finra

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

Society of American Business Editors and Writers' (SABEW)
36th Annual Conference

Wyndham Washington Hotel, Washington, DC

May 4, 1999

 

Introduction

 

Good Morning. It is a pleasure and an honor to be with you today—even at this hour! What I’d like to talk with you about, in a very broad sense, is the importance of the confidence of retail investors to our capital markets and our economic health and how we can best keep that confidence. We are living in good economic times, and much of the credit goes to the strength of our capital markets. In this country at least, the strength of those markets is very much dependent on the participation of millions of average, retail investors. Those investors now have unprecedented access to information and services—that is, much more power in terms of self-determination than ever before.

 

For the first time, we live in an era where a person can gain nearly real time access to business and financial activity from the privacy of one’s own home, while in the office, on the road, or from virtually any location. This evolution, revolution if you will, is driven in large part by relatively recent technological advances and the advent of the Internet. How we take advantage of the blessings of this change, and at the same time deal with the blemishes, is the theme of my comments today. In particular, I’d like to focus on our efforts at NASD Regulation to deal with and help to shape investors’ expectations, confront fraud, police advertising, and address volatility, including associated day trading practices.

 

We all know how much the Internet has shaped commerce in many respects. I think almost everyone has been surprised how quickly it has transformed investment habits. It’s estimated there are more than 40 million Internet users in the US today, and that up to one-quarter of all retail trades are done on-line, and that may well be an understatement. Indeed, a recent study shows that the number of on-line trades increased 49% from the fourth quarter of 1998 to first quarter 1999. But before I start talking about all those blemishes, let me make one point loud and clear: on the whole, this is a change that has been good for individual investors because it has given them access that most of them could never before afford to buy.

 

The US markets traditionally have been the strongest in the world because they have been the most open and have invited participation from all quarters. Through technological progress, we’ve made them that much more accessible. Retail investors can now get virtually instantaneous execution of trades—most of the time, that is—while paying cheaper commissions. They get free access to multiple sources of good research, and can receive a lot more at an affordable cost. They can communicate more quickly with securities firms, and can take advantage of design tools to better plan and track the progress of their portfolios. For those who like to see themselves as champions of the little guy, the 90s has been a good decade.

 

Investor Confidence

 

And hopefully that trend will continue, but there are dangers that we cannot afford to miss. Investor confidence is a kind of goodwill asset for the markets as a whole, and generally speaking, it is a lot easier to lose than to establish and maintain. One of the key danger zones is investor expectations. We must be able to manage them properly, and to assure that the honest and unscrupulous alike do not create unrealistic expectations. On-line investors have come to expect that their orders will be executed within seconds, and that means one or two, not nine or ten. Most of the time, during normal conditions, most firms can meet those expectations, but some firms may over-promise their ability to perform, and virtually all firms have had trouble meeting that kind of standard in periods of extremely heavy volume and fast-moving prices.

 

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.

 

Investors can’t guard against systems 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 and when to use it, is one important lesson. Knowing how margin accounts work and what you risk when you trade on margin is another. We are broadcasting these and other messages as loudly as we can, and the press is an indispensable ally in the effort. Without jeopardizing your independence and skepticism, you play a critical role in helping people to understand the pitfalls and how to navigate them.

 

Advertising Regulation

 

When speaking of shaping investor expectations, advertising can not be ignored. Advertising should not attempt to seduce investors into the perception that easy access to the markets and market information, somehow transforms one into a professional trader. Nor should they be led to believe that on-line trading portends quick and easy profits. In this regard, I am deeply concerned by advertisements that suggest fabulous wealth simply through electronic access to the markets or aggressive trading strategies. Some of those ads are made by firms with well-known brand names. Major firms that have spent a lot of years building those brand names seem to be risking much of their goodwill by appeals to the get-rich-quick mentality. What’s more, many of these ads don’t appear to meet our published guidelines requiring balance and disclosure of risks. Whatever happened to John Houseman, and doing business the old-fashioned way? Maybe I’m a little old-fashioned myself on this issue, but I hope we don’t lose the message that the best investors are those who think before they click.

 

Firms that place ads that make specific or identifiable claims need to be able to back them up. Our advertising and public communication rules prohibit exaggerated statements and require that firms be able to substantiate their claims. Firms can’t describe themselves as "best" or "fastest" unless they can factually and objectively support those statements. In times of heavy volume, fast moving markets and volatility, we know speed and accessibility can’t be promised. In fact, account access and speed of order execution is one of the fastest growing areas of customer complaints. Even complaints that do not lead to a regulatory action tend to show a mismatch between investor expectations and reality.

 

To address the growing concerns over the types of advertisements I mentioned, I have directed our Advertising Regulation Department to carefully scrutinize all advertisements that exaggerate opportunities or make service claims like instant access that simply cannot be delivered. Where violations are found, aggressive enforcement will follow. For the twelve-month period ending May 1st 1999, we stopped the use of 811 misleading public communications by our members. During this period we also announced 23 formal disciplinary actions against member firms and individuals for violations of our advertising rules.

 

Day Trading

 

Of course, we’re worried about more than advertising, and one of our concerns relates to 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 millions 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, knowledge, 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 hard-earned money has been lost.

 

The Wall Street Journal recently featured a story describing the ways in which day trading has become a form of addiction like gambling, and that treatment programs and support groups are springing up to help people with recovery. 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 national asset called investor confidence, I think that would be a very negative development.

 

We also know that we can’t be the watch dog for all human frailties. But one thing that has traditionally made the securities industry strong is that we actively discourage people from unfairly preying upon others. There are many who have suggested that we stop trying to protect people from their own folly. And I will admit that there is a certain amount of superficial appeal to that. But you can’t be a regulator and give up just because the goal is difficult and maybe even impossible to attain. We will always try to improve the landscape for the investing public even if to some it appears that we are occasionally tilting at windmills.

 

Proposed Rules

 

To that end, NASD Regulation just issued for comment on April 15 a set of potential rules focused on day trading. As proposed, the rules would require brokerage firms that actively promote day trading to determine whether this is an appropriate strategy for the particular investors who are solicited. 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 disclosure statement to customers making the following points:

 

  • Day trading can be extremely risky. Customers should be prepared to lose all funds used for day trading.

  • Customers should be cautious of statements and advertisements that emphasize the potential for large profit.
     
  • Day trading requires knowledge of the securities markets.

  • Day trading requires that investors have knowledge of a firm’s technical operations.

  • Finally, day trading on margin can result in losses that exceed the initial investment.


NASD Regulation anticipates widespread support for the disclosure statement aspect of the proposed rules. The requirement for an appropriateness determination will be 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. In any event, we expect to hear a lot of different points of view expressed on this issue, and the one promise we make is to listen to them all.

 

Market Volatility

 

We have a more general concern with increased volatility in particular sectors of the market, which has been associated with electronic trading activity. Consumers are bombarded with news about soaring Internet stocks that move 15, 20, 30 and more points in a single session. This, in turn, fuels much day trading activity as investors attempt to capitalize on short term price swings. The reality is that these stocks are just as volatile on the down side, and short term strategies can hammer the average investor who thinks that he or she can compete with the professionals. The pros, by the way, know how to limit their own exposure during periods of high volatility; the retail investor who is new to Internet trading likely does not.

 

In response to the volatility issue, NASD Regulation issued a notice to our members asking them to disclose important information to investors about trading during volatile markets. We urged members to explain to customers that they may experience delays accessing accounts, placing trades, and obtaining executions during periods of strong market volatility. NASD Regulation also urged firms to explain the difference between "limit" and "market" orders to customers and how these kinds of orders can limit risk. Many firms already had provided this kind of information to on-line investors, and since our education campaign, more are now doing so.

 

This is a classic case of the convergence of self-interest and the regulatory interest. Firms that prepare their customers to better help themselves will build stronger long-term relationships and fare much better in a highly competitive environment.

We don’t yet know whether the higher volatility we have seen in recent months is a temporary condition, or a more permanent by-product of the increase in on-line and day trading. We should not rush to judgment on that question, but we should bear in mind that on the whole volatile markets are not conducive to long-term investor confidence.

 

Margin Regulation

 

One way that traditionally has been used to limit the amount of speculation that fuels volatility is the use of margin restrictions. Although those rules are probably obscure to most investors, they have an extremely significant role to play in limiting systemic risk. The margin rules don’t foreclose wide price springs but they do place a limit on the amount of leverage that is contained in the system, and speculation relies on leverage. NASD Regulation shares responsibility for setting and enforcing margin limits with the Federal Reserve Board and the other self-regulatory organizations.

 

We’ve recently issued a notice asking for public comment on a host of questions connected to margin limits, including whether our own rules should be adjusted. Firms generally make adjustments on their own now, by increasing the margin required to trade in extremely volatile Internet stocks. In some cases, firms have refused to extend any credit for participation in certain initial public offerings, which have experienced some of the most volatile trading. Practices differ from firm to firm, however, and there is no consistent method for factoring volatility into the margin required to be maintained for individual stocks. Maybe there’s a role for regulators to play in creating some consistency; we’d like to hear what people think about that, or any other changes to the margin rules people might suggest.

 

In addition, there is a subset of issues relating to the use of margin by day traders, who rely on credit more than most investors. The issues relate both to risk to the financial solvency of member firms and to protection of investors. For the most part, firms have every incentive to make sure that they don’t become liable for debts that overextended customers can’t pay. Usually, they will cut off the credit pipeline before the firm suffers any real damage. Some of their customers, however, may face forced liquidation of their stock in order to meet margin calls.

 

Also, at day trading firms, principals sometimes arrange for credit to be extended from customers who have some equity in their accounts to those who have run out of equity. Investors should have the freedom to seek credit from third parties when that doesn’t violate the rules, but firms should be providing clear disclosure to them about default risks and procedures, from the standpoint of both the creditor and the borrower.

 

Internet Fraud

 

The final aspect of electronic trading I’d like to talk about is in a sense the most familiar: the use of the Internet to defraud and manipulate. The techniques are not particularly novel, although the Internet gives the unscrupulous a new array of tools with which to practice them.

 

About the only good news in this area is that it’s a truly exceptional case where a registered securities professional is involved in this kind of scheme. But make no mistake: when we do discover that someone under our jurisdiction is involved in something like this, we will do everything we can to get them out of the industry, permanently and as quickly as possible.

As the investment use of the Internet grows, the challenge to the securities regulators, self regulators, and law enforcement will similarly grow. The good news here is that better technology for surveillance is often an antidote to new methods of deception. At NASD Regulation, for example, we have staff dedicated to Internet surveillance through the use of software that reviews many different Internet sites simultaneously and patrols for key words and patterns, and hype.

 

One of our current priorities is to attempt to address the fraudulent duplication of web pages, the production and distribution of fraudulent press releases, and hyping of stocks in chat rooms through anonymous or fictitious e-mail exchanges. When our market surveillance and enforcement groups detect these kinds of schemes, we bring cases when we can and work with federal regulators and law enforcement to help build cases when we don’t have authority. Tips from the public, and the media, provide important leads, and investigative reporting is also extremely beneficial.

 

Concluding Remarks

 

This is an exciting time to be involved in the financial services industry, whether as a participant, a regulator, or a member of the media. And notwithstanding the points of caution I’ve tried to express today, I’m very optimistic about the future of this industry and about the ability of the individual investors who fuel it to make good use of the power that’s been given to them. I’m also cautiously optimistic about the ability of regulators to keep that power from being distorted or turned against investors, but I’m by no means lackadaisical about the challenge. This is a fight we have to wage every day, but it’ a good fight and one that I sincerely believe we are winning.

 

Thank you for your attention.