ago, is the granddaddy — that try to get ahead of millisecond-by-millisecond price movements and take advantage of rebates paid by exchanges to those who create liquidity (that is, offer to buy or sell stock at a certain price and assume the market risk). Not surprisingly, the exchanges cater to these firms — with flash orders and "co-location" arrangements that put traders' computers right next to their own, giving the firms a profitable millisecond-or-so edge in trade execution...