Madoff's Longtime Rival On What Made Him Tick

How could a very smart man near the close of a very successful financial career betray his sons, his friends, and causes he clearly held dear?

Let’s forget the psychologists—they’ve never been in the trenches on Wall Street—and turn instead to someone who competed directly against Bernard Madoff for years, who like Madoff, made millions and who was engulfed by a scandal that cost his former firm $79 million to settle: Kenneth Pasternak.

Among his peers, few probably know Madoff as well as Pasternak, the former CEO of Knight Securities. Handling massive blocks of trades, the two were neck and neck for years, each running market-making operations in an unsexy business that exploded during the Nasdaq boom. They served on panels together and were heavyweights on various committees seeking to set the regulatory and stock market agenda. Madoff, of course, was Nasdaq’s chairman.

He did this totally in a flawed effort of human nature to be viewed as a somewhat larger than life person, not to make money.

Madoff couldn’t have done it alone, Pasternak told The Daily Beast by email: “He would have needed help at [his firm] to produce the statements and do the cover-up. They would have to have known the statements were a fraud with no trading.”

So why did Madoff do it? Was he in over his head, blindsided by the calamity that’s hit the markets this year and knew of no further way to recoup? No, he was driven by something more basic. He wanted esteem. It’s as simple and as tragic as that, Pasternak suggests.

“The irony here is that Mr. Madoff had one of the most profitable market makers of our time that made hundreds of millions if not nearly a billion dollars for him during the last 25 years,” he said. “He did this totally in a flawed effort of human nature to be viewed as a somewhat larger than life person, not to make money.”

A federal judge cleared Pasternak of SEC trading-fraud charges in June of this year after a six-year legal battle; a second Knight executive was also cleared. His former firm, now called Knight Capital Group, settled in 2004 and agreed to pay $79 million. He retired from Knight in 2002 and invests for his family via non-marketed hedge fund Chestnutridge Partners L.P. and runs KABR, a distressed real estate partnership.

Some have suggested that the savviest investors in Madoff’s funds, were probably aware that Madoff’s stated, rather simple trading strategy couldn’t generate the ever-reliable returns he was posting and thought it wise not to look too closely. But Pasternak doesn’t think so.

“The notion that they can look out for themselves is a false one,” he said. “Even the Fund of Funds didn't catch this one.”

And neither did the SEC. The regulator probed Madoff Securities twice and came up with nothing. Pasternak expects a regulatory crackdown is coming.

“The industry will be held to a higher, more regulated standard to protect even accredited investors who still need regulatory protections,” he said. It means, in his view, that the freedoms hedge funds for one enjoy over their more regulated counterparts in the investor business is probably about to dissolve.

Funds as well as regulators “need to hire ex-traders and portfolio mangers who understand the business and help them do compliance reviews. They will understand when things don't make sense and know how to test quickly for them,” he said.

Emily Church is an editor with The Daily Beast.