Q&A: Bernie Madoff talks trading, ECNs , PFOF Payment For Order Flow And More (2000)
NEW YORK (CNNfn) – Bernie Madoff is chairman of Bernard L. Madoff Investment Securities, which he founded in 1960. It is one of the largest market maker companies on Wall Street. It serves other securities companies, accepting buy and sell orders from brokerage houses and executing the trades.
Madoff Investment Securities profits from the spread, the difference between the bid price and the ask price on a stock. The company trades Nasdaq stocks and also makes a “third market” trading New York Stock Exchange stocks off the trading floor.
CNNfn.com interviewed Bernie Madoff about trading and the state of the market at the Securities Industry Association’s conference on market structure last week. Madoff is also chairman of the SIA’s trading committee.
CNNfn.com:Are electronic communications networks going to put a lot of market makers and specialists out of business?
Madoff: No. ECNs provide a valuable, limited service. They will have some stiff competition from the Nasdaq supermontage. They’re innovative people and I think they’ll come up with something [in response]. The big difference is, they don’t provide liquidity. We’re providing liquidity on all the stocks we trade and have hundreds of millions of dollars of inventory that we are working with and have at risk.
CNNfn.com:But will the roll of market makers and specialists shift?
Madoff: It depends on the individual firm. There may be some firms that pick up stocks, drop stocks. You’ll see more proprietary trading, with greater risk capital being employed. That’s been our profile forever. We still give a 5,000 share guarantee on 90-odd percent of the stocks we make markets on.
CNNfn.com:Has the free money gone, making life riskier?
Madoff: Yes, there’s more risk involved in trading. But there’s more volume, and there are more opportunities to make money. Market makers’ profits have never been greater. When the industry moved to [trading in] sixteenths, everybody was hysterical about profitability being thrown out. We said, ‘Yes you’ll make less per trade but you’ll do a lot more trades. The bottom line? You’ll benefit form this move.’ That’s exactly what happened. Specialists never had better years. Market makers also. Some did not. But the greater preponderance did very well.
CNNfn.com:Your company is one of the biggest payers of order flow, paying brokerages to ship trades your way. Why?
Madoff: It’s a relatively small part, maybe 20 percent, of our business today. Payment for order flow was only an issue as it related to best execution. Does inducing someone to send an order to you present a problem as far as getting the right price goes? Quite honestly that depends on the firm. You’re all fiduciaries. As long as you operate in the proper fiduciary capacity, and you’re dealing with a reputable firm, it wasn’t a problem. Fidelity was sending us order flow. They weren’t going to allow us to give them a worse execution than an order that wasn’t paying for it.
CNNfn.com:How much are the payments for a customer’s trade?
Madoff: It used to be two cents a share on Nasdaq [trades] and one cent a share on listed stock. Now we pay a percentage of the spread, so it probably comes out to less than half a cent a share on average for listed, three quarters of a cent on Nasdaq. So that’s relatively small. It wasn’t just cash payment. There were reciprocal arrangements, people owned affiliated companies, there were partnerships, all different ways. The SEC said ‘These are the 11 ways we deem to be payment for order flow.’ Almost every firm in the country was receiving payment. And as long as the quality of execution is not altered because of payment for order flow, then that’s fine.
CNNfn.com:Will payment for order flow ever disappear?
Madoff: No. I think it will get lower and lower as the spreads get lower and lower with decimals. No one tells a firm how they can advertise. If I want to hire salesmen to generate order flow, no one is going to object. I don’t have them. So if I want to use Fidelity’s salesmen and pay part of my trading profits in the form of a rebate, why shouldn’t I be allowed to do it? It was characterized as this bribe and kickback and something sinister, which was very easy to do. But if your girlfriend goes to buy stockings at a supermarket, the racks that display those stockings are usually paid for by the company that manufactured the stockings. Order flow is an issue that attracted a lot of attention but is grossly overrated.
Madoff: Whoever holds limit orders has an information advantage. But there are very strict rules that I would assume most firms comply with. There’s a price that people pay to get those limit orders. We present print protection for all our limit orders, which is costly for us. But we guarantee any of the 500 brokerage firms that give us their limit orders, that they are going to get as fast an execution as if they put that somewhere else. The person who sees that order gets certain information. It’s just part of the marketplace.
CNNfn.com:That’s why institutions want to see other investors’ limit orders but not reveal their own?
Madoff: They don’t want to disclose their own, and there’s a valid reason for that. They feel that they can move markets and they don’t want to tip their hand. My issue is that the public doesn’t want to move markets also. And an aggregation of lots of small orders has the same impact as one large order. You would not know to tell your broker at Schwab, don’t display my 200-share order. You’d think ‘It’s only a 200 share order.’ But typically you have hundreds of you guys coming in at the same time. If you all got together in a room, you would say ‘Hey, wait a minute, maybe we should not display our order, like the institution does.’
CNNfn.com:As a lifelong trader, do you think that many investors fancy themselves, or fancied themselves, as traders?
Madoff: Yeah. It’s a bull-market phenomenon. The market has been very hospitable to day traders. The last couple of months changed a lot of that. It’s a sunny day, temperatures are balmy, everybody goes to the beach. It’s cloudy, it rains, people go to the movies. The environment will change.
CNNfn.com:Will volume come back?
Madoff: The day-trading volume will decrease in a bear market — if and when we get one. Clearly the great preponderance of day traders are a bull-market scenario. I think volume will come back depending on the market. Tell me what the market is going to do, I’ll tell you what volume is going to do.