Remarks at the 2000 Spring Securities Conference
President, NASD Regulation, Inc.
J.W. Marriott Hotel
Good morning and welcome to Washington, DC. I am delighted to see so many of you here. Your presence is a testament to your desire to both learn about important new developments and enhance your firm’s compliance programs, all for the ultimate protection of investors—our shared mission. Today I'd like to talk about margin practices, margin disclosure, capacity, investor education, and the role we all play in ensuring a U.S. marketplace characterized by stability and integrity.
But first, let me point out that during the next day and a half you will have the opportunity to hear from industry experts about the most important regulatory and compliance issues facing us today.
I urge you to take advantage of a new program that we have incorporated into our conference. Dubbed "Office Hours," this addition is designed to provide you with direct access to NASD Regulation subject-matter experts who can answer your regulatory and compliance questions one-on-one. An agenda of Office Hour topics, locations and times is listed behind the first tab in your workbook.
Following my remarks, we will hear briefly from Gregor Bailar, the Chief Technology Officer of the NASD who will update us on decimalization, and then we will have a Question and Answer panel with NASDR senior staff. So while Gregor and I are speaking, feel free to jot down your questions on the blue cards. Conference staff will walk the aisles to collect the cards and provide them to the panelists for discussion.
In viewing recent events in the U.S. securities markets, a bit of history comes to mind. When asked why he chose to climb Mt. Everest, the highest point on earth, Edmond Hillary replied: "Because it was there."
In the last few years, many investors appear to have invested in U.S. equities for exactly the same reason. Not because of research, fundamentals, or historic P/E’s, but because the stock market was there, the new economy was there, and the Internet was there. Ironically, at a time when investors have the easiest, fastest access to company information, research reports, analysts recommendations, and other data, a growing focus is on sound bite generated decisions and short term trading. Even the recent unprecedented volatility, that a few years ago would have unnerved the most sophisticated investor, is taken in stride by the novice.
In fact, the dramatic market declines we have seen in this month alone still left many stocks trading at high historical values. New economy stocks—ones with earnings—trade at price/earnings ratios in the thousands, while the historical average of the S&P 500 stocks is around 15 times earnings. The market declines also led to thousands of investors seeing the equity in their accounts reach new lows. Not surprisingly, many firms are now telling us to expect a surge in arbitration filings, lawsuits, and customer complaints.
Recognizing that this rapidly evolving, highly volatile world of investing is one in which we—as regulators—and you, as member firms—will continue to operate for some time, we must band together and work on enhanced and continuing education for the investor community. At the same time, the regulators, self-regulators, and industry must work together to guard against the development of serious operational and financial problems that could create a lack of confidence in the stability and integrity of our markets.
The goal today is to raise the level of consciousness about these pressing issues, help focus the discussion, and present some solutions. As a starting point, let’s look at "the numbers" to help us understand and prepare for the challenges that lie ahead.
As one might have anticipated, as the barriers to entry have fallen, the number of individuals now participating in the capital markets has dramatically increased. It is estimated that more than 50 percent of all U.S. households have investments in the securities markets. Between 8 and 10 million investors have online brokerage accounts and only infrequently speak live with a securities professional.
With the ability to enter securities transactions online or via a phone touch-tone key pad, investors of all categories—high net worth, low net worth, sophisticated, novice, young, and old—have increasingly embraced the securities market. Some, as we learned from the recent arbitration case regarding a college student, look to the market not as a long term strategy but as a way to meet current expenses. We therefore arrive at a new era in investing where brokerage firms find themselves dealing more frequently with novice investors, with customers knowingly or unwittingly taking tremendous risks, and with clients leveraging investments through margin.
At NASDR, we have been closely following and assessing the margin phenomenon. In short, I can tell you that I am increasingly concerned about the use of margin, particularly by online investors.
On February 24, NASDR and the New York Stock Exchange issued a Joint Statement concerning the growth in investor margin debt. The Statement says, in part, that customers should be advised about the risks of investing on margin, that firms should take appropriate steps when and if individual investors significantly change their levels of margin borrowing, and that any account executive incentive programs which would promote the solicitation of margin accounts should be carefully reviewed and curtailed as appropriate. When the Joint Statement was released, outstanding margin debt stood at $260 billion, up about $100 billion from the prior year. We now estimate that the total outstanding margin debt as of March 31, 2000 will be just shy of $300 billion.
Admittedly, margin debt is low when compared to U.S. market capitalization. As of January 2000, outstanding margin debt was about 1.6% of the approximately $15 trillion in total U.S. market capitalization. This translates to about $58 in market value to support every $1 in margin debt. Despite this so called cushion, we must be vigilant about the upward trend in margin debt. Because in fact, while margin debt is low compared to market cap, it is quite high in historical terms and is increasing at a greater rate than market capitalization.
The good news is that many firms have already implemented programs to avert a crisis that could stem from the increasing margin levels. Specifically, the substantial market swings in certain securities have led many firms to change their lending policies so that highly volatile stocks are "non-marginable." To the extent that volatile stocks are not used as collateral, this proactive approach adds stability to margin lending.
On the other hand, we need to consider that volatility is not limited to very small or less well known companies. A March 28, Wall Street Journal article reported that as of the close of business March 27, Cisco Systems had passed Microsoft as the U.S. corporation with the largest market capitalization, at more than $555 billion. The article noted the 10 largest U.S. stocks had market capitalization of $3.5 trillion, and included 6 NYSE and 4 Nasdaq-listed securities. Two weeks later, when the Dow and Nasdaq experienced declines of 617 points and 355 points, respectively, these 10 securities had declined in value by well over a ½ trillion dollars. The largest company was no longer Cisco Systems at 555 billion dollars, but General Electric at 480 billion. Cisco had lost $160 billion in market value.
I can’t predict whether the level of margin debt will be problematic in a sustained, or protracted, declining market.
However, I am certain of one thing—the obligations of margin debt remain constant in the face of collateral that can rapidly erode in a volatile market. Last week margin calls were up several hundred percent. Even though investors and firms appear to be weathering the storm given the build up of equity during the sustained bull market, lending policies clearly deserve significant attention by any firm that intends to be prepared for the fallout of highly volatile markets.
Not surprisingly, NASD Regulation believes that proper disclosure is the flip side of the margin lending coin. Investors must be made aware that volatile market conditions create sudden changes in the market value of a security that, in turn, may lead to an unexpected margin call. Investors must appreciate that their failure to meet the call may cause the firm to liquidate securities in the account. Also, those with small accounts must understand the heightened potential for the entire account to be liquidated.
Customers must also be educated on the important point that firms are free to set their own requirements—generally called "house" requirements—as long as they are higher than the margin requirements under Regulation T or the rules of the NASD and the exchanges.
Similar to designating some securities as non-marginable, some firms have raised their maintenance margin requirements for certain volatile stocks to help ensure that there are sufficient funds in customer accounts to help cover the large swings in the price of these stocks. These changes in firm policy often take effect immediately and may alone cause the issuance of a maintenance call and the liquidation of some or all of the customer’s account. This clearly is not understood by all investors given a simple review of some recent arbitration claims and customer complaints.
In this regard, investors should be encouraged to carefully review the margin agreement provided by his or her firm. Customers need to understand the interest charges that he or she will incur by trading on margin.
There are fundamental issues that must be explained to investors regarding margin, for example:
- Customers must be made aware that the firm can force the sale of securities in a customer’s account if the equity in the account falls below the maintenance margin requirements under the law or under the firm’s higher house requirements.
- Customers must understand that they remain accountable for any short fall in the account after a margin caused liquidation.
- Investors must be made aware that the firm can sell their securities without contacting them. I guarantee you that many investors mistakenly believe that a firm must contact them for a margin call to be valid, and that the firm cannot liquidate securities in their accounts to meet the call unless the customer approves the transaction.
- Customers must understand that they are not entitled to extensions of time on a margin call. While an extension of time to meet initial margin requirements may be available to customers under certain conditions, a customer does not have a right to an extension. Similarly, there is no right to an extension of time to meet a maintenance margin call.
- Entirely different disclosures should be made when firms arrange or facilitate loans between customers. This most often happens in the area of day trading where borrowing customers incur additional finance charges and lending customers face additional credit risks. Lending customers also need to consider the potential loss of SIPC coverage on the amount of the loan.
Margin lending is and will continue to be an important component of broker-dealer revenue. Buying on margin has allowed many investors to take advantage of leverage and to increase profits. Nonetheless, it is in everyone’s interest that investors fully understand the complexities of trading on margin.
Before I leave financial integrity issues, I would also like to touch on the need for financial surveillance and the vigilance required in establishing proprietary trading limits. Not long ago, the NYSE published an SEC interpretation on moment-to-moment net capital. The Interpretation cautioned firms to make sure that they were in net capital compliance throughout the day, not just at the end of the day. This interpretation emphasized the importance of financial surveillance, a subject that is even more critical in today’s environment where a firm’s inventory is subject to tremendous price swings. I can’t overstate the importance of financial surveillance, internal controls, and risk management.
In this regard, compliance departments, back office personnel, trading desks, and firm senior management must develop standard procedures for establishing and monitoring proprietary positions, margin exposure, and other areas that could lead to a financial crisis under various volatility scenarios. In short, I ask all of you to revisit your business processes, shore up where necessary, and be prepared!!
Now, I would like to turn to another area that has received increased attention over the last few months; and that is "capacity."
While many factors have contributed to the development of volatile market conditions, one significant factor is the role played by rapid advances in technology, which have provided masses of customers with easier and less costly access to the securities markets. Customers are now able to trade their accounts far more actively than in the past, and firms are often flooded with large numbers of customer orders for certain stocks. At times, this leads to sharp increases in both price volatility and trading volume, large order imbalances, system queues, and backlogs. These market conditions cause a variety of challenges, including providing best execution.
Recognizing the capacity issues that face the markets and the industry, I am calling on all firms to develop contingency plans for their systems, and to launch an educational campaign around capacity and execution-related difficulties, even beyond those related to your own firm systems, to include those that are related to Internet access, outside disruptions (like denial of access attacks) and order imbalances in systems. Many investors simply do not understand these distinctions and may believe that their problems lie solely with their firms and, importantly, operate under the mistaken belief that orders are executed when entered, that canceled orders are acted on, and that dual executions cannot occur. We are seeing an increase in customer complaints based on all of these scenarios.
All of us know that good planning, good education, and good disclosure equals good business. We are in a world where consumers are keenly aware of their legal rights. Therefore, it is important to recognize that disclosures should help investors better understand that trades entered in an environment of volatile markets and unusual volume may subject transactions to delays and that market orders may be executed at prices quite different from the quotations that the customer sees online when placing the order.
For our part, NASD Regulation is committed to providing investor education. Over the last year NASD Regulation has published on our Web Site—at www.nasdr.com—guidance for investors about the practice of purchasing securities on margin, the risks involved with trading securities in a margin account, as well as a separate guidance about market volatility.
We have also just published an Electronic Investing Web Page designed in question and answer format to provide investors and member firms with important information about online, and other types of electronic, investing activity. Many leading on-line firms are directly linked to the site. We are also inviting state regulators to participate by linking to the site and providing content. We hope that in doing so we can create a central, vibrant source of information for all on-line investors. We invite all of you to link up as well.
Last Wednesday, we posted to our Web Site a margin account disclosure statement for firms to distribute to customers. The statement stuffer provides some basic and brief guidance to investors on what to consider when trading on margin.
In conclusion, I want to leave you all with the message that virtually everyone in the securities industry is playing an increasingly important role in managing the stress placed on investors, firms, and the markets as a whole in such a volatile environment. Salespersons, those most frequently in direct contact with customers, must be the leaders in investor education that goes well beyond traditional standards. This means regular discussions with your clients about volatility, the impact of unusual volume, long term strategies, short term risks, and the risks and benefits of margin accounts. Beyond the sales force, supervisors, back office personnel, and Financial and Operations Principals must refocus and redouble both investor and firm protection efforts, including developing and implementing sound internal controls and innovative ways to monitor and manage financial risk so that early warnings result in solutions before a crisis forms.
Finally, I would be remiss if I did not call on investors to be accountable for their own actions. Investors have a tremendous opportunity today to become well educated and informed on virtually any aspect of their investment strategies and decisions. They must take advantage of the education programs and initiatives offered by firms, the regulators, the SROs, and private groups. It is simply not satisfactory for investors to attempt to hold broker-dealers to the standard of an insurer in situations where wrongdoing is not a factor and the only real issue is ignorance of investment fundamentals.
Clearly, we all, firms, investors, and the regulatory community, have a responsibility to promote and adhere to sound principles and standards, particularly against the backdrop of today’s volatile markets.
I hope you find the remainder of the Conference worthwhile and enjoy your stay in Washington, DC. Now I’d like to turn the program over to Gregor Bailar.