"But it was the SEC’s decision in the 1990s not to take a stand on the controversial issue of “payment for order flow”

From the FT, another SEC failure. Perhaps James Grant is right:

"SEC inaction that helped fuel scheme

By Greg Farrell in New York

Published: December 23 2008 23:32 | Last updated: December 24 2008 01:44

Stung by claims that it missed discovering a massive fraud, the Securities and Exchange Commission is now poring over Bernard Madoff’s books, trying to unpick an alleged Ponzi-like operation that appears to have lost investors tens of billions of dollars.

But it was the SEC’s decision in the 1990s not to take a stand on the controversial issue of “payment for order flow” that helped fuel the rise of Bernard Madoff Investment Securities, the successful broker-dealer operation two floors above Mr Madoff’s private fund operation in Manhattan."

From the SEC:

"Payment for Order Flow

As a way to attract orders from brokers, some exchanges or market-makers will pay your broker's firm for routing your order to them – perhaps a penny or more per share. This is called "payment for order flow." Payment for order flow is one of the ways your broker's firm can make money from executing your trade. The firm can also make money by internalizing your order.

Upon opening a new account and on an annual basis, firms must inform their customers in writing whether they receive payment for order flow and, if they do, a detailed description of the type of the payments( NOTE WELL ). Firms must also disclose on trade confirmations whether they receive payment for order flow and that customers can make a written request to find out the source and type of the payment as to that particular transaction.

To learn more about the basics of trade execution – including order routing, payment for order flow, and internalization – you should read Trade Execution: What Every Investor Should Know.

http://www.sec.gov/answers/payordf.htm"

Back to the post:

"According to regulators and competitors, Bernard Madoff Investment Securities, enjoyed at least a decade of outsized growth in the 1990s because it paid brokers for business and exploited wide bid-offer spreads in the market.

By paying for order flow, Mr Madoff’s firm siphoned roughly 10 per cent of the volume of trading on the New York Stock Exchange away from the specialist firms that dominated the Big Board’s floor, creating what was known as a “third market”. Then, according to competitors and regulators, Mr Madoff’s firm thrived by trading within the bid-ask spreads, which could be sizeable.

“Mr Madoff was the cleverest and most successful competitor the specialist business ever had,” says Robert Fagenson, former chief executive of the Van der Moolen specialist firm. “When he created the third market his firm was fabulously profitable.”

The SEC had a long-standing rule regarding disclosure of any “remuneration” received in connection with stock transactions. But as the practice of brokers paying for order flow became popular in the 1980s, concerns were raised about whether the brokers doing the paying were buying stocks at the best prices for investors( HOW NICE ).

In 1990, the NASD empanelled a group of experts to study the subject. The committee was headed by former SEC chairman David Ruder, and included Mr Madoff. The so-called “Ruder committee” delivered a report in July 1991 dubbed, “Inducements for Order Flow”.

The report found no legal basis for restricting the practice of payment for order flow, but recommended that the NASD require its members to disclose in advance the “factors that influence their order-routing and execution decisions”( LIKE PROFIT ).

“There was some concern about payment for order flow,” says Mr Ruder, a professor at Northwestern University School of Law. But the report was broadened to include all “inducements for order flow” because, says Mr Ruder, “there’s practically no business done on Wall Street without some exchange of value, promise of future business, custody work or stock loans( YES )”.

In the 1990s, then SEC chairman Arthur Levitt criticised payment for order flow in speeches, but he never restricted the practice. Mr Levitt says he often asked his counsel for market regulation to figure out a way to ban the practice, but those requests went nowhere.

By paying for order flow, Mr Madoff’s firm generated so much traffic that it could act as a market maker, matching buyers and sellers outside of the NYSE. But that kind of traffic cost money, a penny or two per share. The key to the firm’s profitability was that Bernard Madoff Investment Securities did not accept limit orders( ORDERS AT OR BELOW A SPECIFIC PRICE ), according to Mr Fagenson. Without limit orders, the firm was able to buy securities on behalf of one broker for, say, $40.25, and match those same securities to a buy order at $40 per share( IN OTHER WORDS, NOT IN THE CLIENT'S BEST INTEREST BUT THEIRS ). An order for 100 shares of a stock, executed in such a way, generates $25 in profit.

According to Mr Fagenson and other specialists on the NYSE, Mr Madoff paid a penny per share to brokers who routed their transactions through his firm. By exploiting gaps in the bid-ask spreads of, say, eighths of a dollar, Mr Madoff’s firm would make more than 12 cents per share on trades, and give up only 1 cent per share for the order flow. For a firm that represented about 10 per cent of volume on the NYSE during the 1990s, the business model generated big profits.

All that changed in 2000, when the markets shifted from spreads of eighths and sixteenths to decimals. “One thing we can surmise is that when the minimum spread went from a sixteenth to a penny, there was a margin erosion of over 90 per cent( GOOD WORK. I WONDER IF THAT FIGURED INTO TO HIS CASH FLOW PROBLEMS ? ),” said Mr Fagenson."

Just another part of the Fiduciary Mismanagement committed daily and for years legally