Testimony of Mary L. Schapiro
President, NASD Regulation, Inc.
Before the Permanent Subcommittee on Investigations Senate Committee on Governmental Affairs on the Securities Day Trading Industry
September 16, 1999
I am Mary L. Schapiro, President of NASD Regulation, Inc. NASD Regulation, Inc. and our parent, the National Association of Securities Dealers, Inc. (NASD®), would like to thank the Subcommittee for this opportunity to testify on the securities day-trading industry.
My testimony today will address the issues that you identified in your invitation letter to this hearing. Those issues deal with the general characteristics of day trading, risks involved, our examination findings, our recent rule proposals, and any needed legislation.
By way of summary, NASD Regulation believes that day trading is a legitimate trading strategy, and to the extent it is conducted by individuals capable of understanding and assuming the risks involved with such a strategy, we do not intend to discourage such activities. However, with that said, NASD Regulation sees day trading as a highly risky form of trading that deserves close investigation and study by regulators. We have been addressing the risks that we have seen through a combination of continued dissemination of information to our members and investors, focused examination and enforcement efforts, and the development of new NASD rules and other policy initiatives. Given our current experience, we do not now see a need for new legislative initiatives, but we intend to continue to work together with the SEC and the states on these important issues, and will promise to inform you if we perceive a need for new legislation to protect investors and our markets.
Let me briefly outline the role of the NASD in the regulation and operation of our securities markets. Established under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934, the NASD is the largest self-regulatory organization for the securities industry in the world. Virtually every broker-dealer in the U.S. that conducts a securities business with the public is required by law to be a member of the NASD. The NASD’s membership comprises 5,600 securities firms that operate in excess of 75,000 branch offices and employ more than 600,000 registered securities professionals.
The NASD is the parent company of NASD Regulation, Inc. (NASDR), the Nasdaq Stock Market, Inc. and the American Stock Exchange (AMEX). NASDR and Nasdaq operate under delegated authority from the parent, which retains overall responsibility for ensuring that the organization’s statutory and self-regulatory functions and obligations are fulfilled. The NASD is governed by a 27-member Board of Governors, a majority of whom are non-securities industry affiliated. The NASDR subsidiary is governed by a 10 member Board of Directors, balanced between securities industry and non-industry members. Board members are drawn from leaders of industry, academia, and the public. Among many other responsibilities, the boards, through a series of standing and select committees, monitor trends in the industry and promulgate rules, guidelines, and policies to protect investors and ensure market integrity.
NASD Regulation is responsible for the registration, education, testing, and examination of member firms and their employees. In addition, we oversee and regulate trading on Nasdaq and the over-the-counter markets.
The 1,600 member staff of NASDR is devoted exclusively to carrying out the NASD’s regulatory and enforcement responsibilities. NASDR carries out its mandate from its Washington headquarters and 14 district offices located in major cities throughout the country. Through close cooperation with federal and state authorities and other self-regulators, overlap and duplication is minimized, freeing governmental resources to focus on other areas of securities regulation.
NASDR Enforcement brings cases against members and their associated persons based on information developed internally by periodic examination of member firms, broker terminations for cause, market surveillance, and referrals from our arbitration, corporate financing, and advertising programs. It also uses external sources, including federal and state agencies, customer complaints, news media, and anonymous tips. Enforcement investigations gather information through on-site examinations, document requests, trading activity analysis, and customer and member interviews. If cases are not settled, they go to formal hearings for disposition, and may be appealed to the NASD’s National Adjudicatory Council, the Securities and Exchange Commission (SEC), and the US Courts of Appeals. In 1998 alone, NASDR initiated more than a thousand disciplinary cases and suspended or barred more than 650 individuals from the industry.
While our regulatory jurisdiction is limited to our broker-dealer member firms and their associated persons, our examinations, surveillance, and regulatory intelligence alert us to illegal conduct outside of our jurisdiction. We routinely refer such findings to the SEC, the states and criminal prosecutors for their action. In recognition of the resources we were devoting to assisting prosecutors in bringing securities cases, we formed a Criminal Prosecution Assistance Group in April 1998. Since the beginning of this program, we have provided assistance in more than 100 criminal investigations and prosecutions around the country.
NASDR is responsible for developing rules that govern the conduct of the brokerage industry in areas as diverse as sales practices, advertising, trading and underwriting. Rulemaking is a widely participatory process with broad input from industry members, trade associations, other regulators, and the public. By the requirements of the Securities Exchange Act of 1934, NASDR rules do not become final until they are approved by the SEC.
NASDR has examination responsibilities for all of its 5,600 members. In addition to special cause investigations that address customer complaints and terminations of brokers for regulatory reasons or other cause, NASDR has established a comprehensive routine cycle examination program. This program is carried out through a regulatory plan that focuses each District's examination efforts on the firms, individuals, issues and practices that present the greatest regulatory challenges and concerns. Annual on-site inspections are conducted of high priority areas. In addition, NASDR has established an examination frequency cycle for all of its members, which is based upon the type of business conducted by the member, the scope of that business, the extent of customer exposure, method of operation, past regulatory history, and other factors. During 1998, 2,606 main office routine examinations were completed and 5,671 customer complaints and 3,535 terminations for cause were investigated.
NASDR shares responsibility for developing and administering qualifications testing for securities professionals. All sales and supervisory persons associated with NASD member firms must demonstrate a requisite understanding of the products offered by their firms, as well as regulatory requirements. Individuals acting in a management capacity must pass the appropriate principal's examination, while sales personnel must demonstrate specific understanding of the products they intend to sell and the regulations that govern those products. In 1998, NASDR administered 267,000 examinations for 29 different qualification areas.
The Nasdaq Stock Market
The Nasdaq Stock Market, Inc., develops, operates, and regulates a variety of marketplace systems and services. Nasdaq is the largest electronic, screen-based stock market in the world, capable of handling trading volume in excess of one billion shares a day. Today, more than one-half of all equity shares traded in the United States each day are traded on Nasdaq.
The American Stock Exchange
The American Stock Exchange is the nation’s second largest floor-based securities exchange and is the only U.S. securities exchange that is both a primary market for listed equity securities as well as a market for equity options, index options, and equity derivatives.
Day Trading and On-Line Trading
A recent outgrowth of technological advances in the securities industry has been the increase in popularity of day trading. The term "day trading" refers to a trading strategy where an individual buys and sells the same security in an attempt to profit from very small movements in the price of a security over a short period of time. Although the term is commonly used to refer to aggressively buying and selling a group of securities in a single day (or selling short and then buying to cover the short position), there are varying degrees of day trading currently being employed. For example, some individuals "day trade" in that they execute purchase and sale (i.e., "round-trip") transactions in a single day; however, they limit such activities to only one or two round-trip transactions in a day, and only on an occasional basis. These individuals typically do not rely on their day-trading activities as their primary source of income and may conduct such activities from computers located at their places of regular employment or their homes. In addition, although as a practical matter, day trading typically requires electronic delivery of orders, day trading can include orders transmitted by non-electronic means, such as by telephone.
However, the term "day trading," as commonly used within the industry, generally refers to the trading activities of the "professional day trader," that is an individual who conducts intra-day trading in a focused and consistent manner, with the primary goal of earning a living through the profits derived from this trading strategy. This form of day trading requires aggressive and frequent securities trading and, as a result, generally requires a significant amount of capital, a sophisticated understanding of securities markets and trading techniques, and high risk tolerance. Day traders typically have a relationship with a brokerage firm that provides them with more direct access to the markets as well as access to real-time trading and related information.
Another outgrowth of technological advances in the securities industry has been on-line trading. Only a few years ago, most individuals had little or no exposure to on-line trading. Individuals with on-line accounts were more likely to work in the financial or securities industries or to have engineering or other technological backgrounds. Recent reports, however, indicate that there are several million on-line trading accounts in the United States. Access to on-line trading resources has enabled investors to be better informed about their own portfolios, as well as specific trends or news in the markets.
While there are differing opinions of what constitutes "on-line trading," the term generally refers to accessing and using securities trading resources via the Internet. On-line trading activities can range from occasionally buying or selling securities on-line, to aggressively day trading on location at a brokerage firm. As requested, my testimony today focuses on issues relating to day trading specifically, rather than on-line trading generally.
While many factors have contributed to the increase in day trading, one significant factor is recent rapid advances in technology, including the widespread availability of the Internet. The Internet has provided individuals with quick, easy, inexpensive access to the securities markets and information and this, in turn, has encouraged greater participation in the markets by individuals not employed in the securities industry. As a result, individuals have been trading their accounts far more actively than in the past.
Over the past few years, brokerage firms began to consider how best to incorporate technological advances that could impact customer trading activities into their own business model. Certain brokerage firms began to focus primarily, or even exclusively, on promoting day-trading strategies to individuals. These firms generally advertise on the Internet and elsewhere as "day-trading" firms or otherwise promote their execution and other services as desirable for "serious" or "professional" traders. These firms often provide reduced transaction costs through lower commissions and other margin-related costs. In addition, many of these firms offer training on day-trading techniques, as well as provide computer facilities, high speed access lines and software packages specifically designed to support and accommodate day trading. Although day trading can be conducted using the facilities of any brokerage firm, most day trading occurs at these types of firms due, in part, to their programs that offer more direct access to the markets, relatively favorable transaction costs and access to lenders for margin purposes.
The Use of Margin by Day Traders
Day traders often use margin to leverage their trading activity. Day traders typically do not carry securities positions overnight and therefore do not face standard maintenance margin requirements. However, they are subject to special margin requirements under NASD rules that are calculated based on the largest open position held by the day trader during the day. For example, assume that a trader starts the day with $50,000 cash, makes 20 buys and sells, and ends the day flat (neither long or short the stock) with $50,000 cash. During the day, the largest open position at any given time held by the trader was 4,000 shares of a $25 stock, and 1,000 shares of a $50 stock ($150,000). Even though the day trader ends the day flat, he will receive a margin call for 50% of the $150,000, less the equity in his account, or $25,000.
The use of margin by day traders can result in financial losses beyond their initial investment. For example, assume that a day trader begins the day with $50,000 cash in her account. She purchases 5,000 shares of a $20 stock ($100,000) and has therefore received a margin loan of $50,000. The stock price drops to $9 per share. The day trader sells the stock and receives the proceeds from the sale of $45,000. As a result, she has lost her initial $50,000 investment and owes an additional $5,000.
Regulatory Response to Day Trading
The growth in day-trading activities has raised unique investor protection issues and concerns. Day trading is a risky, speculative activity, and even the most experienced day traders may suffer severe and unexpected financial losses, even beyond their initial investment. At a minimum, day trading requires sufficient capital and a sophisticated understanding of the markets and market dynamics. It also requires an expertise in identifying securities to trade and in accurately timing purchases and sales.1
Given these risks, the NASD, SEC and state securities regulators have worked together to address the investor protection concerns in this area. Our approach has been three-pronged, relying upon: (1) the dissemination of advisories and other information to NASD member firms reminding them of their obligations under existing rules; (2) focused examinations, investigations and follow-up enforcement actions; and (3) the institution of rulemaking initiatives.
(1) Advisories Concerning Obligations under Existing Rules
In response to the increase in day-trading and other on-line trading activities, the NASD has published the following Notice to Members (copies of which are attached, along with any related NASDR press release):
(2) Examination and Enforcement Activities
NASD Regulation is engaged in a cooperative day-trading examination initiative with the SEC. Beginning last Spring, the staffs of NASDR and the SEC launched a broad-based, coordinated examination program of day-trading firms. As part of that effort, NASDR examined 22 day-trading firms that varied significantly in size and makeup. Fifty-five NASDR examiners received special training in the intricacies of day trading. Customized examination modules were developed and used to implement this special program. The two largest firms examined had 1,500 or more day-trading accounts, while at six of the firms, fewer than 20 of its customers were day trading. At about half of the firms examined, day-trading activity accounted for nearly all of the firm’s business.
During these specialized examinations, several potential problem areas surfaced, including advertising, Regulation T and margin lending, registration of individuals, short sales, and supervision. We are currently reviewing the results of those examinations and completing the investigations growing out of them. To the extent that these investigations indicate that violations of our rules or the federal securities laws have taken place, formal enforcement actions will be instituted.
NASD Rule 2210 governs "Communications with the Public." The Rule applies to "advertisements" and "sales literature" and prohibits "exaggerated, unwarranted or misleading statements or claims." Generally, electronic advertising such as those found on the Internet, are treated no differently from hard copy advertising and marketing materials.
Nearly 80 percent of the day-trading firms examined had potentially problematic advertisements that have been referred to our Advertising Regulation Department for further review. The problem areas noted in these advertisements range from allegations of immediate execution to statements of profits that can be generated from day trading. One practice under review is the dissemination—-through websites, training materials, and public statements—of what may be materially misleading and unwarranted information regarding the "success rate" of their customers. The staff is reviewing whether the firms’ claims of customer success rates in their marketing and communications with the public can be substantiated as our rules require.
Other materials reviewed from day-trading firms have contained unsubstantiated claims regarding "profit potential," "lowest commissions," "trading for a living," or "industry leader in day trading" without corresponding risk disclosure or qualifying language. In addition, day-trading websites and other communications with the public have indicated that losses can be controlled or minimized through the use of certain strategies or techniques. In short, at least some day-trading firms appear to have failed to provide investors with a sound basis for evaluating the services being offered and contain exaggerated statements rendering the promotion or presentation misleading.
We have already filed one formal disciplinary action against a day-trading firm for violations of our advertising rules. On June 10, 1999, a complaint (attached) was filed against Lakeside Trading, a Metairie, Louisiana day-trading firm, and its president and principal. In addition to alleged margin violations and improper use of customer funds, the complaint alleged that the firm’s Internet website contained:
Regulation T and Margin Lending
Our day-trading examinations have revealed that at some day-trading firms, principals and employees arrange for credit to be extended from customers who have some equity in their accounts to those who require funds to cover margin calls. Absent these infusions of capital, many of the recipients of the loans would be unable to continue to trade.
Approximately half of the firms examined facilitate the lending of money between customers. At one firm, all the lending was done by one customer. In other instances, the firm works with its clearing firm to identify customers with credit balances who could be lenders. NASDR is investigating potentially violative activity relating to loans made by and between customers that are arranged by the firm or one of its employees for the purpose of meeting initial and maintenance margin requirements. We are reviewing the role of the member in arranging these loans and what, if any, representations are made to the lending customers concerning the risks associated with making the loans.
NASD rules prohibit equity traders from trading in the Nasdaq and over-the-counter markets without first passing a qualification examination for trading (the Series 55 examination) and registering with NASD Regulation. The Series 55 registration rule, which became effective in April 1998, applies to market makers, agency traders, proprietary traders, and persons who supervise these activities. The rule was developed in response to concerns about rule violations by traders conducting market-making and principal trading functions in both the Nasdaq and over-the-counter markets.
We have found instances where persons engaging in day trading for a firm’s proprietary account are not Series 55 registered. One disciplinary action has already been concluded in this area. On July 7, 1999, NASD Regulation censured and fined On-Site Trading, Inc., a Great Neck, NY day-trading firm, $25,000 for failure to properly qualify and register 14 individuals. (AWC and press release are attached.) These individuals effected approximately 3,700 trades in 250 Nasdaq securities on behalf of the firm’s proprietary accounts. Without admitting or denying the allegations, On-Site consented to findings that it lacked adequate oversight to ensure proper registration of its traders, and agreed to implement new compliance procedures to prevent future violations. Relatedly, we have also found instances in which individuals entering orders on behalf of customers were not Series 55 registered.
We have found short selling practices at some day-trading firms that appear to violate our rules and the federal securities laws. Specifically, our rules require that firms mark all sales as either "long" or "short" and that the firm determine if it can obtain shares of the security sold short to deliver to the buyer. We have seen practices at some day-trading firms that facilitate short sales by customers when the short sales are not marked as such and when no determination has been made that shares can be delivered to the buyer. We have also seen potential violations of our rules prohibiting customer short sales on what is commonly known as a "downtick." Rule 3350 (the "Short Sale Rule") prohibits member firms from effecting short sales at or below the current inside bid as disseminated by Nasdaq whenever that bid is lower than the previous inside bid.
The staff of the Market Regulation Department of NASDR reviews and investigates short sale activity. Among other activities, the staff utilizes an electronic surveillance program to conduct sweeps of reported short sale activities. These sweeps review trading by all firms that report short sales and objectively identify those trades that appear to violate the Short Sale Rule. Since initiating these sweeps in 1998, more than one-third of these reviews by the staff have involved day-trading firms.3 Overall, the staff has found a significant number of violations of short sale rules and believes that day-trading firms too frequently lack adequate supervisory procedures to detect and deter such violations. Where appropriate, we intend to initiate disciplinary action against the member firms and associated persons involved.
We are also reviewing short selling by customers of day-trading firms of hot IPOs in the immediate aftermarket. We are investigating whether some of these activities violate our rule requiring a firm effecting a short sale for a customer to determine if the shares being sold can be located and delivered to the buyer.
Adequate supervision and the development and compliance with supervisory procedures are important issues at all broker-dealers, including day-trading firms. NASD Conduct Rule 3010 requires each of our member firms to "establish and maintain a system to supervise the activities of each registered representative and associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations" and NASD Rules.
Day-trading firms have initiated new sales and marketing practices outside the traditional broker-client relationship. They have built a business niche around new technology and new software. These innovations require new supervisory techniques. Yet, at some of the firms we have examined, written supervisory procedures have not adequately addressed many aspects of their core day-trading business. Areas of potentially deficient supervision include procedures in the following areas:
NASDR is taking the necessary steps through disciplinary action to ensure that these potential deficiencies are addressed.
(3) Rulemaking Initiatives
Disclosure and Appropriateness Determinations
To effectively address the unique investor protection concerns associated with day trading, the NASD determined that rulemaking in this area was necessary to supplement existing rules and regulations. On April 15, 1999, the NASD issued Special Notice to Members 99-32, seeking comment on proposed rules addressing approval procedures for day-trading accounts including appropriateness determinations and disclosure of risks of day-trading activities. The staff received 39 comment letters in response to the Notice, 16 of which were from individuals and 23 from firms or other organizations. The majority of the commenters generally supported the NASD’s efforts to address the investor protection concerns raised by individual’s engaging in day-trading activities. However, commenters also raised varied suggestions on how best to regulate day-trading activities and presented disparate views on the scope of activities that should be covered by the rules. Based on its review and consideration of the comment letters, the staff made certain revisions to the proposed rules. The proposed rules, as revised, were approved by the Board of Directors of NASDR at its meeting on July 28, 1999.
On August 20, 1999, the NASD filed the proposed rules with the SEC. (Rule filing and press release are attached.) Specifically, the proposed rules would require firms that promote day-trading strategies to (i) determine the appropriateness of day trading for a customer; and (ii) disclose to customers the risks associated with this type of trading. In order for a firm to approve an account for day trading, the firm would be required to have reasonable grounds for believing that a day-trading strategy is appropriate for a customer. In making this determination, the firm would be required to exercise reasonable diligence to ascertain the essential facts relative to the customer, including his or her financial situation, tax status, prior investment and trading experience, and investment objectives. The firm also would be required to prepare a record setting forth the basis on which the firm has approved the customer’s account. A firm need not make this determination if it obtained from the customer a written representation that the customer did not intend to use the account for day-trading purposes. If a firm later discovered that a customer who provided this written representation was using the account for day trading, the firm would be required to approve the account for day trading within 10 days of the date of discovery.
In addition, the proposed rules would require a firm that is promoting a day-trading strategy to deliver a risk disclosure statement to a customer prior to opening an account for the customer that provides the following:
Firms would be permitted to develop an alternative disclosure statement as long as it is substantially similar to the mandated statement and is approved by NASD Regulation’s Advertising Department prior to use.
Margin and Customer Lending
We are continuing to consider whether changes to existing rules regarding margin and lending practices are desirable and have solicited comment on this issue. Concerns identified include:
We are still considering these issues and will determine whether further rulemaking in this area is necessary.
In conclusion, day trading is a highly risky form of trading that we are investigating and studying closely. We intend to continue to work together with the SEC and the states to address the issues in this area. At this time, we do not see a need for any new legislative initiatives, but believe that through a combination of continued dissemination of information to our members and investors, focused examination and enforcement efforts and the development of new NASD rules and other policy initiatives, we can effectively address the investor protection concerns associated with day trading.
1 In your request letter dated August 25, 1999, in addition to asking about risks, you requested estimates on the percentage of individuals who actually profit from day trading. At this time, we are aware of only one report that has provided any data on the profits derived from day trading, the Report of the Day Trading Project Group, dated August 9, 1999, released by the North American Securities Administrators Association, Inc. While limited in scope and based on a small statistical sample, it is a useful first step in gauging the extent to which day trading has been a profitable trading strategy. It is difficult to draw any firm conclusions on this issue pending a more comprehensive review. The NASD has been closely reviewing the issue of day-trading profitability as part of our ongoing examinations and investigations of certain day-trading firms.
2 Regulation T of the Board of Governors of the Federal Reserve requires certain minimum margin in connection with the purchase of any security (initial margin). NASD Rule 2520 generally requires initial margin of at least the Regulation T amount. Rule 2520 also requires customers to maintain a certain minimum margin – "maintenance margin" – based on the positions in the customer’s account.
2 For the purposes of this statistic, day-trading firms are those that have customers physically present at the firm or at remote locations that buy and sell stocks throughout the day through the use of a Nasdaq terminal and/or internal electronic software systems.