I was watching a documentary on Bernie Madoff, and I can't understand how he got his operation started as a market maker. The 45-second span beginning at 2:30 in this video is what confuses me: https://www.youtube.com/watch?v=t8e8Aq3Ss0o#t=02m30s (it wont let me embed the video for some reason)

I get that it was the 1960s, but even then, with $50,000, how does someone just start taking in orders and executing trades? I assume he was selling stock from companies not on the NYSE or AMEX, but how did he actually go about doing that? Does he call some little mining company or some furniture manufacturer and say he'd like to sell their stock, and then he tries to find saps willing to buy shares of some company they've never heard of? I just have no concept of how this would work.

And then the mention of buying "order flow" by paying a mutual fund company to buy stocks for their portfolios through him--how could he afford to do this, and how did he get access to broker stock from the companies to be bought at a cheap enough rate that he could afford to pay mutual funds for order flow? Why wouldn't Merrill Lynch just use whatever channels Bernie was using to purchase the stocks they want directly?

buy shares at 49p, sell shares at 50p. not exactly rocket science is it

No, in the 80s and 90s Madoff had agreements with brokers like Charles Schwab, Fidelity etc and he would pay them say, half a penny per share for dibs on the customers order flow. They might get orders to buy 30k CSCO at market from Schwab and sell 50k CSCO at the 50.25 from Fidelity. In that case he would buy 50k from Fidelity at 50.25 and sell 30k to Schwab at 50.50, and probably send the difference to someone else.

It was/is a completely legitimate business but seems almost like a scam compared to what's going on today.

This isn't what I'm asking about.

But how did Madoff establish himself to get this arbitrage business? Why wouldn't Charles Schwab just buy the CSCO shares directly from Fidelity?--they're both huge companies that are aware of the other, so there's no sense in letting some nobody scalp them for a quarter a share. How is it that some nobody with 50k can just start executing orders and getting rich off the arbitrage?

I'm sure it evolved from a smaller business. Lots of firms were making markets back in the day and Madoff was just another market maker. They were also taking various risks. They paid for the orders whether or not they wanted to trade against them.

Schwab and Fidelity were fine. They got paid per share and din't have to take any trading risk.

You just described market making like in the pits at commodity exchanges(CBOT, CME, COMEX etc.). Back when all execution was on the floor of the exchange before computers that is what all those guys in the colorful jackets were doing. There were 2 types of traders in the pits. Brokers and Locals. Brokers stood on the outside of the ring and were handed orders originating from typical financial institutions. The Locals were the market makers who bought and sold the orders and determining the "spread" and taking the risk. Any schlub with the proper stake could become a Local market maker.

There were a few "market makers" that made out like bandits during the 2007/2008 mortgage crises. A ton of people knew banks had to unload for 20/30 cents on the dollar AND knew buyers willing to buy at 60 cents on the dollar.

It was basically free money if you happened to be in that small area where you had liquid cash, understood finance, knew the right people, and weren't conflicted out. You just bought from BoA (for example) on one phone at like 11:55 and sold to Quicken (for example) on the other.

Yes, anyone with liquid cash (and weren't legally conflicted out) could have done it.

Not really. I don't know about 2008, but defaulted mortgages were trading in the 40s in 2011 and didn't creep into the 60s/70s until the market dried up around late 2014. It was a very gradual process. I traded (buy side) that **** with just about any big bank you can think of.

The easy money definitely already dried up by 2011.

In its simplest sense market making is providing liquidity. Market makers naturally have to pay below the "true" market price so they can sell at market price. The spread and time frame vary by industry and product. Pawn shops, stock market makers, JG wentworth (structured settlement cash outs) are all market makers providing liquidity to various markets.

I market make in real estate by offering cash for any property at any time. The price and spread I determine on many factors but I will provide a bid on almost any piece of real estate.

OP, good questions...

not sure how much at the beginning madoff was taking principal positions vs. charging tiny commissions.

he did have a backer? maybe his wife's father... and in early 60's he would have been out of business and/or disgraced if he hadn't done some fraudulent paperwork. so the ponzi scheme that started - really by accident - in the mid 80's wasn't his first time doing phony paper work.

as to why didn't people just deal through merrill or lehman etc? why did they deal with madoff, spear leeds or knight?........ i think it's because back in those days 1) nasdaq was considered much lower class; 2) those big firms weren't so capital intensive themselves - although much more than madoff.

so i think the dominant answer is that nasdaq was considered quite a bit more frontier-ish than it is today.

it's interesting that td waterhouse i think during internet stock boom was getting paid very nicely for its order flow. seems controversial but i suppose that's why they can offer such nice commissions. otherwise, they'd charge more and give you the $$$$ that leeds/knight pay them. so would work out same.

if you are interested, pick up michael lewis' flash boys... or google SOES bandits. i think that's teh right acronym.