How would you describe it to a layman?
His broker-dealer, Bernard Madoff [Investment] Securities, executed orders in Big Board-listed stocks away from the Big Board that were given to that broker-dealer by other broker-dealers in return for payment from order flow. He would pay a penny a share to many of the regional broker-dealers in the U.S. to effectively buy their order flow. And in return, he would execute those orders in-house, at Madoff [Securities], and take the risk of the offset—meaning that when he had an inventory, he would lay that inventory or sell that inventory back to the primary markets, principally to the NYSE. And when he had an exposure as a result of being short, he would cover, or buy shares to cover his risk on the primary markets. The broker-dealers who gave him that order flow effectively got a penny a share.
....When you saw what he was doing, did it seem to be profitable to you?
Extraordinarily profitable, because remember during the period of time when he was doing it, the minimum price variation was 12.5 cents—meaning the tightest the spread could be was separated by an eighth of a dollar, which meant that if he paid a penny coming in and paid a penny going out—meaning a penny to the buyer and a penny to the seller—it was potentially 10.5 cents of profit for the Madoff organization.
But that good thing came to a halt:
And how long did he get away with this?
Oh, I would say 20-plus years. You see, what killed that business was when we went to pennies. Because you crush the spread and you crush costs. And there’s no more opportunity for him to pay a penny coming in if the market is a penny bid offered at two cents.
Right. What year was that?
We started that process in 1997 by going from an eighth to a sixteenth, which, you know, took 50 percent of the profitability opportunity out. And then, by 1999, we went to a penny.
So could that have been the first problem he had?
Yes, I don’t think there’s any doubt that the economics of his primary business evaporated.