Bernard Madoff shock in the capital markets take place on December 11, 2008. According to the statement of the website of Securities and Exchanges Commission (SEC), Mr. Madoff, founder of Bernard L. Madoff Securities Investment and board of executors of the company for 48 years, was arrested. The cause of investigation was the statements Madoff made to his sons, who are senior executives in the company. Our successful businessman said his fellow colleagues: "What we are doing is nothing but fraud; you can only call this Ponzi financing". And the fellow colleagues, without wasting time, reported their father/boss to the SEC.

 

SEC immediately handed over the company to a trustee and initiated investigations. "SEC vs Madoff" suit is taking shape now. According to the news, there were many Madoff customers including famous financial institutions. The amount of funds that disappeared was around 50 billion dollars. In his statement on December 17, SEC president maintained that transparency rules were violated and investors were defrauded. The company kept more than one record books. There existed a problem the dimensions of which were not completely known.

 

What would you do in such a case? You would first accuse public authorities. It was so in this case.  But when you look who the ones making the accusations, you cannot stop thinking "How dare do these people get on the stage and talk" and seeing red.

 

Let us first get to know Madoff's company. Then, talk about why we saw red and tie the issue to the global financial crisis.

 

Bernard L. Madoff Securities Investment, started operations in 1960 as a securities broker company. Later, the company started to provide investment consultancy services. By this way, it was possible to give consultancy and carry out transactions on behalf of the clients at the same time. The company started to grow with the development of the third market. Third market transactions were based on a highly debated issue; "payment for order flow". When the system was developed in 1990s, SEC continuously published warnings about payment for order flow. Back then, Madoff was a highly disputed entrepreneur. But this did not stop Madoff.

 

What is the third market? The market where the new securities are sold to the investor for the first time by the company is called primary market. Secondary market is the market where the same security is exchanged between investors. And third market is where securities are traded out of the stock exchange in the office of an intermediary institution. In short, when moved to the office of an intermediary firm, the secondary market becomes a third market.

 

So, how do some orders go to the tiny little office of Madoff rather than the giant New York stock exchange? Apparently since Madoff pays a commission to the broker that directs the order to his office. Imagine that you apply to a broker to sell the security you hold at the highest price. To receive this service, you pay a commission. You want your order to be directed to the deepest market. However, the broker directs your order to Madoff's office in exchange for the commission he pays per order. SEC stepped in years ago and decided that investors shall be saved from being fooled. Upon this decision, a public disclosure standard for the brokers that pay and receive money to direct orders was set. Is not the reason apparent? If takes a better offer from another broker, the broker you work with may not give weight to directing your order to the right place that ensures the highest gain for you.

As SEC, after all efforts it initiated, ultimately kept silent, Madoff expanded the business. He established his own transaction system. He started to trade securities and set security prices in his office. He also started to carry out security storage and delivery works as well as other back stage works. Maybe the first steps dragging him to the current situation were taken back then. If your clients trust in you and resign their accounts to you, you undertake a huge responsibility. If you start to trade financial contracts that are not priced in the collective markets, the responsibility gets even bigger. We will learn what is going on at the end of the investigation carried out by SEC; but is seems possible to imagine the starting and ending point of the issue.

 

A while ago, we explained that financial contracts are classified under three groups considering their valuation: First group of financial contracts were those whose value is set in collective markets, for instance in stock exchanges, and is known by everyone. Second group was those whose value was occasionally set in collective markets. And the third group was the financial contracts the value of which was set behind closed doors rather than in collective markets. And the main factor that led to a confidence shock during the latest crisis was that the share of this "third kind of financial assets" in the system increased. The increasing share of these assets, the value of which is set by the financial institution, made balance sheets suspicious.

 

Now, focus on the Madoff case. Value of the asset is set in your discretion and only you know what you are keeping on behalf of your client. It is either setting a thief to catch a thief, or taking the gilt off the ginger.

 

Then, why are we feeling sorry for the people speaking on the issue on the TV? Those complaining about SEC on the TV are solely the executives of giant financial institutions. But since they have access to full information, they do not have the right to complain. If an ordinary man lost money as a result of this, SEC and even the whole public regulatory authorities would be guilty. The duty of regulatory authorities is to "save investors from being fooled", not "to prevent the investors to act like a fool." So, what can we say about the loss of leading banks like Santander and HSBC amounting 36 billion dollars for now? The only thing we can say is "You should have not acted like a fool". This is the first point.

 

However, the prevalence of the issue indicates that for the sake of the system, a more comprehensive public disclosure system including highly informed investors is required. In this context, there is need for a new regulation framework to provide more detailed information on the transactions carried out. When designing the regulation, the scope of the public disclosure system shall not be narrowed or expanded depending on whether the investors have access to information or not. The lessons from this issue imply that the size of the information set shall be broad. And this is the second point.

 

And this is the third point: Let us hope that the executives of giant financial institutions have gambled with the money of other people unintentionally without knowing the consequences. They are the ones that shall get the heaviest penalty. The ones abetting the crime shall be punished as heavy as the criminal itself.

 

I guess the fourth point is already obvious. Dr. Hikmet Kıvılcımlı, when writing on imperialism with his unique style said:  "Criminals cannot commit a crime without aid and abet." And it is completely true. Accomplices shall be severely punished.

 

This commentary was published in Referans daily on 27.12.2008