finra

Remarks By Mary L. Schapiro
President, NASD Regulation, Inc.

NASD Regulation Fall Securities Conference

Sheraton Hotel & Towers, Seattle, WA
October 22, 1999

 

Good Morning. It is wonderful to be here and to have the opportunity to see you all as we begin the second day of the Fall Conference.

 

I thought that rather than doing my usual "State of the SRO" speech and running through a long list of issues, I would use our time together to talk about some of the issues that have been raised by advances in on-line trading and technological developments generally in the securities industry. I know that during the course of the conference you have the opportunity to focus on specific areas of concern to you in far greater detail than I can cover here, so I’d like to take a step back and talk more generally about the industry.

 

This is my eighth NASDR conference and there is one consistent message that I hope I have sent each time. That is that those of you who work in compliance and legal departments are as important to the continued health and success of this industry as anyone else. The firm that cares about doing what is best for their customer and instills an ethic of honesty and compliance will be here for the long run and will prosper. Empowering compliance departments is an integral part of that. We rely on you to be vigilant. Far more importantly, your customers rely on you to ensure that the firm and the people with whom they have entrusted their hard earned money is operating honestly, with integrity and with the customer’s best interest in the forefront.

 

I admire and applaud what you do day in and day out to ensure that our markets remain the most honest and open in the world.

 

Technology really is changing the ways that financial services are provided and, through those changes, the power that individual investors have to shape their own future. These developments have important implications both for regulators and for members of the industry, and they reinforce the need for good cooperation between the two.

 

Even as technology has changed the industry, it is also true that, over time, the securities industry has been a major motivating force in accelerating the pace of technological change. The demands of quickly processing transactions among millions of investors in every geographic region and overseas have impelled the industry to find more and faster ways of communicating, and of clearing and settling trades.

 

The NASD has long been in the forefront of electronic commerce, because of its history and its assigned role as a primary self-regulator for the securities industry and its stewardship of the Nasdaq market. Prior to 1971, dealers in the over-the-counter market communicated by phone and relied on written quotes to get an idea of market prices. This clearly was not an efficient system. So the NASD created a screen-based system that was capable of disseminating quotations on a current basis. Over the nearly 30 years since, Nasdaq and systems that were designed around it evolved into a true trading system, capable of routing orders to other market participants, executing trades, and providing last sale reporting of trade prices and volume virtually instantaneously and throughout the day. Each enhancement allowed more trades to be done more quickly, and most important, in a way that was more transparent to the outside world.

 

Enhanced transparency has meant more competition among firms and in some cases lower profit margins. For that reason, we have sometimes seen resistance to improvements to systems that provide transparency. Interestingly, however, in every case, the long-term effect of those changes has been good both for investors and for the industry, because they have encouraged more participation by more investors—that is, whatever short-term loss firms have suffered in terms of profit margins has been more than outweighed in the long term by greater volume.

 

At the same time, the securities markets have become more and more important to the overall health of the economy as companies have come increasingly to rely on those markets for new capital. Every kind of statistic bears this out. Close to half of all American adults now own securities in some form, either directly or indirectly. For the first time in history, American households have more of their wealth invested in the stock market in some form than in real estate. The volume of shares traded on the major exchanges and Nasdaq has been on a long-term, very steep trajectory. In recent months, Nasdaq average daily share volume has exceeded one billion shares per day, a level that would have seemed improbable only a few years ago. All of these events owe much to advances in electronic trading technology.

 

Technology, as we know, can also present perils, especially for unsophisticated retail investors. We know that on a societal scale our dependence on technology has to be managed. The vulnerability of computers connected to Y2K makes the point more strongly than I could. And we clearly are not going to reverse the fact of our dependence. The genie cannot be put back into the bottle; the issue is whether we can command it to grant the right wishes and serve the right interests.

 

In the context of the securities markets, the right interests are always those of investors, since they are the people who ultimately pay the freight and make the machinery work. To this point, technological advances have always in the main served their interests by making markets more efficient, lowering costs, and above all, providing more information.

 

Perhaps the biggest single technological development with regard to investment services in recent years is the growth of on-line brokerage accounts. According to Gomez Advisors of Massachusetts, while brokerage accounts overall are growing at a rate of about 5 to 7% per year, the number of on-line accounts has increased 73% last year and is expected to increase to 10.5 million by the end of this year.

 

The advent of on-line trading and services has been a significant benefit to individual investors in a number of ways. For the first time, small investors have access to the kind of investment research that before was available only to institutions and very wealthy individuals. Commissions have been lowered so much that firms can no longer compete effectively solely by lowering commission costs, so they compete by trying to provide more useful services and increasingly by offering asset-based advice. Internet accessibility also means that firms can offer an increasingly sophisticated array of tools. Do you want to know how the stocks in your portfolio have performed over different periods of time? Do you want to contrast that against the performance of benchmarks in the same business sector? What about the impact of commission costs on your net return? The ways that Internet technology can be used in the service of retail investors are truly limitless.

 

Those investors also have the opportunity now more than ever before to exercise choice in terms of trading decisions. Investors who are active traders can acquire what effectively amounts to direct access to the markets, with most if not all of the tools available to professionals, provided they’re willing to pay for them. That doesn’t mean they can easily acquire the experience and acumen that professionals have, but that’s a different matter, and one that I’ll discuss more in a moment.

All of this amounts to a real democratization of the marketplace. People like to talk about empowerment these days. It’s a word that has gained a cheap currency, but I think that developments in the securities markets really have given individual investors a hugely broader range of choices and information. It’s a trend that has been hastened by technology and the free market forces that have rushed in to exploit it.

 

Well, if that’s all there was to the story, of course, it would be much less interesting and this speech would be much shorter. I would suggest that it’s true in every realm of human endeavor that a grant of power needs to be accompanied by the means to use it wisely. To put it another way, a lot of power coupled with a little bit of knowledge can be a very dangerous thing to those who are empowered, and maybe others as well. From the perspective of both the regulators and the industry, the challenge is to see that effective decision making ability and the means to exercise it wisely both continue to flow downhill, where the vast majority of us live.

 

We start by acknowledging the need to continue to police the markets as effectively as possible, recognizing that the Internet has given fraudsters a whole new bag of tricks to use. The old tricks are still very much in evidence, of course—the non-existent company with a cure for cancer, the cutting edge technology company that amounts to nothing more than a corporate shell. Ostrich and eel farms have been a favorite in recent years. Those tricks haven’t changed, but the means to spread the message have. Internet chat rooms are an especially favored venue—they’re cheap, fast, allow access to lots of people, and most important, they’re anonymous—or so the perpetrators hope. Another recent innovation is the bogus press release designed to generate interest in a security in order to allow the perpetrator to sell at the inflated price.

 

The NASD has invested in artificial intelligence technology that allows us to survey many different parts of the Internet at the same time, looking for key words and other clues and correlating that information with market trends. The SEC also has a number of people dedicated to the same activity, and the growing number of successful enforcement cases testifies to the value of this effort.

 

It’s an effort that must continue, because investor confidence is a kind of goodwill asset for the markets as a whole, and generally speaking, it’s a lot easier to lose than to establish and maintain. But make no mistake about it—our efforts will not protect investors against every fraud or con artist who has hyped their particular brand of evil on the Internet.

 

Another aspect of the regulatory challenge is to make sure that firms are doing everything they can to keep pace with technology and are creating an environment that adequately protects investors and responds to their needs. For one thing, we need to make sure that firms maintain the systems capacity needed to handle increasing share and on-line traffic volume. The firms that are heavily into this business have spent great sums of money upgrading their capacities to keep pace with heavier volume and to anticipate highly unusual conditions. Many of the well-publicized glitches and system down-time can be ascribed to pretty normal growing pains that exist in any rapidly changing industry. But firms themselves can alert investors to the problems that may occur from time to time.

 

Both regulators and the industry have a critical obligation to educate investors about these and other issues. Investors can’t guard against system outages that are beyond their control, but they can learn to anticipate when those events are more likely to occur, and they should know some basics about on-line investing to be able to make smarter decisions on a day to day basis. Knowing what a limit order is, and how to use it, is one important lesson. Knowing how margin accounts work and what you risk when you trade on margin in another. You have an obligation to educate your customers. And, we have a way to help—we will shortly be unveiling a new educational web site devoted to on-line investing that firms will be able to link to.

 

Speaking of investor expectations, we cannot ignore the power of advertising in shaping them. Advertising should not attempt to seduce investors into the perception that easy access to the markets and market information somehow transforms them into professional traders. Nor should they be led to believe that on-line trading portends quick and easy profits. Some of the ads that have created a feeling—not unlike a feeding frenzy by a bunch of sharks, are quite funny. And, yes, we do have a sense of humor, but that’s beside the point. You have an obligation—one that arises not just from the rules but from good business sense as well, to keep investor expectations reasonable.

 

In any event, in certain cases, we have insisted that a member terminate the use of particular television advertisements, at significant expense to the firm. Beyond that, we review ads and sales materials that are filed with us. In 1999, we expect to review more than 80,000 filings. Because of that review process, for the 12 months ending August 31, we stopped the use of 782 public communications that we found to be misleading. But beyond that, even where a particular ad doesn’t violate the rules, I am very troubled by ads that cast brokers generally in a negative light or belittle the professionals in the industry. Investor confidence and trust is an asset that we have all worked to build and no segment of the industry has the right to squander it by calling into question the integrity of a whole class firms just because they have a different business model.

 

You’ve all heard a lot about after-hours trading lately, and this is another topic that is intimately tied up with the promises and perils of advancing technology. This is an issue that has many facets. Do we cater to those investors who want the flexibility to trade at any hour of the day or night, without regard for the effect of that activity on the markets from the standpoint of investors who have no interest in trading outside of normal working hours? On the other hand, how do we stop, and why should we stop, people from trading whenever it suits them? If there’s not much liquidity for some stocks that are traded after hours, how can we be sure that investors are getting fair prices?

 

We think the concerns about the potential impact of after-hours trading are real. We think the answer is to start out slowly, impose certain ground rules, and gain experience with after-hours trading before we decide to open it up further. To start with, investors should have to make a conscious, affirmative decision to choose to trade outside normal hours, and firms should give them plenty of information about the risks before they say yes. The stocks that have after-hours trading privileges initially should be those that command a lot of interest and volume during the day, and so are more likely to generate more liquidity in trading at night. Investors also will be better protected if they can submit only limit orders after hours, so that they’re not surprised by having their order executed at a price that’s dramatically different from the one they saw on their screen when they placed the order. Finally, and perhaps most importantly, investors need disclosure about the after hours market and what they might expect. If your firm is providing after-hours access, you should be making appropriate disclosures about volatility, liquidity and executions.

 

It’s impossible these days to talk about trading and the Internet, and ignore the topic of day trading, which is really more generally about the blurring of the functions of investor and professional trader, and the blurring perceptions by investors about that dividing line. Day trading is not a new phenomenon, but it is now practically accessible to many more investors than ever before, and there are dozens of firms that have sprung into life specifically to service that potential demand.

 

There is nothing per se troubling about any of that. To investors who have the resources, sophisticated understanding of the markets and market dynamics, stamina, and just plain guts to go up against the pros—fine. My concern is that at least some of the people who are being actively encouraged to get into this activity lack any of those attributes, and are playing a very dangerous game. What’s more, the danger may not be evident until a lot hard-earned money has been lost.

 

Again, to make the point clear, I think the real danger is not that a small group of investors at the margins will treat investing as if it were a form of gambling. The larger concern is that a lot more mainstream investors will come to see it that way, and in terms of nurturing that asset called investor confidence, that would be a very negative development. With certain safeguards, day trading can be a legitimate strategy. The safeguards are however, critical to investor protection.

So, what do I mean by safeguards? 

 

We know that day-trading is a high risk strategy not to be used by the uninitiated; it draws on a person’s financial and emotional resources. In this regard, day traders must establish a financial foundation that will support them in times of turbulent markets and high pressure decisionmaking that frequently leads to monetary loss.

 

Moreover, firms that promote or encourage day trading must never prey on the unsophisticated investor. During these times of rapid technological advances, investors are increasingly turning to online accounts for trading. While it is critical to distinguish online accounts from day trading, I am concerned that access to real time information and market access is developing in the views of some a false impression of their own market sophistication. As a general proposition, investors are NOT professional traders simply because the are enabled by automated tools similar if not identical to the pro’s. This false sense of security makes it increasingly important for day trading firms not to prey—even inadvertently—on those investors who mistakenly present themselves as knowledgeable, sophisticated individuals ready to bear the risks of an aggressive day trading strategy.

To that end, the NASD has just proposed new rules that, if approved by the SEC, will set new standards for day trading firms. The rules would require firms that actively promote day trading as an investment strategy to determine whether this is an appropriate strategy for the people they solicit. Firms would be required to make this determination as part of the account approval process, based on any information they gather about resources, experience, and objectives.

 

The proposed rules also would require firms to provide a specialized disclosure statement to customers about the special risks of day trading.

 

We’ve heard a lot of support for the disclosure statement aspect of the proposed rules. The requirement for a new appropriateness determination is a little more controversial because it would require a documented judgment that is subject to audit and second guessing. There is, however, already a disconnect with the rules that exist now. Specifically, while the law already requires brokers to document and make a suitability determination for every recommended security, firms that advertise and promote risky trading strategies are not explicitly made responsible for conducting a similar review.

 

We are also looking very closely, in cooperation with the New York Stock Exchange at margin and lending practices, including the appropriate levels of margin, timing of margin deposits, and the facilitation of customer to customer lending by firms. We will have more to say on these issues very shortly.

 

ALL of these issues raise a more general point about the interrelationship between the popularity of on-line trading and the changing nature of the broker-customer relationship. The old model of that relationship, or at least the idealized version of it, was that of the small town, avuncular banker who knew all his customers personally, knew how to take care of them financially and, what’s more, wanted to take care of them because he had known them for years and that’s what you were expected to do. At its most extreme, the new model is something very different. The firm may not be represented by a human being at all, at least not from the standpoint of individual customers, who look to the firm to provide a range of services and fast, cheap execution but not personal advice and certainly not hand-holding, which many customers would see as inconvenient or even patronizing.

 

Of course, the contrast is really not as stark as that description would imply. There were probably never very many securities brokers who looked like George Bailey from It’s a Wonderful Life, and I know there are plenty of brokers out there today who take a personal interest in their customers’ welfare. The real difference is that investors have a lot more choice about the kind of professional relationship they want and how much independent decision making authority they want to exercise. Also, they have a lot more tools available to exercise that authority if they choose to do so. The important thing is that both parties clearly understand the terms and conditions of the relationship in the individual case.

 

This is a particularly pertinent point in the context of choosing securities. Under NASD rules, it has long been the case that any firm recommending a security to a customer has an express obligation to determine that the security is suitable for that person based on his or her unique situation. What happens when a customer uses an on-line brokerage account to trade but doesn’t get recommendations from a salesperson? The firm may still be making a recommendation in other ways if, for example, it selectively sends notice about new offerings or products that the firm is promoting, based on information that it has collected about the customer. The extent of the firm’s legal obligations cannot depend on whether the customer is trading on-line or not. The question instead should be: what are the reasonable expectations of the firm and the customer about the nature of the relationship that is being created?

 

This is an exciting time to be involved in the securities markets in any capacity. Individual investors have never been in a better position to chart their own destiny. Regulators and the industry working together can help them to use the power that technology has given them to provide financial security for themselves even as they continue to fuel economic expansion well into the new millennium.