Securities Operations: Day Trading Requires Continued Oversight (Letter
Report, 02/24/2000, GAO/GGD-00-61).
Pursuant to a congressional request, GAO reviewed day trading, focusing
on: (1) the nature and extent of day trading; (2) regulatory actions
taken to address the day trading risks; and (3) the actions day trading
firms have taken to address regulatory concerns.
GAO noted that: (1) day trading among less experienced investors is an
evolving segment of the securities industry; (2) day traders, who
represent less than one-tenth of 1 percent of all individuals who bought
or sold securities, accounted for a growing part of trading on Nasdaq,
estimated by industry officials to be about 10 to 15 percent of Nasdaq
volume; (3) these traders all did their trading at specialized day
trading firms, but the firms employed various structures and operating
strategies that affected the risks the traders faced; (4) some firms
encouraged any individual who wanted to be a day trader, and had the
capital to begin trading, to use the firm's systems and facilities to
trade, risking the trader's own capital; (5) others emphasized that they
wanted only people who were qualified and able to be professional
traders to trade, risking the firms' capital; (6) these traders could be
fired if they suffered significant loss, but they do not lose their own
capital; (7) some firms employed a combination or variations of these
strategies; (8) the effects of day trading on both individuals who
engage in it and the markets as a whole are uncertain; (9) federal
regulators have taken some actions to address the risks of day trading;
(10) the regulatory arm of the National Association of Securities
Dealers (NASD), called NASD Regulation (NASDR), and the Securities and
Exchange Commission (SEC) have made a special effort to target their
examination resources during the last 2 years on day trading firms,
performing 67 examinations of day trading firms and their branches; (11)
the rule violations found most frequently in their examinations of firms
related to supervisory procedures, net capital computations, and
advertising; (12) they also found violations involving margin and
lending issues; (13) NASDR has recently submitted proposed rule changes
to SEC that require day trading firms to assess the appropriateness of
day trading for each potential customer and to fully disclose the risks
of day trading; (14) NASDR and the New York Stock Exchange have also
submitted proposed rule changes to SEC to tighten margin requirements;
(15) some of the day trading firms GAO visited recognized these
regulatory concerns and told GAO that they have already taken steps to
provide better disclosure, screen prospective traders, and restrict
certain activities, such as customer-to-customer lending; and (16)
determining the adequacy and extent of oral disclosures, screening, and
planned restrictions presents a difficult challenge because neither the
regulators nor GAO could directly observe the interactions between the
firms and traders or potential traders.
Abbreviations
ECN Electronic Communications Networks
ETA Electronic Traders Association
LLC Limited Liability Corporations
NASD National Association of Securities
Dealers
NASDR National Association of Securities
Dealers, called NASD Regulation
NYSE New York Stock Exchange
SEC Securities and Exchange Commission
SIA Securities Industry Association
SOES Small Order Execution System
Results in Brief
Day trading among less experienced investors is an
evolving segment of the securities industry. Day
traders, who represent less than 1/10th of 1
percent of all individuals who bought or sold
securities, accounted for a growing part of
trading on Nasdaq, estimated by industry officials
to be about 10 to 15 percent of total Nasdaq
volume. These traders all did their trading at
specialized day trading firms, but the firms
employed various structures and operating
strategies that affected the risks the traders
faced. Some firms encouraged any individual who
wanted to be a day trader, and had the capital to
begin trading, to use the firm's systems and
facilities to trade, risking the trader's own
capital. Others emphasized that they wanted only
people who were qualified and able to be
professional traders to trade, risking the firms'
capital. These traders could be fired if they
suffered significant loss, but they do not lose
their own capital. Some firms employed a
combination or variations of these strategies.
The effects of day trading on both the individuals
who engage in it and the markets as a whole are
uncertain. For example, day trading is risky, and
state regulators have reported that most
individual day traders they investigated lost
money. However, officials at day trading firms we
visited said that although most people lose money
initially, the majority of their experienced
traders (those that traded longer than 6 months)
made money. Two firms supplied us records that
showed many of their traders were extremely
profitable; however, other firms did not supply
records, and we could not verify the extent of
profitability in the industry as a whole. From a
market standpoint, day traders' access to the
markets provides direct competition for market
makers and institutional traders that may benefit
all individual investors, but day traders'
frequent trading during the day also could
potentially make market prices more volatile.
Gaining a better understanding of the effects of
day trading on individuals as well as the markets
could help regulators better ensure that investor
protection and market integrity objectives are
met.
Federal regulators have taken some actions to
address the risks of day trading. The regulatory
arm of the National Association of Securities
Dealers, called NASD Regulation (NASDR), and the
Securities and Exchange Commission (SEC) have made
a special effort to target their examination
resources during the last 2 years on day trading
firms, performing 67 examinations of day trading
firms and their branches.1 They were concerned
that these firms were advertising day trading as a
profitable strategy without fairly representing
the risks associated with day trading. The rule
violations found most frequently in their
examinations of day trading firms related to
supervisory procedures, net capital computations,
and advertising. They also found violations
involving margin and lending issues.2 In addition
to these examinations, NASDR has recently
submitted proposed rule changes to SEC that
require day trading firms to assess the
appropriateness of day trading for each potential
customer and to fully disclose the risks of day
trading. NASDR and the New York Stock Exchange
(NYSE) have also submitted proposed rule changes
to SEC to tighten margin requirements.
Some of the day trading firms we visited
recognized these regulatory concerns and told us
that they have already taken steps to provide
better disclosure; screen prospective traders; and
restrict certain activities, such as customer-to-
customer lending. The risk disclosure statements
from all of the firms we visited contained
language the same as or similar to that in NASDR's
proposed risk disclosure statement. Determining
the adequacy and extent of oral disclosures,
screening, and planned restrictions presents a
difficult challenge because neither the regulators
nor we could directly observe the interactions
between the firms and traders or potential
traders. However, ongoing implementation of such
controls by firms and oversight by regulators are
important for ensuring that potential day traders
understand that they are directly competing with
professional market makers and institutional
traders and can lose as much as, or more than,
they have invested.
We are making a recommendation to the Chairman,
SEC, in conjunction with NASD, to evaluate the
implications of day trading on the integrity of
the markets after decimal trading is implemented.
We are also recommending that the Chairman, SEC,
do at least one more cycle of targeted
examinations of day trading firms to ensure that
the firms take the corrective actions they propose
in response to previous examination findings.
Background
Day trading requires a continuous stream of
current market data and the ability to trade
without delay. Numerous day trading firms have
developed sophisticated order routing and
execution systems as well as software that can be
used on computerized workstations. These systems
enable day traders not only to monitor the market
on a real-time basis, but also to trade on a real-
time basis-similar to practices followed by
professional traders at proprietary firms. The
order routing and execution systems of these firms
allow day traders to be linked directly to the
stock markets, enabling the traders to send orders
to a particular market or market maker without
involving an intermediary firm. As a result, day
traders have the tools to employ the trading
strategies and techniques that were previously
available only to market makers.
SEC has stated that over the last 3 years some day
trading firms have focused on marketing day
trading as a strategy to investors, and these
firms have emphasized the opportunity for
individuals to profit from day trading without
fully disclosing the risks. Reports have surfaced
about day traders who have lost money and claimed
they were not informed of the risks. SEC and NASDR
are focusing their efforts on trying to ensure
that day traders completely understand not only
the risks associated with day trading, but also
that there are high costs that can result from
frequent trading.
Although investing in securities always involves
some degree of risk, day trading involves a higher
degree of risk of loss because of the way it is
conducted. Day traders try to anticipate market
movements and profit from short-term price
movements in individual stocks. Using this
strategy, day traders trade frequently, incurring
commissions and fees for computer and electronic
services provided by the day trading firm that can
significantly reduce a trader's earnings.
Furthermore, unlike investing through a full-
service broker-dealer, who may be responsible for
determining whether a particular trade is suitable
for the investor, day traders typically are the
only ones accountable for their trading decisions.
Day trading typically requires direct electronic
access to the markets. Day trading firms provide
order entry terminals to Nasdaq as well as NYSE.
Day trading is primarily transacted through
Nasdaq, which is an electronic communications
system where market makers display prices at which
they are willing to buy or sell stocks for their
own accounts or for their customers. In the last
few years, day trading has also been transacted
through electronic communications networks (ECNs),
which allow customers to display their orders to
other customers and also allow customer orders to
be paired. ECNs are primarily used to access
Nasdaq. However, they may also be used to trade
stocks listed on exchanges. Day traders also have
electronic access to listed stocks through the
Superdot system, which is an electronic order
delivery system that links NYSE member firms to
individuals on the floor of an exchange who
execute their orders.
Electronic Day Trading Has Changed
Regulatory changes to Nasdaq spurred the
development of electronic day trading. Nasdaq
first introduced electronic executions when it
developed the Small Order Execution System (SOES)
in 1985.3 The system was not fully implemented
until 1988 when SEC required all market makers to
participate.4 Nasdaq also introduced SelectNet in
1990 as a system for market makers to communicate
and to execute transactions electronically with
each other.
Shortly after market maker participation in SOES
became mandatory, a few firms realized that they
could profit from using SOES. These firms became
known as SOES day trading firms, and market makers
called them SOES Bandits.5 Nasdaq market makers
did not like losing profits to SOES day traders.
As a result, NASD proposed various SOES rule
changes to limit the activity of day traders.
However, a series of events between 1993 and
1996-including an investigation of market makers'
possible collusion-affected how SOES day traders
were viewed in the market. As a result of these
events, NASD and SEC implemented several rules
changes. In January 1997, NASD implemented SEC's
order handling rules.6 These rules required Nasdaq
market makers to display customer limit orders and
to disseminate the best prices placed by market
makers in ECNs, which previously were not included
in the Nasdaq market.7 NASD also implemented
actual size rules that allowed market makers to
display quotes in minimum sizes of 100 shares for
certain stocks, which had the impact of limiting
the use of SOES by day traders because the trade
size fell from 1,000 shares to 100 shares. As a
result, SOES day trading firms began to develop
and use ECNs in order to continue to provide day
traders access to the market without the
limitations of SOES that resulted from the rule
changes. 8
With the decline in the use of SOES, day trading
firms began to evolve into customer-based firms
that offered their traders direct access to ECNs,
SelectNet, Nasdaq, and the major stock markets.
Moreover, the inclusion of ECNs in the Nasdaq
market enabled ECNs to explode in popularity, and
these networks have become the choice of trading
for day traders, according to industry officials.9
According to industry statistics, ECNs account for
30 percent of the Nasdaq trades. In fact, one of
the largest ECNs was created by a day trading
firm.
Day traders' use of ECNs has meant that not only
has the venue they use to trade changed, but whom
they trade with has also changed. ECNs allow
orders to be paired or traded with each other. By
trading on ECNs, day traders are trading more and
more with each other and less and less with market
makers.10 For instance, one firm estimated that 35
percent of its order flow would match internally
if was conducted within a single ECN.
ECNs are also designed to handle limit orders, and
the increased use of ECNs has resulted in the
increased use of limit orders.11 Before 1997, day
traders were submitting most of their orders as
market orders through SOES. The Electronic Traders
Association (ETA) estimated that limit orders
constitute nearly one-half of day trader orders,
which they said helps to improve prices. They
stated that if a market maker quoted a stock at 50-
50-¬, a customer limit order of 50-1/8 would
effectively narrow that spread, thereby improving
prices for all investors. Industry and regulatory
officials have stated that limit orders are now a
part of the quote montage (all listed quotes), and
the inside price (best price) may well be set by a
public order from a day trader.
Nature and Extent of Day Trading
Day trading is different from on-line trading or
trading through a full service broker. Day trading
is usually conducted on-site at firms that offer
technology that is superior to the technology
offered by on-line trading firms. These firms have
developed order routing and execution systems that
allow day traders to trade directly into the
market with no intermediary, which is something an
individual has never before been able to do. The
firms that we visited had different structures and
operating strategies, with the common
characteristic that their traders used day trading
strategies. Although state regulators have
reported that most day traders lose money,
officials at six of the firms we visited said that
most of their experienced traders were profitable.
The effects of day trading on the markets have
been controversial, but we found no overall
analysis of the benefits and costs of day trading.
How Day Trading Is Conducted
Day traders attempt to profit from small movements
in the prices of stocks over a short time period.
For example, they try to anticipate the likely
move of a stock in the next few minutes or hours,
buying and selling quickly, and generally hoping
for a small profit (this could be as little as 25
cents a share) on a large number of shares
(averaging about 1,000). Day traders are generally
momentum traders-hoping to buy when prices are
increasing and sell before prices fall or sell
when prices are decreasing and buy back before
prices rise. Most day traders also try not to
carry positions overnight.
As a result of their trading strategies, day
traders are not considered to be investors. They
do not pay close attention to such factors, as
price/earnings ratio or investing and earnings
models, which investors are taught to follow. They
do not hope to gain by buying and holding shares
over extended periods of time.
Day trading is also different from trading on-
line, although the distinctions between them are
beginning to blur. On-line trading provides
investors a cheaper, faster way to place orders
with their brokerage firms than contacting them by
telephone. On-line traders may use any number of
trading strategies designed to profit from either
short-term or long-term favorable price movements
in the stocks they buy and sell. On-line traders
may also employ day trading strategies, but these
traders generally lack the access to the markets
and instantaneous updated prices that day traders
have.
Direct Access to the Markets Versus Payment for
Order Flow
A day trading firm provides its traders with
direct access to the markets through the firm's
order router, which instantaneously sends orders
to the market location with the best price by
interfacing directly with the major stock markets
and ECNs. As a result, day traders send their
orders to a particular market without having an
intermediate firm involved in routing the order.
In doing so, day traders can receive a trade
execution within seconds of placing their orders,
which is necessary for them to be able to
capitalize on small price movements in stocks.
Day traders' direct access is different from the
access to the markets provided by many on-line
trading firms. These on-line trading firms may
take customer orders and either match them
internally or sell them to a specific market maker
in return for payment for order flow. In these
arrangements, the market maker pays a penny or
more a share for the order flow created by the on-
line firm's customers and is to provide the
customer an execution at the best prevailing
quoted prices.
The distinctions between on-line firms and day
trading firms are becoming less obvious as these
industries develop. For example, on-line trading
firms are beginning to provide their frequent
traders news and price quote services similar to
those already provided by day trading firms.
Although market makers, institutional investors,
and day traders have direct access to ECNs, a few
on-line firms have decided to offer their
customers some level of direct access to ECNs or
funnel some of their customer order flow into
ECNs. Additionally, some day trading firms are
going after the active trader at on-line firms by
promoting the advantages of direct access to the
markets.
Technology and Software of Day Trading Firms
The technology and software that day trading firms
provide enable day traders to have real-time data
and information as well as direct access to the
markets similar to what proprietary firms offer
their traders. The computer facilities, high-speed
access lines, and software packages that day
trading firms use are specifically designed to
support and accommodate day trading. For example,
these firms provide day traders access to Level II
data, which shows the best bid (buy) and ask
(sell) prices and the number of shares available
for every market maker and ECN. The Level II data
are often provided by day trading firms with
extreme speed that enables day traders to
capitalize on momentary fluctuations in prices.
Other software features of day trading firms
include
ú offering traders a broad view of the market,
such as allowing them to open up a list of
hundreds of stocks and watch them update in real
time;
ú point and click order-entry windows that
allow traders to send out orders to different
exchanges;
ú real-time profit and loss windows;
ú fundamental data on companies;
ú ticker features; and
ú programmable key strokes that allow traders
to specify any function key combination for order
entry functions;
Structures of Day Trading Firms Pose Different
Risks to Day Traders
Day trading firms are typically organized as (1)
broker-dealers that have customers who open
accounts with the firm and use the assets in their
own accounts to trade; or as (2) limited liability
companies (LLC), which sell an interest in the
firm to individuals wishing to day trade. As
broker-dealers, these firms must register with
SEC, and they are subject to SEC rules and
regulations. Broker-dealers with customers are
also required to be members of NASD and are
subject to NASDR rules. LLCs are also registered
broker-dealers, but individuals who day trade at
these firms typically are not customers; they
become part owners of the firms and are called
associated persons. These firms allow their
associated persons to trade using a portion of the
firms' capital contribution. Many LLCs are members
of the Philadelphia Stock Exchange and are subject
to its rules. The seven day trading firms we
visited were all registered broker-dealers, six
were NASD members, and one was an LLC that was a
Philadelphia Stock Exchange member. These
structures affect the risks faced by the day
traders at the firms.
The structures and operations of the firms we
visited were very different. Three firms had
mostly registered proprietary day traders, who
traded on behalf of the firms and the firms'
customers. They also had a few nonproprietary day
traders who traded using their own capital and the
firms' software and facilities. One of these firms
was completely unique in that it had only four
registered proprietary day traders trading on
behalf of about 19 investors and had no
nonproprietary day traders. This firm did 80
percent of its trades automatically through
specially designed software programs and 20
percent by its proprietary traders, and it traded
almost 10 million shares a day. The other four
firms had mostly nonproprietary day traders and a
few proprietary traders.
Officials at five of the day trading firms we
visited asserted that they were selective about
whom they allowed to trade at their firms. They
said they looked for individuals who would
approach day trading in a professional manner and
eventually become professional traders similar to
the traders at market making firms. In general,
these firms tended to already have a high
percentage of proprietary traders and were looking
to hire more individuals who would be proprietary
traders. One firm said that it was moving away
from having nonproprietary day traders towards
having only proprietary day traders. However,
officials at two firms said that as long as
individuals met the initial capital requirement,
which was at least $25,000, they would allow
anyone to trade.
Nonproprietary day traders trade using their own
money and risk losing as much as, or more than,
they have invested. Proprietary day traders who
trade at LLCs typically are limited partners that
have invested their own money into the firm in
order to trade, risking the accumulated capital of
the limited partners. In many cases, these
proprietary traders' potential losses are limited
to the amount of their initial investments. Rules
designed to ensure that day traders understand
their risks of loss and the pitfalls of trading on
margin or with borrowed funds carry added
significance for any day trader whose own money is
at risk. However, we found some non-LLC day
trading firms that hire proprietary traders to
trade, risking the firms' money or that of
investors in the firms. These traders can be fired
if they continually lose the firms' money, but
their risk of loss is different because they do
not risk their own money. None of the investors in
these firms had filed any complaints with
securities regulators.
Extent of Day Trading
Day traders are few in number, but they account
for a growing amount of the Nasdaq trading volume.
SEC estimated that about 7,000 people are day
traders at day trading firms. By comparison, about
80 million individuals own stock, and more than 5
million use on-line brokerage firms. As a whole,
day traders represent less than 1/10th of 1
percent of all individuals buying and selling
stocks. SEC also estimated that there are about
100 day trading firms operating, with hundreds of
offices around the country, which is a small part
of the nearly 8,000 registered broker-dealer
firms. However, NASDR and SEC officials said they
could not be sure of the total number of day
trading firms because these firms are required to
register only as broker-dealers, not as day
trading firms. ETA estimated that there are 62 on-
site day trading firms.
Day trading firms account for an estimated 10 to
15 percent of the total Nasdaq trading volume in
1999, according to industry officials. Their
trading volume has steadily increased over the
last few years. In 1997, day trading firms as a
whole represented an estimated 7.7 percent of the
Nasdaq trading volume. As of year-end 1999, we
estimated that the seven firms we visited
represented about 9 percent of Nasdaq's trading
volume. An industry report estimated that on-site
day traders were responsible for 11 percent of the
Nasdaq trading volume during the first quarter of
1999.12 ETA has consistently said that day traders
represent about 15 percent of the Nasdaq trading
volume.13
Day traders trade more often than the average
trader placing orders through a brokerage firm or
on-line. The firms we visited told us they
generally executed anywhere from about 2,700
trades a month to about 1.8 million trades a
month. On a yearly basis, day traders at the firms
made anywhere from 33,000 trades a year to about
22 million trades a year.14 In contrast, one
industry study stated that the average full-
service brokerage customer conducts between 6 and
12 trades a year, and the average on-line investor
conducts between 15 to 25 trades a year.
Profitability of Day Traders
Whether day trading is profitable is the subject
of much debate within the securities industry.
State securities regulators have estimated that
more than 70 percent of day traders lose money,
and only about 12 percent demonstrate the capacity
to be successful. Moreover, ETA officials stated
that the risk of loss in day trading can be
substantial. It estimated that the learning period
for day trading is about 3 to 5 months, and not
only will most people lose money in that period
but a substantial number of day traders will never
be successful. However, officials at six of the
seven firms that we visited said that the most of
their experienced traders were profitable.
All of the firms we visited agreed with ETA's
estimate that it takes individuals from 3 to 5
months to be profitable. Some of the firms said
that although they have had individuals leave
during the 6-month period, none had experienced a
high turnover rate because of unprofitability.
However, two firms said that they had asked
individuals who, in their estimation, could not be
profitable day traders to leave.
One of the firms that we visited published the
profitability of its day traders on its Web site.
The data showed that 47 percent of its traders
made money after commissions in 1998, and 52
percent made money in 1999.15 We estimated that of
the 47 percent who made money, 74 percent-35
percent of the total number of traders-beat the
return of the Standard & Poor's index of 500 (S&P
500) stocks in 1998.16 In 1999, 55 percent of this
firm's traders made money. We estimated that of
the 55 percent who made money, 78 percent-43
percent of the total number of traders-beat the
return of the S&P 500. In comparison, industry
statistics show that less than 25 percent of all
stock mutual funds have been able to beat the
return of the S&P 500 in the last few years. The
other six firms that we visited told us that many
of their experienced traders were profitable.
These firms did not, however, publish data on the
profitability of their traders on their Web sites.
Further, day traders have achieved these results
during an extended bull market.
Day trading firms we visited said they make a
profit from day traders' activities. These firms
charge commissions on each trade made by day
traders as well as fees for computer and
electronic services provided by the firms. The
firms that we visited said that they net about $2
or more on each trade. Using the data from 1 firm
that had 500 traders conducting about 20 trades a
day, we estimated that the firm nets about $20,000
a day. Some firms netted more than that amount,
and others netted less. Officials at one firm said
that the firm's daily net profit was about
$150,000.
Effects of Day Trading
The effects of day trading in its current form are
unknown. When day traders primarily traded through
SOES, several studies analyzed the effects of SOES
trading on spreads, liquidity, and volatility. Our
previous review of these studies found that they
could not isolate the effect of SOES trading from
that of other changes in the market.17 The effects
of day traders in the more recent environment,
which depends less on SOES and more on ECNs, have
not been similarly assessed.
Industry officials have said that day traders have
provided some benefits to the markets. For
example, as evidenced by their growing share of
the Nasdaq volume, day traders bring substantial
liquidity to the markets. These officials also
said that the increased use of limit orders by day
traders has helped to improve price efficiency for
all traders. For example, when day traders enter a
limit order that is between the best bid and ask
spread, they improve prices for all retail orders.
Additionally, day trading firms have also been an
impetus behind the development and use of some
ECNs, which has enabled individuals, for the first
time, to have direct access to the securities
markets.
On the other hand, as we reported in 1998, market
participants have said that day trading through
SOES caused increased volatility in the market.18
They stated that the trading strategies of SOES
day traders, such as the momentum-based strategy
of buying in "up trending" markets and selling in
"down trending" markets, have led to increased
volatility. The studies that examined volatility
and trading through SOES showed that they were
related. However, the studies did not clearly
establish whether SOES trading caused volatility
or whether other market forces caused volatility,
which then attracted SOES trading. Market and
regulatory officials have been concerned that the
effects of day trading through ECNs are similar to
those they attributed to SOES trading. However,
they have not yet attempted to evaluate these
effects. They have been primarily concerned about
the practices of day trading firms because some
day trading firms have violated securities rules
and regulations and misled customers.
Securities Regulators' Oversight of Day Trading
Firms Found No Widespread Fraud
Over the last 2 years, securities regulators have
focused their oversight efforts on day trading
firms through both targeted examinations and
proposed rule changes. NASDR and SEC performed 67
examinations of day trading firms and their
branches during this period.19 Although they found
no widespread fraud among the day trading firms,
they found a number of violations and are
concerned about compliance with some rules. The
most frequently occurring violations involved
rules relating to written supervisory procedures,
net capital computations, short sales, and
advertisements. The examinations also found
violations relating to margin and customer
lending. During the same time period, NASDR and
NYSE have also proposed rules that would address
some of the risks of day trading. SEC is reviewing
the rule proposals.
SEC and NASDR Targeted Examination Resources at
Day Trading Firms
NASDR, NYSE, and SEC examine all securities broker-
dealers on a cyclical basis based on the risks
they pose to their customers and the securities
markets. NASDR and NYSE examine all their member
firms on a regular schedule, and SEC examines a
sample of broker-dealers each year to assess the
effectiveness of NASDR and NYSE examinations and
to ensure compliance with securities laws. These
routine examinations review various aspects of
broker-dealer operations, including sales
practices, advertising, and financial integrity,
among others. NASDR, NYSE, and SEC also do "cause"
examinations to address particular problem areas
identified through various means, such as customer
complaints. They also target high-priority areas
for annual on-site inspections. During 1997 and
1998, NASDR and SEC targeted day trading firms
because they were concerned that the firms were
marketing unrealistic expectations and
unsubstantiated representations about the
profitability of day trading, but not adequately
describing the risks.
SEC and NASD officials told us that the violations
found at the day trading firms were generally
similar to violations they find at most securities
firms. They said that when they find violations,
they notify the firms and give them 30 days to
respond in writing, stating the steps that they
are taking to correct the violations. SEC
officials said that if firms do not agree to take
necessary corrective actions, SEC examiners would
either refer the matter to SEC's Enforcement
Division for review or take other action. As of
January 2000, neither SEC nor NASDR had reexamined
any of the firms or branches they targeted in 1997
and 1998.
SEC and NASDR examiners may also refer firm
conduct or violations that they consider warrant
investigation to SEC's Enforcement Division for
further review. Their examiners referred 15 day
trading firms to the Enforcement Division. SEC
officials said that the Enforcement Division's
investigations of these firms relate to margin
lending, net capital, broker-dealer registration
issues, short sales, supervision, and advertising.
The investigations were ongoing as of February 16,
2000.
Written Supervisory Procedure Violations
NASDR rules require each broker dealer to
establish, maintain, and enforce written
procedures that enable it to supervise its
registered representatives and associated persons
and that are designed to ensure the member
complies with applicable securities laws.
Examiners are to review a firm's procedures and
its books and records to determine if the firm is
enforcing and complying with the procedures.
During their day trading examinations, NASDR and
SEC found 29 instances in which day trading firms
failed to enforce their own written supervisory
procedures. Of the seven firms that we visited,
two had such violations. SEC and NASDR examiners
found that firms violated rules or failed to
enforce internal supervisory procedures that
ú forbade a registered representative or any
person associated with the firm from recommending
securities or trading strategies,
ú directed supervisory personnel to evaluate
prospective clients by reviewing a client's income
and type of employment,
ú prevented employees from arranging for credit
to a customer on terms more favorable than
available through other means, and
ú required an annual review of branch offices.
In some cases, violations resulted from a firm's
failure to have appropriate written supervisory
procedures. For example, some firms
ú failed to have procedures that addressed the
lending of funds between customers;
ú failed to have procedures that addressed the
types of business in which it engaged;
ú failed to have procedures that specifically
supervised the type of business in which it
engaged (one firm advertised itself as a broker-
dealer that specialized in on-line day trading,
but it did not have procedures that specifically
supervised this type of business);
ú failed to have procedures pertaining to short
sale transactions; and
ú failed to have procedures that addressed the
disclosure of credit terms between customers.
Short Sale Violations
SEC and NASDR's short sales rules prohibit
investors from selling an exchange-listed stock
short unless the stock's last trade or bid was at
the same price as or higher than the previous
trade or bid.20 The purpose of these rules is to
keep firms and investors from exacerbating price
movements when markets are declining. NASDR also
requires that securities firms mark all sales as
either "long" or "short" and that the firms
determine if they can obtain shares of the
security sold short to deliver to the buyer.21 SEC
and NASDR examiners found 14 violations of short
sales rules. Of the seven firms that we visited,
the regulators found two firms that had violated
the short sale rules.
The regulators also found that some day trading
firms lacked the surveillance systems needed to
prevent and detect short sale violations by day
traders. They found that this was particularly
true of day trading firms that were organized as
LLCs.22
Net Capital Violations
Day trading firms, like all other broker-dealer
firms, are required to comply with the net capital
rule. The net capital rule is a liquidity-based
capital standard that requires broker-dealers to
(1) maintain a minimum level of liquid capital
sufficient to promptly satisfy all of its
obligations to customers and other market
participants and (2) provide a cushion of liquid
assets to cover potential market, credit and other
risks.23 Examiners usually evaluate a firm's net
capital as of a given date. They are to check to
see whether the firm has computed its net capital
and whether the calculations were done according
to the rules. Inaccurate computations result in
firms either overstating or understating their net
capital or having net capital deficiencies.
SEC and NASDR examiners found 16 examples of day
trading firms either not maintaining the required
minimum net capital amount or not preparing their
net capital computations in accordance with the
rules. Of the seven firms we visited, one firm had
violated the net capital rules.
Advertising Violations
NASDR reported that 80 percent of the day trading
firms that it examined had potentially problematic
advertisements that had been referred to its
Advertising Regulation Department for review. The
problem areas ranged from exaggerated statements
of profits that can be generated from day trading
to day trading Web sites and other communications
with the public that have indicated that losses
can be controlled or minimized through the use of
certain strategies or techniques. SEC has also
stated that it is concerned about Web sites that,
although not operated by day trading firms, are
trying to capitalize on day trading. Many of these
sites appear to advertise the potential rewards of
day trading by use of the sites' recommendation.
SEC said it is looking into whether these sites
are violating the federal securities laws.
SEC and NASDR examiners found over 20 advertising-
type violations. One of the seven firms that we
visited had advertising violations. The types of
advertising violations found at day trading firms
included
ú failure to maintain and evidence written
approval by a registered principal on one piece of
sales literature utilized during the day trading
seminar sponsored by a branch office of the firms;
ú failure of an affiliate of a day trading firm
to file a pamphlet, which appeared to contain
misleading or exaggerated statements, with NASDR's
advertising department;
ú failure to refrain from making
recommendations in advertisements;
ú exaggerated or unbalanced statements
advertising a trader's profit; and
ú failure to file initial advertisements with
NASDR.
Fewer Violations Relating to Margin and Customer
Lending
SEC and NASDR found fewer violations relating to
margin and lending issues. Although these
violations tended to be isolated, margin and
related customer lending are two issues that
regulators believe are potential problems with day
trading firms because of the nature of day trading
and the way it is conducted.
Margin
Day trading generally occurs in margin accounts.24
Generally, a customer that trades in a margin
account is subject to the initial margin
requirements of Regulation T and the maintenance
margin requirements imposed by the SROs. The
initial margin requirements under Regulation T
permit a firm to lend its customers up to 50
percent of the initial purchase of stock.25 To
comply with Regulation T, the customer would have
to deposit funds or margin securities equal to 50
percent of the purchase price of the stock bought
during the day and held in the account at the end
of the day. For instance, a customer who wants to
buy $150,000 worth of stock can put up $75,000 and
then finance the other $75,000 with a loan from
the broker-dealer. Once stocks have been
purchased, NASDR and NYSE maintenance margin rules
require a customer to maintain equity in his or
her account equal to at least 25 percent of the
value of the stock held in the account. For
instance, a customer who bought $150,000 of stock
on margin would have to have equity in a margin
account of at least $37,500. If a customer does
not satisfy these requirements, the broker-dealer
must ask the customer to deposit additional cash
or margin securities to satisfy the margin
deficiency, known as a margin call. Thus, there
are two separate margin requirements for each
account: one for the initial purchase of stock and
the other for the amount that has to be maintained
on margin once stock has been purchased. Both
calculations are made at the end of the day, and
if a customer has not met the appropriate margin
requirements, a margin call is issued. Regulation
T margin calls must be satisfied within one
payment period after the margin deficiency was
created or increased, which is generally 5
business days. NASDR and NYSE maintenance margin
calls must be satisfied as promptly as possible,
and in any event within 15 business days from the
date the margin deficiency occurred.
Because initial and maintenance margin
calculations are made at the end of the day, the
above requirements are generally not applicable to
day traders because their stocks are sold by the
end of the day before the margin calculations are
made. Accordingly, NYSE and NASDR have also
established separate margin rules for day traders
in order to addres this and other concerns. Under
NYSE and NASDR rules, when day trading occurs in a
day trader's account, the margin requirement is
calculated at the end of the day based on the
total cost of all the day trades made during that
day. 26
Regulators have found that some day trading firms
that are structured as LLCs allow their day
traders to be highly leveraged. Under an LLC, a
day trader contributes to the firm's capital and,
as a result, is permitted to trade using the
firm's capital. Accordingly, the day trader is not
subject to the margin requirements outlined above;
rather, the day trader's leverage is limited by
the firm's overall net capital requirement. This
enables a day trader who is a member of an LLC to
be leveraged far higher than the 2-to-1 leverage
allowed day traders under initial margin and
maintenance margin rules. Regulators implemented
margin requirements not only to protect the
financial integrity of broker-dealers that provide
credit, but also to protect customers from taking
on too much leverage. The leverage afforded
through LLCs enables their day trading members to
have much more capital with which to trade, and
their exposure to loss is much higher than would
be afforded to day traders of a broker-dealer firm
that has a more traditional structure and treats
day traders as customers. As a result, some day
traders can be leveraged to a greater extent than
was intended by margin rules.
NASDR and SEC examiners found five margin
violations. Of the seven firms that we visited,
one firm had margin violations. Margin violations
included the following:
ú An account was allowed to trade when
Regulation T margin requirements had not been met.
ú One firm's customers did not make the
required deposits of additional margin into their
accounts.
ú An associated person of the day trading firm
extended credit to day traders of the firm in
amounts that exceeded the amount the firm is
allowed under under Regulation T.
Lending
SEC and NASDR found that some day trading firms
allow the use of customer-to-customer lending,
where one customer lends money to another who
requires funds to meet margin calls.27 NASDR found
that half the firms that were examined allowed
customer-to-customer lending. Combined, SEC and
NASDR examiners found 23 day trading firms that
allowed customer-to-customer lending. Of the seven
firms that we visited, three allowed customer-to-
customer lending.
Although customer-to-customer lending is not
illegal, regulators are concerned about the
practice, especially when such lending is used to
satisfy day traders' margin requirements.
Regulators believed that some day traders would be
unable to continue to trade without the infusion
of capital from the loans. NASDR expressed concern
about customer-to-customer loans that were
arranged by the day trading firm or one of its
employees for the purpose of meeting margin calls.
NASDR's concern was with the role of the day
trading firm and what type of information was
conveyed to the borrower about the risks.
The lending violations that the regulators found
related to disclosure of credit terms in margin
transactions and disclosure and other requirements
when extending or arranging credit in certain
transactions. For instance, Regulation T was
promulgated to regulate the extension of credit by
broker-dealers; it defines a creditor to include
any person associated with the broker or dealer as
defined in the Securities Exchange Act. Examiners
found that some day trading firms were extending
credit to day traders at the firm in violation of
the rules. Examiners also found instances where
associated persons of the day trading firms
extended credit to customers without establishing
procedures to ensure that day traders were given
disclosures related to the terms of the loan. Of
the seven firms that we visited, examiners found
two firms had violations relating to lending.
Proposed Rule on Appropriateness and Disclosure
NASDR's proposed rule to require day trading firms
to assess the appropriateness of day trading for
each new customer is similar to the suitability
rules NASDR imposes on broker dealers. Suitability
rules require broker-dealers that recommend
securities products to investors to make sure that
the products are suitable for the investors, given
the broker-dealers' knowledge of the investors'
objectives, finances, risk tolerances, and so on.28
Because day trading firms do not generally
recommend particular products, they likely are not
subject to the suitability rules.29 However, the
proposed appropriateness rule would require NASD
firms that promote a day trading strategy to (1)
assess whether such trading would be appropriate
for each customer before opening an account for
the customer or (2) get a signed document
indicating that the customer is not going to use
the account for day trading.30 The proposed rule
does not expressly define what promoting a day
trading strategy would be. However, it does state
that a firm would be promoting a day trading
strategy if the firm promoted day trading through
advertising, training seminars, or direct outreach
programs. In essence, to approve a potential day
trader for trading, the day trading firm would be
required to determine whether day trading is
appropriate for the individual by reviewing such
things as the day trader's financial situation,
investment and trading experience, and investment
objectives. Day trading firms would be required to
prepare a written record setting forth the basis
on which the firm had approved the account for day
trading.
Risk Disclosure Statement
The proposed account approval procedures would
also require a day trading firm to provide a
potential day trading customer with a disclosure
statement on the risks of day trading. A day
trading firm's risk disclosure statement would be
required to point out that day traders should be
prepared to lose all of their funds and that
trading on margin may result in losses beyond the
traders' initial investment. Specifically,
information that should be disclosed could include
the following statements:
ú Day trading is extremely risky.
ú Be cautious of claims of large profits from
day trading.
ú Day trading requires knowledge of securities
markets.
ú Day trading requires knowledge of a firm's
operations.
ú Day trading may result in paying large
commissions.
ú Day trading on margin or short selling may
result in losses beyond the initial investment.
Ensuring that day trading firms provide their
potential traders an appropriate risk disclosure
statement does not address what firms tell the
traders orally. This presents a difficult
challenge to regulators because they generally do
not directly observe the interactions between
firms and traders or potential traders. Also,
unless they have a criminal investigative
function, the regulators are precluded from posing
as potential traders to test the oral disclosures
firms provide.
Recommendations
Because the effects of day trading in an
environment that depends less on SOES and more on
ECNs are uncertain, we recommend that the
Chairman, SEC, in conjunction with NASD, evaluate
the implications of the growing use of ECNs by day
traders on the integrity of the markets. We
recognize that major changes are occurring in the
structure of securities markets, especially the
change to decimal trading, and recommend that the
evaluation of day trading begin after decimal
trading is implemented.
Also, day trading is risky for individual
investors, represents a large and growing portion
of the Nasdaq trading volume, and is an evolving
part of the securities industry. Therefore, we
recommend that the Chairman, SEC, do at least one
more cycle of targeted examinations of day trading
firms to ensure that the firms take the corrective
actions they propose in response to previous
examination findings.
_______________________________
1 SEC and NASDR are responsible for ensuring
investor protection and market integrity in the
securities markets.
2 Margin is the amount of cash or securities a
customer must maintain with a firm in order to
obtain a loan.
3 SOES allows small orders placed through it to be
automatically executed against Nasdaq market
makers at the best bid (buy) or ask (sell) prices
displayed on the Nasdaq system. It allows
customers to access and trade with market makers
without having to call them on the phone.
4 The requirement was a direct result of the
market makers' poor performance during the 1987
crash. At that time, market makers failed to
answer their phones to honor their quoted prices,
and customers could not get orders executed at any
price. In response, Nasdaq implemented an
automatic electronic execution system for
customers through SOES.
5 The trading strategy used by SOES day traders
was one of looking for the beginning and end of a
trend-specifically the trends of market makers-and
trying to buy and sell a stock using SOES and
SelectNet while the stock was moving in price.
Because of the automatic execution feature of
SOES, day traders had a trading advantage over
market makers and their customers in that they
could execute trades faster than the market makers
could update their quotes. This ability allowed
SOES day traders to profit at market makers'
expense from short-term price movements in stocks.
6 SEC intended these rules to make the Nasdaq
market a more competitive, customer order-driven
market and thus reduce bid-ask spreads. As a
result of the order handling rules, market makers
have to fill or display any customer's limit order
that improves on the inside price. This gives the
customer's limit order protection in the market,
as opposed to just having the market maker execute
the order when conditions were favorable to the
firm.
7 Limit order is a customer order to buy and sell
a security at a specific price.
8 One ECN, Instinet, already existed, but it could
be accessed only by institutions.
9 One reason ECNs are popular is that as spreads
narrow on volatile stocks, market makers are more
inclined to step aside and post trades into ECNs,
where investors can trade directly with one
another. Another reason is that investors can save
money because fees are low and because they can
effectively negotiate prices with limit orders.
ECNs match up potential stock buyers and sellers
directly while allowing customers to maintain
anonymity.
10 When Nasdaq was first developed, it attracted
illiquid stocks that did not meet the New York
Stock Exchange's or the American Stock Exchange's
listing requirements. Nasdaq market makers
typically quoted wide spreads (the difference
between the bid and the ask price), reflecting the
nature of illiquid stocks. In addition to the wide
spreads, Nasdaq ensured that market makers were
able to earn the spread on every transaction. A
market maker was always on the other side of every
trade. This meant that customers were rarely
allowed to trade with each other. They were forced
to buy and sell stocks from a market maker who
would benefit from wide spreads.
11 The open limit order display system gives orders
greater market representation, which increases the
possibility of matches. Orders that are not
immediately matched are typically displayed for
all subscribers to see.
12 See Gregory W. Smith, "The Electronic Brokerage
Industry," Hambrecht & Quest, October 5, 1999.
13 Ibid.
14 Our figures are based on the average number of
daily trades done by all the traders at each firm,
assuming 20 working days in a month.
15 This particular firm required $75,000 initial
capital contribution. Our estimate was based on
the individual having $100,000 in capital. The
1998 return of the S&P 500 was 19.3, and the 1999
return was 19.5. We did not assess the reliability
of these numbers from the firm.
16 The firm provided more specific data to us on
individual traders. We did not assess the
reliability of these data.
17 See Securities Market Operations: The Effects of
SOES on the Nasdaq Market (GAO/GGD-98-194, Aug.
31, 1998).
18GAO/GGD-98-194.
19 SEC did 47 examinations of 41 separate firms and
their branches. NASDR did 20 examinations, 15 of
which were of different firms than SEC examined.
In total, SEC and NASDR examined 56 separate day
trading firms.
20 A short sale refers to any sale of a security
that the seller does not own or any sale that is
consummated by the delivery of a security borrowed
by, or for the account of, the seller.
21 NASD rule 3370 also requires that broker-dealers
keep written records of short sale affirmative
determinations that include, among other things,
the identity of the individual and firm that
offered the assurance and the number of shares
needed to cover the short sale.
22 A firm is supposed to have procedures that are
designed to prevent a trader from selling on a
downtick when the firm's aggregate position in the
stock is short. However, when the firm does not
aggregate all of the positions of the traders at
LLCs-known as associated persons-then the firm
does not know whether it is holding long or short
positions in an individual security and could end
up marking short sales as long sales and vice
versa.
23 Generally, a firm's net capital is computed by
deducting illiquid assets from its "net worth," as
determined under Generally Accepted Accounting
Principles, adding to that amount properly
subordinated debt under Appendix D of the net
capital rule, and further deducting certain
prescribed percentages, known as haircuts, from
securities held in the firm's proprietary
accounts.
24 A customer may purchase and sell a security on
the same day in a cash account if the customer has
the money in the account. However, if the customer
does not have the money in the account, a day
trade may amount to free riding-purchasing a stock
and then selling it without having paid for the
purchase.
25 Regulation T is a Federal Reserve rule that
specifies margin requirements. For example, it
requires an initial margin of 50 percent for new
purchases of stocks in margin accounts.
26 However, under a NYSE rule interpretation, if
the broker-dealer keeps a record showing the "time
and tick" of each trade as evidence of the
sequence of the day trades, the day trader may
maintain margin based on the largest aggregate
open position during that day. In effect, this
requires day traders to demonstrate that they have
the ability to meet the initial margin
requirements of Regulation T for at least their
largest open positions during the day. For
example, a day trader who makes 20 buy and sell
trades during the day and ends the day flat would
receive a margin call based on 50 percent of the
largest open position held during the day,
assuming that there was a margin deficiency in the
account. NASDR margin rules are substantially the
same as NYSE's rules. However, NASDR has not
adopted the "time and tick" interpretation
regarding day trading margin.
27 Regulators have also found that customer-to-
customer lending may be facilitated by a day
trading firm that would work with its clearing
firm to identify day traders with credit balances
who would be in a position to lend money to other
customers.
28 Suitability Rules refer to NASD Rule 2310
Recommendations to Customers.
29 Suitability applies only when a broker makes a
recommendation. There can be no claim against the
broker for unsuitable investments when the broker
does not make a recommendation.
30 According to NASDR, a day trading strategy is an
overall trading strategy characterized by the
regular transmission by a customer of intraday
orders to effect both purchase and sale
transactions in the same security or securities.