Madoff prison letter: Beware 'dark pools' on Wall Street

Madoff prison letter warns of lack of transparency in the markets from 'dark pools,' where institutions buy and sell privately outside stock exchanges. Hedge funds' push into riskier ventures also comes under fire in Madoff prison letter.

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Shannon Stapleton/Reuters/File
Bernard Madoff (center) enters the Manhattan federal courthouse in New York in this 2009 file photo. A new Madoff prison letter warns that a lack of transparency on Wall Street and riskier moves by hedge funds pose the greatest risk to the investing industry and regulators.

The recent rash of insider trading cases may be a shock to some on Wall Street, but not to one long-time market player: Bernie Madoff.

In a Christmas Eve letter from the medium security federal prison in North Carolina where he is serving a 150-year sentence for running a massive Ponzi scheme, Madoff tells CNBC that insider trading has been around "forever."

He also rails against what he calls a lack of transparency in the financial markets, and says the growth of hedge funds is forcing market players to take outsized risks in order to earn decent returns.

Madoff has granted only a handful of interviews since he went to prison in 2009. More recently, he has declined to speak on the record about his case. But he was willing to share some views about the financial markets in the e-mail, which he sent to CNBC and a handful of attorneys and academics he has been communicating with.

Before confessing four years ago this month to the largest investment scam in U.S. history, Madoff was prominent in the financial community. He served as a non-executive chairman of the NASDAQ, and his firm was once among the largest market makers on Wall Street.

"(O)ne would be led to believe that with the recent spate of insider trading prosecution that insider trading is a new development," Madoff writes. "This is false. It has been present in the market forever, but rarely prosecuted. The same can be said of front running of orders."

Front running refers to the illegal practice of brokers using knowledge of their customers' pending orders to trade for their own accounts first.

Madoff says markets are suffering from what he calls a "lack of transparency" created by the growth of so-called "dark pools"—arrangements outside the established stock exchanges that allow parties to trade stocks privately, with trades and prices only disclosed after the fact.

"Institutions have always attempted to guard this buy and sell information from exposure to the market for fear of being front run," Madoff writes. "Certainly they are entitled to have this right of confidentiality. That being said, the more secret this information, the more valuable this information is to those that can obtain it. Therein lies the problem. It is nave to think that there will be no leakage of this information."

(Watch Now: American Greed Special: Bernie Madoff Behind Bars)

Madoff built his fraud on one of the largest hedge funds on Wall Street, which attracted investments from individuals as well as a series of so-called "feeder funds." But Madoff now says the rapid growth of hedge funds and feeder funds—and their commissions and fees—have created a problem for investors and regulators.

"It has been this additional layer of costs that have created the need for more risk to be taken to earn worthwhile returns. This has created a minefield of regulatory problems involving the very reasons that the desire for a lack of transparency has grown. Both of these areas are going to be the greatest challenge that both the industry and the regulators are going to face."

Here is the full text of the Madoff prison letter:

A number of you have been asking my views on a couple of subjects that I am comfortable in going on the record, because they are not related to my case. there for(sic) the following are remarks that you are free to use for whatever value you feel are appropriate.

The issue of electronic trading has recently been focusing on the lack of transparency of the markets with the emergence of DARK POOLS.

This has now spread to the recent acquisition of the NYSE . While I have always been an advocate of electronic trading due to the efficiency the lower costs they bring o the markets, I am nit (sic) a fan of the lack of transparency the DARK POOLS create.

It is important to examine why there has been this growing interest in the use of dark pools. Markets have always focused on the speed with which information becomes available. Of course this information can be composed of various types.

It could be corporate developments like earnings or mergers or it can be information regarding the placements of buy and sell orders and who is placing these orders. It is the latter information that has created the interest in the dark pools.

Institutions have always attempted to guard this buy and sell information from exposure to the market for fear of being FRONT RUN. Certainly they are entitled to have this right of confidentiality.

This being said, the more secret this information. The more valuable this information is to those that can obtain it. Therein lies the problem. It is naive to think that there will be no leakage of this information.

Although one would be lead to believe that with the recent spate of Insider trading prosecutions, that insider trading is a new development. This is false. It has been present in the market forever, but rarely been prosecuted. The same can be said for front running of orders.

The other area of discussion involves the growth of hedge funds, particularly feeder funds. In spite of the early held belief. of which I was of this opinion, that the extra layer of costs related to commissions and profit sharing that went along with feeder funds.

They have continued to grow. It has been this additional layer of costs that have created the need for more risk to be taken to earn worthwhile returns. This has created a minefield of regulatory problems involving the very reasons that the desire for a lack of transparency has grown.

Both of these areas are going to be the greatest challenge that both the industry and the regulators are going to face .

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