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Primex Trading's Dark Pool Operations

Wall Street Powerhouses Invested Alongside Madoff


There has been much debate among Wall Street veterans as to why major European investment banks suffered serious damage from the Bernard Madoff Ponzi scheme while our biggest U.S. investment banks escaped unscathed.

For the past two decades, Wall Street watchers could count on four U.S. firms to land in the middle of every securities scandal. From Nasdaq price fixing to fake research to rigging the IPO markets to peddling toxic subprime assets, one could rest assured that Citigroup’s Smith Barney, Morgan Stanley, Merrill Lynch and Goldman Sachs would be heading the lineup. Their complete absence from the greatest Ponzi scheme in history raises the question: what did they know and when did they know it?

The answer may reside in a pentagonal structure created in 1999 to serve the interests of a Wall Street cartel.

On September 14, 1999, it was officially announced that Citigroup’s Smith Barney, Morgan Stanley, Merrill Lynch and Goldman Sachs had partnered with Bernard Madoff to compete head on with the New York Stock Exchange in a venture called Primex Trading.

Madoff had bought the rights to a new technology called Financial Auction Network (FAN) created by Christopher Keith, a 17-year veteran of technology creation at the New York Stock Exchange (NYSE). Mr. Keith had retired from the NYSE and started a technology think tank in lower Manhattan in the early 1990s called Exchange Lab. FAN was one of the early technology offerings and the rights to develop it were bought by Madoff. The firm that emerged was Primex Trading, a division of Primex Holdings. (Primex Holdings holds two patents and may be part of those secret Madoff assets the court won’t release to the public.)

In addition to harnessing the brains of Mr. Keith from the New York Stock Exchange, Primex hired Glen Shipway, the Executive Vice President of the over the counter stock market, Nasdaq, whose duties had included market surveillance of broker dealers like this gang of five.

The partners made a big splash in the press at the time, extolling altruistic intentions of getting better prices for their customers in an electronic version of the New York Stock Exchange. Here’s an excerpt from the New York Times on September 19, 1999:

“Primex is aiming to be an electronic version of the New York Stock Exchange. Participants will not only be able to buy and sell stocks at prevailing market prices, as they now do through many traditional and electronic exchanges, but also interact openly with one another — in effect, bargain — to find the best prices possible. ‘I think the fact four of the world’s largest securities firms have backed this system suggests that it brings something new and unique to our ability to obtain the best execution for our customers,’ said Bill Hart, a managing director in equity trading at Salomon Smith Barney.”

In reality, a very different motive was at work. One of the best kept secrets from the public is a benign sounding process on Wall Street called internalization. That’s where broker dealers like Madoff’s Primex partners match their customers’ buy and sell orders in-house rather than sending them off to the New York Stock Exchange or some other transparent stock exchange. The entities that engage in this trading process are called dark pools. (Recall that “pools” were the same secretive creatures that rigged the stock market leading up to the crash of 1929.)

While the investing public was being served up visions of Primex creating a more transparent and fairer pricing market mechanism, the goal for Madoff’s partners was to legitimize the highly questionable trading practice of internalization.

On October 29, 2002, the Securities and Exchange Commission (SEC) held a Market Structure Hearing to look at internalization, among other market issues. Here are relevant excerpts that cut to the chase of what Madoff’s partners were really up to:

“[Edward] Kwalwasser, [Group Executive Vice President at the NYSE in charge of regulation at the time]: I think we have to look at, from a market perspective, and when we talk about payment for order flow and internalization. The last panel — first panel agreed that one of the characteristics of a National Market System that we all said — who were sitting here said was really good, was that customer orders should be able to interact without the benefit of a dealer. Both internalization and payment for order flow are distortions of that public good that we all agree was there. And, to the extent that those orders aren’t in the marketplace, they’re not helping create the best price for all orders in the marketplace…I never thought Bernie [Madoff] was a bad guy. I started out, however, out of law school representing people in the record industry and in the rock-and-roll part of the business. And to think that the securities industry has a lower code of conduct than the record industry is really, I think, something that I — I never wanted to believe would be part of an industry that I was working at…

“[Bernard] Madoff: …Now, we came up with a — with a system, and joined in partnership with — with four of the largest firms that exist today in — in the United States and NASDAQ, to build a system that — that achieves that. I won’t mention the name of the system because this is not to be a marketing effort.

“[Robert] COLBY [SEC]: Primex System.

“[Bernard] Madoff: But — but, basically, the concern that all of these firms had was that they wanted to internalize their order flow, but they all very fully realized that the danger of having these various pockets of liquidity not visible to everybody and not allowing orders to interact, this was a problem unto itself. And even though that may be what a lot of people would like to do, if you — if you degrade the market in such a way that you really don’t do what you’re supposed to do for the investor, then you really have no marketplace, anyhow. So we went about building this type of system that would allow firms to internalize their order flow, allow orders to interact with limit orders, and to do it anonymously…”

Now, it’s easy to see what Citigroup’s Smith Barney, Morgan Stanley, Merrill Lynch and Goldman Sachs hoped to get out of Primex. But why was Madoff cannibalizing his own business? Madoff already owned Bernard L. Madoff Investment Securities, a third market firm that engaged in the unseemly practice of paying broker dealers a penny or two a share to send their trades to him instead of a regulated and transparent stock exchange. If clients started moving their trades to Primex, wouldn’t that put him out of business?

There are a number of possibilities that might explain Madoff’s motives: he could have made a huge gamble that Primex really would be the next New York Stock Exchange and his cut of the fee revenue would eclipse his other firm’s revenue stream. He could have already lost so much market share from the onslaught of competitive electronic trading platforms that he had little to lose if Primex failed. And, very likely, he needed to add the imprimatur of the big four firms to burnish his tainted image from his payment for order flow practices.

In the end, the gamble failed. Nasdaq licensed the Primex Auction System and ran it for two years before abruptly shutting it down on January 16, 2004. Madoff was left with just his Ponzi scheme and a third market operation faced with mounting competition.

The firms that Madoff went into business with could easily be confused with a spy agency. John Deutch, the former CIA Director, has sat on the Board of Citigroup for over a decade; each of the firms regularly taps the top investigation firms in the country and has legions of the largest law firms sleuthing around on their behalf, not to mention their revolving door with SEC enforcement staff.

Did they get wind of the Madoff Ponzi scheme somewhere along the way in their Primex relationship. If so, did they report it? If not, why not?

Since the Inspector General of the SEC has promised a broad look at how Madoff escaped detection for decades, I’d like to suggest he interview the former Primex partners. When not one of the four got scammed by Madoff but their major counterparts in Europe did, we need to find out why. To help out the SEC and save taxpayers a little dough, I’ve reconstructed the time line below.

September 14, 1999: Mainstream media report that Citigroup’s Salomon Smith Barney, Morgan Stanley, Goldman Sachs, and Merrill Lynch are investing alongside Bernard L. Madoff Investment Securities as partners in Primex Trading.

March 31, 2000: Primex announces that the NASD, parent of Nasdaq, has approved moving forward with its agreement to license the Primex Auction System for U.S. equities.

December 17, 2001: Nasdaq begins operation of the Primex Auction System with trading limited to the 30 stocks of the Dow Jones Industrial Average.

January 7, 2002: Nasdaq adds the stocks in the S&P 100 to the Primex Auction System.

January 22, 2002: the Nasdaq 100 stocks are added to the Primex Auction System.

March 3, 2003: Nasdaq announces that the SEC has given permanent approval to the Primex Auction System.

December 31, 2003: Nasdaq announces that it will cease offering the Primex Auction System, effective January 16, 2004.

PAM MARTENS worked on Wall Street for 21 years; she has no security position, long or short, in any company mentioned in this article. She writes on public interest issues from New Hampshire. She can be reached at pamk741@aol.com