How Madoff Controls Adverse Selection
In Trading & Exchanges, Market Microstructure for Practitioners, by Larry Harris
Madoff obtains most of its order flow through order-preferencing arrangements that it negociates with retail brokers. Since the firm is not a member of the NYSE, it can choose with whom it is willing to trade. Bernie Madoff and his brother have chosen to provide liquidity primarily to retail clients, and primarily in the common stocks of large firms. The Madoffs, along with most investment professionals, believe that retail traders generally are not well-informed traders when they trade large firms stocks.
Madoff’s dealers are less exposed to adverse selection than are dealers who trade on the NYSE, who cannot choose their clients. The firm therefore often offers more liquidity to its clients than they can find on the NYSE.
Many institutional traders would like to trade with Madoff in order to access the liquidity that its dealers offer. The firm, however, will not accept them as clients unless it is convinced that they are generally uninformed traders.
Madoff offers its interested institutional clients a service it calls Time Slicing. Institutional clients who uses Time Slicing send Madoff large orders that Madoff’s computers break into small pieces to trade at periodic intervals. Time Slicing is attractive to institutions that do not want their orders to have immediate market impact. It is also attractive to institutions that want to have a time-weighted averge price for their trades. Time Slicing is attractive to Madoff because it allows its dealers time to adjust their inventories while filling large orders.
Through its Time Slicing service, Madoff ensures that its large institutional clients do noy include traders who demand immediate execution of their orders. Their service thus is not attractive to well-informed traders who trade on material information that will soon become public.
Time Slicing allows Madoff to control the adverse selection problem that all dealers face. By refusing to offer immediate liquidity to well-informed traders, Madoff can offer more liquidity to uninformed traders.
December 12th, 2008 at 9:56 am
this is about the market-making operations, not related to the scam run by the investment management side as least as far as we know so far…nevertheless one way to get an edge, is to deal with suckers…which is what they did on the market making side….and the i.m side.
December 12th, 2008 at 9:36 am
He somehow managed to create an off-market price among “uninformed” participants (trading with “time-sliced institutional flow” to some unknown degree) and got to call it more efficient?
December 12th, 2008 at 10:19 am
So his clients on the IM side made the (unspoken, natch) assumption they were getting the benefits of Madoff picking off “generally uninformed traders”?
Talk about being hoist by your own petard…this story might restore my faith that there is some justice in the world.
December 12th, 2008 at 11:01 am
The “split-strike strategy” looks like a modified (and levered) buy-write strategy:
http://www.altrus.com/altrus/en/products/fairfield_sigma_3x_leveraged_certificates/fairfield%20sigma%20brochure%20eur.pdf
I love the buy-write strategy. How he blew up on that, who knows.
Probably started small one month, when he did something ‘wrong”, and papered in a profit, until ‘the book turned around’, so he may have told himself.
When the book didn’t turn around, he just kept going. For years.
Apparently, you can go a long time with $17 billion (or more?) and a reputation to work with …
December 12th, 2008 at 3:32 pm
Well it’s pretty easy to blow-up with this thing, he has huge basis risk, will work fine in a bull market but not in the crazy market as we have now, the volatility of his basket (small sample) has to be much higher than the index used for the options, all that assuming he was actually following the strategy.
December 12th, 2008 at 5:33 pm
Could be. 35-50 stocks is probably pretty tight, though.
Here are my calculated returns for the CBOE’s buy-write index. Off hand, does this look like a strategy that you could leverage 3X? I’d say not, even before you add in the costs of the puts side of his strategy and the costs…
1988 8.5%
1989 24.5%
1990 4.0%
1991 24.4%
1992 11.5%
1993 14.1%
1994 4.5%
1995 21.0%
1996 15.5%
1997 26.6%
1998 18.9%
1999 21.2%
2000 7.4%
2001 -10.9%
2002 -7.6%
2003 19.4%
2004 8.3%
2005 4.2%
2006 13.3%
2007 6.6%
2008YTD -30.8%
October 28th, 2009 at 7:51 pm
Reply to jck. “this is about the market-making operations, not related to the scam run by the investment management side”
Where do think the massive “liquidity” came from that allowed Madoff to create his own large cap market outside of the NYSE? Without the scam, there is no market maker service.