The Regulatory Implications of Day Trading

By Michael A. Collora
Send Email to: mcollora@dwyercollora.com  

This article was first published in the October 1999 issue of the FT Financial Regulation Report.
 
 
Recent enforcement actions by several State Securities offices and national attention by federal and self regulatory agencies such as the National Association of Securities Dealers has focused attention on a small but growing sector of securities trading in the United States: day trading and the firms that foster it. An association of state regulators issued a 50-page report on August 9, 1999 criticizing the tactics of brokerage firms specializing in these trades (www.nasaa.org) and Congressional Testimony by SEC Chairman Levitt on September 16 1999 has focused on abuses in that area. While day trading conjures up images of a wild west of securities, what is it – and what are the regulatory and financial problems associated with it?
Day traders, whether operating from their own home or office (or if their volume justifies it, at the broker's office) trade volatile stocks hoping for a sharp rise or fall (if betting against the stock) during the day. The PC and the internet are the means to effect these trades and to watch the trading pattern. Typically day traders trade on margin, borrowing up to 50 per cent of the value of their portfolio from the brokerage house, thereby increasing the potential for profit or loss. Normally the day trader does not retain his or her holdings overnight, but liquidates the portfolio at the end of the trading day, and starts again the next day.

Few day traders do basic research on the stocks in question, but instead focus on volatility and price trends. Part of the problem with this investment philosophy is that the day trader may not fully understand why the stock is moving in a particular direction and whether the trend is truly in their favor. This trading is the antithesis of Warren Buffett's "buy and hold" philosophy, as the traders hope to gain only a quarter or half a point, then sell; this trading method also cuts against the general "Wall Street" philosophy of cutting your losses and running with winners, since most day traders sell off even their winners at the end of the day.

There are financial obstacles to making money day trading which regulators claim are not adequately explained by the brokerage houses specializing in this activity. Volatility is required to catch a trend and a stable market may result in little or no profit. Secondly, those who bet the trend is upward will be hurt in a down market. Third, some stocks may be illiquid and difficult to sell at times of rapid price movement. Finally, and perhaps most importantly, while the commission on each trade may not be large, the cumulative nature of trading over the dollar volume involved may make it difficult to make a profit. Fifty trades a day at $25 per trade - i.e., commissions of $1,250 - represent 2.5 per cent of a $50,000 account. In five days, that's over 12 per cent. Add to that, interest on the margin advance, and a loss on some of the trades and many accounts end up losing substantial sums. According to regulators, most day traders lose money eventually.

Day trading firms - that is the brokerage houses who cater specifically to day traders by training them and giving them access to computers - have come under severe scrutiny for tactics such as false advertising as to success rate, permitting unsuitable and excessive trading in an account, lending money in violation of margin rules, encouraging and arranging loans among customers when there is no more loan value in an account, and violating the "short" selling rules by borrowing non-existent stock - a technique known as naked shorting. They also charge substantial fees - up to $5,000 - to take a course in day trading.

So far, the SEC has taken little action, although 67 firms specializing in this area are to be audited; so far ten have been referred to the enforcement division for further investigation. To immediately curb some of these activities, various states have filled the void. For example, the Massachusetts State Securities Division has sued six day trading firms within the last year, reaching agreements with several to mitigate their practices or limit doing business in Massachusetts. See, e.g., All-Tech Complaint and Order Dated 12/10/98 (MA Sec. Div. 98-77) (agreement to reimburse customers, hire a compliance officer, retain independent consultant).

The allegations against Houston based Landmark Securities brought administratively by the Massachusetts State Securities Division on July 8, 1999 (MA Sec. Div. 99-29) are instructive. They allege unauthorized transactions in customer accounts, falsification of new account form information, unauthorized violation of suitability requirements, forgeries of customer signatures and use of fictitious names. Since no hearing has been held, the charges have yet to be proved, but they lend fuel to the charges that day trading firms do too much to encourage this type of investment.

Recently regulators have begun to focus on clearing firms for the day trading firms, using as a precedent the SEC settlement on August 5th of this year in the Bear Stearns administrative case (SEC Release No. 33-7718), where that large firm paid $35 million to settle a claim that it participated in the fraudulent conduct of its customer, a small brokerage firm called A.R. Baron & Co. Presumably by this inquiry, regulators hope to add a supervisory level above the trading firms, since among other things, clearing firms can prevent inappropriate customer lending among each other by refusing to journal the funds among them, and it also can more carefully supervise breaches of the short sale trading rules.

Ultimately, day trading will likely settle down to those few persons willing to knowingly risk most of their equity in a perilous activity. Day trading firms as such will have difficulty surviving as better managed and more recognized firms drive them out of business. But before that happens, there will be substantial regulatory oversight of day trading firms, both here and elsewhere.