In the second part of our exclusive interview, former NYSE Chairman Richard Grasso tells Allan Dodds Frank how Bernie Madoff made $1 billion (legitimately), why the SEC looked the other way, and why it all went foul.
For nearly three decades, former New York Stock Exchange Chairman and CEO Richard Grasso viewed Bernard Madoff as one of the top competitors of the NYSE.
Madoff was one of the leaders in promoting computerized trading of stocks, in lots of 5,000 shares or fewer, outside the trading pits of the New York Stock Exchange. As an influential promoter of over-the-counter stock trading and regional brokerages, Madoff was regarded in New York and Washington as an industry leader.
“I wouldn’t be surprised if in a 20-year period—call it ’79 to ’99—his entity made $700 million to $1 billion.”
Grasso had a bird’s eye view of how the former Nasdaq chairman made his money. He talks with The Daily Beast’s Allan Dodds Frank about Madoff’s rise and fall, how much he believes the disgraced financier legitimately earned, and what investors can learn from the case.
You knew Bernie Madoff. What was he like?
He was very personable, although he was the arch-nemesis and competitor of the NYSE because his third-market business was our largest competitor for order flow, particularly at the so-called consumer end of the market transactions of 5,000 or less; he was very effective at buying order flow from broker-dealers to execute in his model away from New York. He was a likable person; he was involved in virtually every market-structure exercise from the late 1970s forward. He was always at the table with the organized markets and the SEC, and he developed a relationship with me and my predecessors that was very cordial.
So you’re telling me that he had a legitimate business?
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.
How did Madoff start to be a player in market-making?
He was a third-market maker in the…’60s and ’70s, but he was primarily not in listed securities. I think he did more in preferred stocks. Then, when the National Market System Act passed in 1975 and we proposed to the Congress the model of satisfying that being an intermarket training system, which linked all markets, listed and unlisted, together in listed securities, that’s when he really rose to prominence. He was the first third-market participant to be admitted to that system.
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.
How much money do you think he made?
Hard to quantify, but I wouldn’t be surprised if in a 20-year period—call it ’79 to ’99—his entity made $700 million to $1 billion.
So you think he might have made $1 billion legitimately?
It wouldn’t surprise me. Because he was the premier third-market maker in listed securities.
Did you guys [at the New York Stock Exchange] sit around and try to figure out how he was making money?
Oh, we knew how he made money. We did not know he was an investment adviser. He was making money by paying for order flow in the listed market and we railed against it. You can see congressional testimony after testimony where we attacked the practices as being inconsistent with serving the interests of investors’ orders, but it fell on deaf ears. What we were railing against and really what I think few people knew about is investment advisory business. People were railing—I was certainly the person crying foul loudest about payment for order flow because I thought it was inconsistent with the thematic of a best execution.
Yes, I remember that.
The regional broker-dealers loved Bernie Madoff. OK, because they would convert an expense to a revenue. Let me explain that. If I was a regional broker-dealer and I sent an order to buy or sell a hundred shares of stock to the New York Stock Exchange and it had a limit price on it, which meant it had to be booked, when that order got executed, the specialist added a brokerage commission to that execution price.
So to the entering broker-dealer, that was an expense. Not only did you eliminate that expense if you sent that order to Bernie, because he didn’t charge you anything, he pays you a penny a share, [laughs] OK? So what might have cost you, you know, three quarters or a penny of a share as an incremental expense became a penny a share of revenue to the broker-dealer.
And your view was that was basically commercial bribery?
That’s what I thought it was. Look, there’s no secret, you can find testimony after testimony that I gave that it was like payola in the record business.
And the SEC never did anything about it?
Why? Was that due to his political skills?
No, no, no. Because everyone thought it was good sport to beat up on [the NYSE].
Because you had such a monopoly on the market?
But think about it. I mean, you have an order you’ve given to your brokerage firm. They take that order and instead of sending it to the primary market, OK, where whatever the percentage of time, we would have argued somewhere between 30 and 40 percent of the time, as a buyer, you got the stock for less than the offer or as the seller you sold the stock for greater than the bid.
Instead of sending it to New York, it went to Bernie, and in return for my sending it to Bernie, I would be paid a dollar a hundred. And all you were ever guaranteed was that you would sell it at the bid and buy it at the offer.
So if Madoff’s paying a penny a share there, how much was that transaction worth to him?
Think about it, the minimum spread in those days was 12.5 cents. So if I’m paying a penny on the way in and a penny on the way out, there’s 10.5 left for Bernie.
Unless, of course, he was executing at the customers’ best price, not his best price.
He had to match [by law] the national best bid displayed offer. That’s where the dialogue got really into Washington speak. So if there was an offer, say an eighth offered [to buy] at three eighths [to sell]. As a seller, he could not sell it at any less than the eighth bid. Now, if he sold it at the eighth bid to himself, he could immediately reoffer it into the national market at a quarter.
Because remember, write that down, an eighth bid offered at three eighths—there’s a 25-cent spread in there. If I buy it at an eighth, I match the national best displayed bid, if I match that I buy it as a principal, I immediately reoffer it at a quarter.
So he double-deals with himself.
Well, he double-deals, in essence, he becomes a principal when he should have been an agent.
How valuable would the knowledge that he had, of this order flow, have been?
You mean in terms of the profitability of his business?
I have a sense that many investors thought that somehow Bernard Madoff had the inside track on information, almost enough to be inside information that could have been illegal, but since the authorities weren’t doing anything about it, the investors thought they were getting a free ride on what he knew that other people didn’t know.
Again, I was shocked to learn that he was a supposed money manager. Given the target market for his business, which was primarily the S&P 100, but probably a little broader than that—maybe the top 250 stocks in the S&P 500, and trade size limited to 5,000 shares—I wouldn’t think that information was very valuable at all. If he somehow projected the width of inside information to people, when you look at the reality of what his order flow content was—consumer content, which was, in those days, less than 20 percent of the overall market.
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. Oh, again, it goes back to—I had no idea he was in the other business, but—his primary business, and I thought his only business, which was third-market maker against New York, the economics of that business had a tectonic plate shift when we went to pennies.
What was his role in building the Nasdaq?
Remember, Congress passed the National Market Act in 1975 and he became the first of the non-NYSE member organizations to be linked into the NYSE market via the intermarket trading system, which was an outgrowth from the congressional mandate to create an interlinked national market for listed securities. Through that, he became a very powerful voice in the third market, ultimately in the Nasdaq market, because he had a Nasdaq business as well. He became well-respected in that community, and they elevated him through his various committee services to become chairman of Nasdaq.
Do think that helped shield him from regulatory examination?
I would say not. Speaking from my experience with the SEC, not with the NEAC, the SEC was totally apolitical. They went in and their people always tried to do the right thing. It didn’t matter whose toes they stepped on, they had a job to do. They were in no way influenced by Bernie Madoff or whoever else might have been a big name in securities markets. My experience with them was they were tough, they were smart, they had a job to do, and they were gonna do it.
Was he a tough negotiator, or did he prefer to use his humor from the bigger exchange? How did he behave?
His was an advocate of a very different system, so we never had a philosophical alignment. He was tough but fair, and I found him to be engaging, and when he was wrong, he would step up and say he was wrong.
I’m sure you’ve heard from a lot of people firsthand who knew him—what have you heard since the initial charges that stun you the most?
The whole premise that a man who was extraordinarily successful in competing against the biggest market in the world would do something like this. He was successful; I always thought he was very profitable; he appeared to live a very good life. You have to ask yourself the question, “What drives people to do something like this?”
One of the things that strikes me is his demeanor all the time.
Never, ever did he seem emotional or out of control; he was always as calm as a cucumber.
Is it possible that he could have done this by himself?
I would just be speculating—and I hope for his family that they weren’t involved, but the people you talk to say someone else had to be involved. You could not carry out such a grand scheme, with such a broad reporting and accounting responsibility, without having help. That doesn’t mean his family was his help.
Anything else about the Madoff case that people ought to learn from?
The message that I hope people would take away—and you can’t feel anything but terrible over what’s happened to individuals and charities, from very small investors to very large investors to nonprofit institutions—the one thing I see as kind of a red flag is that old issue of diversification. People have got to respect the theory of diversifying your investments; you can’t put all of your eggs in one basket. As good as the returns appeared to be, remember that old adage: If it sounds too good to be true, it is.
Allan Dodds Frank is a business investigative correspondent who specializes in white-collar crime.