The Madoff exemption, for example, allowed market makers to naked short sell, presumably to facilitate liquidity. Unfortunately, due to naked sponsored access rules (pages 153-155 of Secret Weapon), this also meant that almost anyone could get an exemption at will.
Madoff also obtained an exemption allowing market makers to sell short on a down-tick. The SEC was so grateful for his help in this regard that the commission named the new rule the “Madoff Exemption.” This was before Mr. Madoff became famous for orchestrating a $50 billion Ponzi scheme with help from the Mafia (CNBC’s Charles Gasparino has reported that Madoff might be tied to the Russian Mafia; whistleblower Harry Markopolis stated in Congressional hearings that Madoff appeared to have ties to the Russian Mafia and Latin American drug gangs; and Deep Capture’s own investigations suggest that Madoff did business with multiple people with ties to both Russian and Italian organized crime). The options market maker exemption permitted market makers (e.g. Madoff) to sell stock that they did not possess, so long as they were doing so temporarily to “maintain liquidity.” Abusing that exemption in order to facilitate naked short selling in cahoots with hedge funds looking to drive down stock prices was blatantly illegal, but the SEC looked the other way, even as market makers failed to deliver shares for weeks, months, and even years at a time.
The reason for allowing market makers to do naked shorting was simply to provide short-term liquidity for a stock. The assumption was that the market maker would quickly locate the shares and close out the naked position. In reality, however, much of the naked short selling was done for manipulation and not liquidity. In addition, market makers could let others use their status with sponsored access. The head of the SEC has admitted that sponsored access can be dangerous as noted in this article from The Economist (http://www.economist.com/node/21542186):
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