News of Bernard Madoff’s arrest by federal agents on charges of securities fraud against his firm Bernard L. Madoff Investment Securities LLC are shocking and personally disturbing.

I’ve interviewed Mr. Madoff many times over the past 20 years, starting when I was a neophyte. He always gave me his time and explained the intricacies of equity market structure and trading to me. I visited his firm’s offices on Third Avenue in Manhattan. In the 90s, they were among the first to have Bloomberg on plasma screens.

Madoff was a pioneer in automated-market making and guaranteed to match the best price available in the National Market System, which consisted of all the primary stock exchanges and the regional exchanges. In fact, the Madoffs always spoke about price improvement – they were pioneers in using algorithms to get the customer a better price. Because they weren’t members of the New York Stock Exchange, they were outside of the establishment. NYSE Rule 390 required NYSE members to trade NYSE stocks on the floor. The two brothers, Bernie and Peter, who was a lawyer, realized they could trade NYSE stocks off-exchange in what was called the third market.

To do this, they embraced technology. In the 80s, they hired TCAM Systems to build an order management system that could read the consolidated quote with all the specialists bids and offers and the regional markets, the NYSE and the American Stock Exchange (AMEX). This enabled the firm to offer sub-second transactions on the NYSE, much faster than routing orders to the floor where it could take 40 seconds or three minutes to get an execution report back. They later became involved with the Intermarket Trading System, a network linking the NYSE, AMEX and OTC market with the regional stock exchanges. And they also were involved with the Cincinnati Stock Exchange, (now the National Stock Exchange or NSX) which is where they displayed their bids and offers and printed their trades.

“What they did was not too different from how dark pools operate, said Larry Tabb, CEO and founder of TABB Group. “They’re trying to internalize flow and find the best price for it. Whether it was on the New York or some other place, the goal is to find the best prices,” Tabb explained.

One reason why the Madoff’s were successful is they convinced retail brokerage firms to send them order flow and in return they were guaranteed the best price in the NMS and receive a rebate – a penny or two per share. “They were able to buy on the bid and sell on the offer and still make money,” said an industry source familiar with the firm. “When the spreads were an 1/8th or more he was giving out rebates,” said the source yesterday.

But this same source wonders how the firm made money after decimalization was implemented in 2001 and spreads shrunk to fractions of a penny. “All the dealers and even the super good ones had been hurt by decimalization. When you have penny spreads on a lot of liquid spreads how can you make money?” questioned the source.

Well, I can’t answer that question. The Madoffs had a proprietary trading business and a separate investment advisory operation. I only wrote about their brokerage and market making operation. A story that Wall Street & Technology ran in 2000 about Family Influence on Wall Street, noted that Madoff was one of the largest market makers in convertible bonds, preferred stocks, warrants, units and rights. Mr. Madoff ran assets through this investment advisory operation, which dealt with hedge funds, institutions and wealthy individuals. He allegedly lost all the investors’ money, an estimated $17 billion in assets as of the beginning of 2008. In a civil compliant, the SEC is charging him with a giant Ponzi scheme that lost $50 billion through its investment advisory business. Today the SEC was moving to freeze and seize the assets of the firm and to appoint a receiver.

I’m sure all of those retail firms are doing some soul searching now and trying to figure out what they should do. The current charges have serious business consequences. Any retail brokerage firm sending order flow to a firm that is charged with violating the anti-fraud provisions of the Securities Act of 1933 would probably have to monitor this closely or shift their order flow to another brokerage firm.

I reached out to a few industry executives to get their reactions to the news of this prominent Wall Street figure facing such accusations. “It’s just completely shocking,” said Tom Jordan, Advisory Committee Chair of the Financial Information Forum and President and CEO of Jordan & Jordan. “When you think of that company, you think of quality and integrity and honesty. When you go to an industry meeting, whenever a Madoff said anything you’d pay attention. They really understand how this industry works, what the issues are and how to make money,” said Jordan.

I remember Bernie Madoff at theReg NMS hearings in April of 2004 where many Wall Street executives debated the new electronic trading rules and he brought the issue to simple terms. "The definition of a fast market is an automatically accessible market. It doesn't have to be under a second. I just want to know that when I see that quote that it will be accessible to me," said Madoff.

Another industry source reacted to this as a terrible shock. This individual didn’t want his or her named used at all. He/she felt the pain and suffering must be horrible for Mr. Madoff and his family and most importantly, Mr. Madoff is innocent until proven guilty. I agree, but I also feel that these are serious charges that should be vetted in a way that’s fair to the investors who lost their savings. Many of us who knew Bernie Madoff are reacting personally because he is a part of the market’s history and we’re disappointed cause he let us down.