January 7, 2002
The Honorable Harvey L. Pitt Ms. Mary L. Schapiro Mr. Richard A. Grasso Dear Mr. Pitt, Ms. Schapiro, and Mr. Grasso: We are writing with reference to the recent report by the U.S. General Accounting Office (GAO), Securities Operations: Update on Actions Taken to Address Day Trading Concerns (GAO-02-20, November 27, 2001), which was prepared at our request. This 27-page report follows up on the recommendations in GAO’s February 2000 report, Securities Operations: Day Trading Requires Continued Oversight, and describes how day trading has changed since that report which looked at data for 1998 and 1999. In 1999, day trading received intense scrutiny in response to press reports and consumer complaints suggesting that it raised significant investor protection and market integrity problems. A central concern was that day trading firms were using misleading advertising to attract inexperienced traders who did not fully understand the risks of day trading and therefore lost substantial amounts of money. Examinations by state and federal regulators found serious violations of securities laws by day trading firms. This was unacceptable. Day Trading Has Evolved. GAO reports that day trading has changed substantially since 1999. The combination of intense regulatory scrutiny and adverse market conditions drove many unsophisticated traders out of day trading. GAO found that currently day traders are more likely to be experienced and have greater knowledge of the risks involved. According to GAO, the number of day trading firms appears to have remained constant. GAO also reports that, since 1999, many day trading firms have shifted their primary focus away from retail customers and toward attracting institutional customers such as hedge funds and small investment management companies. More of these firms are likely to engage in proprietary trading activities through professional traders hired to trade the firm’s own capital. Another change is the growth in the number of day trading firms being acquired by other brokerages whose customers want the direct access to securities markets and market information on a real-time basis that day trading firms’ sophisticated order routing and execution systems technology provides. Day traders also conduct transactions through electronic communications networks (ECNs). Industry officials told GAO that the growing trend toward direct access and consolidation was also driven by the Securities and Exchange Commission’s (SEC) new disclosure rules on order handling and trade execution which require ECNs, market makers, and specialists to report data on order sizes, speed and unfilled orders. Regulators Have Taken Actions But Some Violations Persist. GAO reports that the SEC and the self-regulatory organizations (SROs) have taken a number of actions to address many of the concerns raised in GAO’s 2000 report. In 2000, SEC approved several SRO rules addressing day trading abuses. NASD Regulation, Inc. (NASDR) adopted rules requiring broker-dealers that promote a day trading strategy to determine if such a strategy is appropriate for customers and to provide customers with a risk disclosure statement (2001 report p. 10). NASDR and the New York Stock Exchange also amended their margin rules with more restrictive margin requirements for certain day traders (2001 report pp. 11-13). GAO also reports that SEC and the SROs continue, to varying degrees, to monitor day trading firms. SEC, NASDR, and the Philadelphia Stock Exchange staff conducted examinations of all 133 day trading firms identified in 2000. SEC and SROs did follow-up examinations to determine whether the previous violations had been corrected. According to SEC, in 2001 and 2002, SRO staff will continue to conduct routine examinations of existing day trading firms and of newly registered firms to determine compliance with applicable rules. SEC also said that it will continue to conduct "cause" examinations when appropriate, while NASDR said that it will no longer prioritize day trading firms but rather will include examinations of day trading firms in its routine broker-dealer examination cycle. As of August 2001, NASDR had completed about 62 such examinations. From late 1999 to early 2001, almost half of the day trading firm examinations completed by SEC were cause examinations. GAO also reports that, according to SEC and NASDR officials, day trading firms’ overall compliance with rules has improved since the 1999 examination sweep but numerous violations still have been found (2001 report, Table 2, p. 15). These include violations of margin rules, short sale rule violations, misleading advertising, net capital deficiencies, violations of SRO and SEC rules related to supervision, maintenance of books and records, and net capital miscalculations. In addition, GAO notes that SEC and NASDR have settled several significant enforcement cases involving day trading firms and their principals (2001 report pp. 17-19). Day Trading Firms Have Also Taken Steps to Address Problems. GAO reports that day trading firms have responded by changing their behavior. In general, most firms have matured and provide more vigorous oversight than in the past. GAO found that their advertising and web site information in general prominently highlighted the risks associated with day trading or provided easy-to-access risk disclosures or disclaimers. In addition, the sites focused on the speed of trade executions and lower fees rather than on unsubstantiated claims of large profits. According to GAO, many of the large day trading firms no longer actively advertise for retail customers but instead rely on personal referrals. Against this backdrop, GAO concluded: "The attention that has been focused on day trading and subsequent changes in risk disclosure should help deter many unsophisticated traders with no understanding of the risks involved from being lured into day trading by prospects of easy profits." We tend to agree. GAO notes that SEC and NASDR both agreed with the report’s findings and conclusions (2001 report, Appendices I and II, comment letters, pp. 26 and 27) and that GAO was making no recommendations. We commend the regulators and the day trading firms for the steps that you have taken to clean up the most glaring problems and we would urge you to continue your vigilance in these matters. While professional traders have long engaged in day trading, day trading as a strategy employed by retail investors is a fairly recent phenomenon, ushered in by the bull market and tech boom that made everybody look smart and feel invincible. Things got so terribly out of kilter because you were afraid to be the skunks at the dot.com-mania garden party. As a result, investors were hurt. We trust that we can count on you in the future to take appropriate action promptly when necessary to carry out your mandates of protecting investors and ensuring market integrity. We may revisit this issue in the future as the need arises. Sincerely,
John D. Dingell Paul E. Kanjorski Edolphus Towns Edward J. Markey
Enclosure cc: The Honorable W.J. "Billy" Tauzin, Chairman The Honorable Cliff Stearns, Chairman The Honorable Fred Upton, Chairman The Honorable Michael G. Oxley, Chairman The Honorable John J. LaFalce, Ranking Member The Honorable Richard H. Baker, Chairman
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