Former NYSE Chairman Grasso Speaks, Part II

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.

Right.

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?

No!

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?

Exactly.

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.

Ha-ha.

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.