[Senate Hearing 106-285]
[From the U.S. Government Publishing Office]
S. Hrg. 106-285
DAY TRADING: AN OVERVIEW
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HEARING
before the
PERMANENT
SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SIXTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 16, 1999
__________
Printed for the use of the Committee on Governmental Affairs
U.S. GOVERNMENT PRINTING OFFICE
61-159 CC WASHINGTON : 1999
_______________________________________________________________________
For sale by the Superintendent of Documents, Congressional Sales Office
U.S. Government Printing Office, Washington, DC 20402
COMMITTEE ON GOVERNMENTAL AFFAIRS
FRED THOMPSON, Tennessee, Chairman
WILLIAM V. ROTH, Jr., Delaware JOSEPH I. LIEBERMAN, Connecticut
TED STEVENS, Alaska CARL LEVIN, Michigan
SUSAN M. COLLINS, Maine DANIEL K. AKAKA, Hawaii
GEORGE V. VOINOVICH, Ohio RICHARD J. DURBIN, Illinois
PETE V. DOMENICI, New Mexico ROBERT G. TORRICELLI, New Jersey
THAD COCHRAN, Mississippi MAX CLELAND, Georgia
ARLEN SPECTER, Pennsylvania JOHN EDWARDS, North Carolina
JUDD GREGG, New Hampshire
Hannah S. Sistare, Staff Director and Counsel
Joyce A. Rechtschaffen, Minority Staff Director and Counsel
Darla D. Cassell, Administrative Clerk
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PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
SUSAN M. COLLINS, Maine, Chairman
WILLIAM V. ROTH, Jr., Delaware CARL LEVIN, Michigan
TED STEVENS, Alaska DANIEL K. AKAKA, Hawaii
GEORGE V. VOINOVICH, Ohio RICHARD J. DURBIN, Illinois
PETE V. DOMENICI, New Mexico MAX CLELAND, Georgia
THAD COCHRAN, Mississippi JOHN EDWARDS, North Carolina
ARLEN SPECTER, Pennsylvania
K. Lee Blalack, II, Chief Counsel and Staff Director
Linda J. Gustitus, Minority Chief Counsel and Staff Director
Mary D. Robertson, Chief Clerk
C O N T E N T S
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Opening statements:
Page
Senator Collins.............................................. 1
Senator Levin................................................ 4
Senator Cleland.............................................. 5
WITNESSES
Thursday, September 16, 1999
Hon. Arthur Levitt, Jr., Chairman, U.S. Securities and Exchange
Commission, accompanied by Robert L.D. Colby, Deputy Director,
Market Regulation, Securities and Exchange Commission.......... 7
Mary L. Schapiro, President, NASD Regulation, Inc., Washington,
DC............................................................. 19
Peter C. Hildreth, President, North American Securities
Administrators Association, Washington, DC, accompanied by
David Shellenberger, Chief of Licensing, Commonwealth of
Massachusetts Securities Division, Boston, Massachusetts....... 22
Saul S. Cohen, Consulting Counsel, Electronic Traders
Association, New York, New York................................ 35
Alphabetical List of Witnesses
Cohen, Saul S.:
Testimony.................................................... 35
Prepared statement, with attachments......................... 178
Hildreth, Peter C.:
Testimony.................................................... 22
Prepared statement, with attachments......................... 167
Levitt, Hon. Arthur, Jr.:
Testimony.................................................... 7
Prepared statement........................................... 55
Schapiro, Mary L.:
Testimony.................................................... 19
Prepared statement with attachments.......................... 79
Shellenberger, David:
Testimony.................................................... 22
Exhibits
* May Be Found In The Files of the Subcommittee
1. GFall 1999 Adult Education Program, Gardiner, Maine,
highlighting the course ``Day Trading For Beginners''.......... 213
2. GPicture of road sign seen by Senator Carl Levin on freeway
exit in Detroit, Michigan, ``Day Traders--Learn To Trade
Futures & Options On-Line--1-800-704-7071''.................... 215
3. GTwo print outs from TCI Corporation's Web site.............. 216
4. GPrint out from All-Tech Investment Group, Inc.'s Web site... 218
5. GTwo print outs from On-Line Investment Services, Inc.'s Web
site........................................................... 219
6. GSupplemental answer provided for the record by Robert L.D.
Colby, Deputy Director, Division of Market Regulation,
Securities and Exchange Commission, regarding Day Trading
Margin Requirements............................................ 221
7. GSecurities and Exchange News Release, dated September 16,
1999, SEC Investor Alert--Day Trading: Your Dollars At Risk.... 225
8. GNorth American Securities Administrators Association, Inc.
(``NASAA''), Day Trading Program Report, dated August 9, 1999
(Three parts: (1) Findings and Recommendations, (2) Appendix,
and (3) Analysis prepared by Ronald L. Johnson, Investment
Consultant, entitled ``Day Trading--An Analysis of Public Day
Trading at a Retail Day Trading Firm'')........................ *
9. GSupplemental questions and answers for the record of Saul
Cohen, Consulting Counsel, Electronic Traders Association...... 228
10. GMemoranda prepared by K. Lee Blalack, Chief Counsel and
Staff Director, Brian C. Jones, Investigator, and Wesley M.
Phillips, Investigator, Permanent Subcommittee on
Investigations, dated September 14, 1999, to Permanent
Subcommittee on Investigations' Membership Liaisons, regarding
September 16 Hearing: Day Trading: An Overview................. 246
DAY TRADING: AN OVERVIEW
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THURSDAY, SEPTEMBER 16, 1999
U.S. Senate,
Permanent Subcommittee on Investigations,
of the Committee on Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 9:37 a.m., in
room SD-628, Senate Dirksen Office Building, Hon. Susan M.
Collins, Chairman of the Subcommittee, presiding.
Present: Senators Collins, Levin, and Cleland.
Staff Present: K. Lee Blalack, Chief Counsel and Staff
Director; Mary D. Robertson, Chief Clerk; Glynna Christian
Parde, Chief Investigator and Senior Counsel; Kirk E. Walder,
Investigator; Brian C. Jones, Investigator; Wesley Phillips,
Detailee/GAO; Eileen M. Fisher, Investigative Assistant;
Elizabeth Hays, Staff Assistant; Linda Gustitus, Minority Chief
Counsel; Leslie Bell, Congressional Fellow; Anne Bradford
(Senator Thompson); Brian Benczkowski (Senator Domenici);
Michael Loesch (Senator Cochran); Felicia Knight and Steve
Abbott (Senator Collins); Seema Singh and Gregory Thomas
(Senator Specter); Nanci Langley (Senator Akaka); Lynn
Kimmerly, John Brownlee, Michael Andel, and Andrew
Vanlandingham (Senator Cleland); Darla Silva (Senator Durbin);
and Peter Ludgin and Diedre Foley (Senator Lieberman).
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. The Subcommittee will come to order.
I would like to thank our witnesses for braving the
hurricane to be with us here this morning. I know that for some
of you, who are coming some distance, that was indeed a
challenge, and I appreciate the efforts that you have made to
be with us today.
We convene the first congressional hearing on day trading.
This hearing is the first in a series that the Permanent
Subcommittee on Investigations will hold on this subject.
Today's hearing will provide an overview of the day-trading
industry, while subsequent hearings will highlight case studies
developed during our on-going investigation. These hearings
continue the tradition of the Subcommittee of investigating
issues affecting small investors.
Unlike traditional investing, day trading involves taking
positions in stocks for very short periods of time, usually
minutes or hours, but rarely longer than a day. One day trader
was recently quoted as saying, ``Wall Street's not about
investing anymore, it's about numbers. Who cares whether [the
stock] is a car company or a chemical company? Who cares what
they're going to be doing in [the year] 2000?''
Day traders seek to profit in small increments from moment-
to-moment fluctuations in the stock's price. The firms that
cater to day traders provide high-speed computer access and
real-time market quotes, which are necessary to rapidly take
advantage of small changes in stock prices.
The technology revolution that is affecting so many aspects
of American life is also changing, in a very fundamental way,
the relationship between the ordinary investor and the markets.
New technology now allows investors to access the markets
directly without the aid, or the advice, of a broker-dealer,
something that was previously limited to a relatively small
number of professional traders. This dramatic change in access
raises a host of questions for Federal and State regulators,
for the security industry, and for investors.
Ironically, the three developments that have made day
trading possible are otherwise very positive for investors. The
first is the ability to execute transactions at the investor's
convenience using the Internet. The second is dramatically
lower commissions, and the third is greatly expanded access to
financial information, including documents such as a company's
Form 10-K contained in the SEC's EDGAR system.
I should emphasize that day-trading firms differ
significantly from traditional brokerage houses, and even from
the discount brokerage industry. Online discount brokerage
firms, such as Charles Schwab, do not provide their customers
with direct access to the trading floor.
Moreover, the Subcommittee recognizes that the use of the
Internet to obtain information about investing or to place,
buy, and sell orders has given consumers substantially greater
access to financial information and investment opportunities
previously available only to industry professionals. Day
trading, however, raises serious concerns unrelated to the use
of the Internet for trading or as a source of financial
information.
I would like to show something that illustrates why it is
so imperative for the investing public to better understand day
trading and its risks.\1\ This course, and you can see the
cover of the Adult Education leaflet that was circulated, is
from an adult education program in Gardiner, Maine. It was
recently sent to me by one of my constituents. As you can see
from the course offerings, folks in Gardiner, Maine, can learn
from their adult education course dried floral arranging,
perennial gardening, and Christmas wreath design, and for a fee
of only $5, they can go to the local high school and attend Day
Trading for Beginners.
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\1\ See Exhibit No. 1 on page 213 in the Appendix.
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The very fact that adult education programs in small
communities like Gardiner, Maine, might be teaching day-trading
strategies reflects the increasing pervasiveness and popularity
of the day-trading phenomenon and the degree to which it is
being presented to ordinary investors as just another bona fide
investing strategy. As an interesting side note, this
particular course was canceled after the tragic shooting by the
Atlanta day trader.
Our hearing today will attempt to answer three questions.
First, is day trading really nothing more than gambling? To
answer this question, the Subcommittee is examining the
profitability of day trading, the risks involved, and the
responses to this development from the industry and the
regulators.
Policymakers need to know whether day-trading firms teach
investing or simply another form of card counting. Many day-
trading firms provide seminars for customers who wish to learn
day-trading strategies. These seminars generally run for only
several days and cost anywhere from $1,500 to $5,000. One such
course is called ``1-800 RetireNow!'' Enticed by such
exaggerated promises, some individuals who complete these
courses actually give up their careers to day trade full time.
Now, very few Americans would think it prudent to quit
their jobs or to cash in their retirement savings to become
professional gamblers who support their families at a Las Vegas
casino. Yet, the day-trading industry estimates that nearly
5,000 citizens are full-time day traders. The SEC's estimate is
even higher.
For example, a 28-year-old bank employee in California left
his job and borrowed $40,000 from credit cards to become a day
trader, only to lose all of his money day trading within 2
months. This young man is now deeply in debt and living with
his parents.
In Chicago, a waiter with no investment experience became a
day trader and lost an inheritance of more than $200,000. The
waiter told the Subcommittee staff that many of the people with
whom he day-traded knew as little about investing as he did.
In Boston, an elderly man with severe health problems lost
about $250,000 of his wife's savings in just a few hours at a
day-trading firm.
The second important question is whether some day-trading
industry firms are engaged in deceptive and fraudulent
practices, and if so, how pervasive is this misconduct? State
regulators have charged the day-trading industry has engaged in
widespread abuses, including deceptive advertising, trading by
unregistered broker-dealers, and violations of rules relating
to suitability and margin requirements. Although several day-
trading firms settled cases brought by State regulators, the
industry as a whole strongly contests these findings. We will
hear testimony on these general issues today, while the
Subcommittee continues to investigate the practices of specific
day-trading firms.
The third question that is central to our inquiry is what
is the impact of day trading on individual companies and the
markets? The industry's own estimates indicate that between 10
and 15 percent of the daily volume on the NASDAQ exchange is
attributable to day trading. Now, some critics argue that day
trading increases and creates excessive market volatility.
Other observers, however, contend that day trading increases
market efficiency and liquidity, while still others believe
that day trading simply has had very little impact on the
markets. By the conclusion of our investigation, the
Subcommittee hopes to have a much better understanding of the
economic impact of day trading on the markets and capital
formation.
Finally, let me add that I convene this hearing highly
skeptical of day trading, but not as an advocate for banning
the practice altogether. State securities regulators have
estimated that more than 70 percent of day traders lose money
and only about 12 percent demonstrate the capacity to be
successful. I find those statistics to be very troubling.
These figures also raise critical questions about whether
investors are truly informed of the risks involved or whether
they are simply being fleeced by some unscrupulous day-trading
company.
If an investor is fully aware of the risks and decides to
engage in day trading anyway, that is his choice. If, however,
a day-trading company fails to disclose the risks and entices
the unsophisticated investor with deceptive advertisements and
exaggerated claims, that is quite another matter.
While we are confronted with many complex issues today, we
are very fortunate to have an outstanding group of witnesses to
assist us as we attempt to sort through the conflicting claims
about day trading. I particularly look forward to hearing
testimony from the Securities and Exchange Commission Chairman
and the National Association of Securities Dealers Regulation
President about their recent examination of more than 60 day-
trading firms. The preliminary results of these examinations
will be released for the first time at our hearing today.
It is now my pleasure to recognize my distinguished
colleague and the Ranking Minority Member of this Subcommittee,
Senator Levin, for his opening statement.
Thank you.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Thank you, Madam Chairman, and thank you for
your leadership in trying to protect American consumers.
Earlier this year, this Subcommittee held hearings on
sweepstakes, and today, we are talking about day trading. To
me, they fall under the same category of business practice,
which involves enticing consumers with the promise of quick
money.
Many of us would love to get rich quickly and retire young,
and when you are told that there is a ready-made investment
system that holds out quick and large returns, the instinct to
jump aboard and try it out is there for many people. What can
be overlooked, however, is the fact that the system being
promoted does not involve investment in the sense that we know
it and understand it, and that it does involve significant
risk.
Once in the system, when you realize that you are starting
to lose money and think perhaps that this is not the right
business to be in, you can be enticed to recover your losses by
borrowing money and making more trades. That is a sketch of day
trading, and its visibility and allure to the public is
growing.
Just the other day, I was exiting a freeway near my home in
Detroit, and I came across a sign on a fence at the exit
ramp.\1\ In big bold letters, it announces ``Day Trading'' and
gives an 800 number to call.
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\1\ See Exhibit No. 2 on page 215 in the Appendix.
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Now, that particular notice does not use any promotional
language other than getting people to notice the name and the
number, but it shows just how pervasive this allure to day
trading is that they put signs on fences for people to see if
they can get them to call 800 numbers to get into the system.
Too many firms, once people make that original contact,
entice consumers with deceptive and misleading advertisements,
such as ``earn 12 percent per day before a commission'' and ``6
to 7 figure income per year.'' One company claims to have a
``trading system with a profit-to-loss ratio of 12 to 1 and an
average return better than 18 percent per trade before
slippages.'' \1\
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\1\ See Exhibit No. 3 on page 216 in the Appendix.
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Moreover, it claims that no experience is needed, and when
asked by State regulators to prove those claims, the company,
TCI, could not do it. Apparently, most day traders lose money.
Regulators have said that day traders must make a 56-
percent profit just to cover commissions and fees. A recent
report by the North American Securities Administrators
Association revealed that at one branch office, over 70 percent
of the traders lost money.
In analyzing the trading strategy used through the types of
trades made, the report concluded that the majority of traders
appeared to use strategies which engendered 100-percent risk of
loss.
Day trading is not investing, and most people, even in the
day-trading industry, acknowledge that. The SEC says it is
gambling.
Given the estimate referred to in the testimony of the
North American Securities Administrators Association that 70
percent of day traders lose money, you would have a better
chance of playing the slot machine.
Now, if day trading is gambling, and it sure looks like it
to this outsider, and more importantly, if it is gambling as is
stated by the SEC, a key insider, then on-site firms are
gambling casinos and should be regulated as such.
We have rules in the securities industry with respect to
suitability and margin requirements in order to protect
consumers. If these rules are not sufficiently protective of
persons solicited for and engaged in day trading, I hope that
we can develop legislation and enact legislation which will
protect those consumers.
Again, I want to thank you and commend you, Madam Chairman,
for your leadership in another area where there is just too
much consumer abuse going on in this country.
Senator Collins. Thank you very much, Senator Levin.
I am now pleased to call on Senator Cleland. Senator
Cleland and I both in previous life were involved in securities
regulations of State officials, and he has been an active
participant in all of our investigations on securities issues.
OPENING STATEMENT OF SENATOR CLELAND
Senator Cleland. Thank you, Madam Chairman.
Ladies and gentlemen, welcome to this hearing.
I am intrigued by the comments by the distinguished Senator
from Michigan, Senator Levin, and marvel at the insight of our
wonderful Chairman here who has decided to focus on a very
fascinating issue of the world of securities and investments in
America. I am delighted to be here at this hearing.
Let me just say that tragically enough, I have a personal
interest in the whole issue of day trading. Maybe the good news
first. The good news is I was securities administrator in
Georgia for 12 years, and my Administrative Assistant today in
the Senate is Wayne Howell who was the Assistant Commissioner
of Securities in Georgia for 12 years--but we had a tragic
incident in Atlanta.
We had a situation in which an individual killed his family
members and then came in with guns ablazing into two different
office complexes killing and maiming a number of other people
that he day-traded with, and then after being apprehended off
of an interstate north of Atlanta, killed himself after losing
almost half-a-million dollars as a day trader.
That is an incredible situation. It has been discovered
that in one 3-day binge, this day trader lost $153,000,
according to a trading report from Momentum Securities in
Atlanta. Ultimately, his losses totalled a half-a-million
dollars.
In the wake of the shootings, the news reports and other
studies have led me to the conclusion, the risks associated
with day trading are extremely serious. While many day traders
are aware of the possibilities of large losses, some are not.
The interesting thing about going to Las Vegas is it is
sometimes called ``Lost Wages,'' and that people understand
they can go in, in a $20,000 car and come out in a $200,000
bus, but people who day-trade are not necessarily aware of
those kind of risks.
The recent tragedy in Atlanta showed us just how stressful
day trading can really become. Traders without the proper
experience or training are at the greatest risk of losing their
entire portfolios. I do not think most people who day-trade are
aware of that.
I believe I do echo the sentiments of my colleagues on this
Subcommittee when I state that there is an obvious need, as
stated by our Chairman and our Ranking Minority Member, and I
state that there is a great need to take a closer look at this
issue.
Specifically, I am concerned with an apparent abuse of
existing regulations by many day-trading firms, as highlighted
in the North American Securities Administrators Association Day
Trading Report.
My Administrative Assistant now, who was the assistant
administrator for securities in Georgia, is a former head of
the North American Securities Administrators Association.
So I am optimistic that in addition to shedding light on
the problems associated with this segment of the securities
industry, this hearing will act as a catalyst for increased
cooperation between representatives of the trading firms,
regulators, and investors. Such cooperation, I think, is
essential to ensuring the continued viability of this practice,
while also protecting the interest of the American people.
We used to say in our office in Atlanta, and in Georgia, to
our investing public, if it sounds too good to be true, it
probably is too good to be true, and that caution should
certainly be applied to day trading.
Madam Chairman, I am glad to be with you today and look
forward to our panelists.
Senator Collins. Thank you very much, Senator.
I am pleased to welcome our first witness this morning, the
Hon. Arthur Levitt, the Chairman of the Securities and Exchange
Commission. Chairman Levitt is now in his second term at the
SEC, and he is the longest-serving SEC Chairman in history.
I also want to add as a comment that I think of all the SEC
Chairmen in history that there is no one who has been more
dedicated to educating the small investor than Chairman Levitt,
and I commend him for the emphasis that he has placed on that
important duty.
We were here previously in this Subcommittee and heard
testimony from Chairman Levitt on the persistent problem of
fraud in the micro-cap markets. We benefited tremendously from
his testimony then, and we look forward to hearing his views on
day trading as well.
I would note that the SEC has just announced today that
they will be posting an investor alert on day trading on their
Web page. I think that is an excellent example of the
Chairman's commitment to investor protection, and I look
forward to hearing his testimony.
Pursuant to Rule 6 of the Subcommittee, all witnesses who
testify are required to be sworn in. So, at this time, I would
ask Chairman Levitt to stand and raise his right hand.
Do you swear that the testimony you are about to give to
the Subcommittee will be the truth, the whole truth, and
nothing but the truth, so help you, God?
Mr. Levitt. I do.
Senator Collins. Thank you.
Please proceed. We would ask that you attempt to limit your
formal testimony to 10 minutes to allow time for questions.
TESTIMONY OF HON. ARTHUR LEVITT, JR.,\1\ CHAIRMAN, U.S.
SECURITIES AND EXCHANGE COMMISSION; ACCOMPANIED BY ROBERT L.D.
COLBY, DEPUTY DIRECTOR, MARKET REGULATION, U.S. SECURITIES AND
EXCHANGE COMMISSION
Mr. Levitt. Chairman Collins, Senator Levin, Senator
Cleland, and Members of the Subcommittee, thank you for the
opportunity to be here this morning to discuss day trading and
its impact on our Nation's securities markets.
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\1\ The prepared statement of Mr. Levitt appears in the Appendix on
page 55.
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This hearing could not be more timely. It seems almost
every day we hear one story or another about day trading. As we
speak, the Commission is conducting examinations of day-trading
firms. I will have more to say about this in a moment, but let
me begin by stating the obvious.
Technological developments are revolutionizing our capital
markets from how people invest to how brokers do business to
how our markets function. Today's individual investor, for
example, has ready, instant access to market data, and in some
cases markets, that up until a few years ago was available only
to securities professionals.
One of the byproducts of this revolution has been the
emergence of the day trader. Through the use of sophisticated
computer software, day traders sit in front of computer screens
and look for nothing more than real-time price movements.
What it is that they are buying or selling is of absolutely
no concern to them. The coin of the realm for the day trader
does not extend beyond volatility. If you sense a stock will
rise, buy. And if you sense that it might fall, sell. That is
the strategy of day trading. It is not illegal, it probably is
not unethical, but it is highly risky.
In recent months, I have been asked more than once why the
SEC cares whether a day trader loses his or her money. It is
their life, and it is their choice, but I do not think that is
the issue.
I am concerned that many day traders do not fully
understand the level of risk that they are assuming. I am
concerned that many people may be lured into the false belief
that day trading is a sure-fire strategy to make them rich,
and, when individuals are swayed by misleading advertising, the
Commission has a duty to act.
That is why I believe we should be focusing on the
advertising and marketing practices of a number of day-trading
firms. It is in this area that I believe that the Commission's
partnership with the States and State regulators is absolutely
crucial. A number of States have been leaders in addressing
this issue not just as a matter of securities law, but more
importantly, as a matter of consumer protection.
The NASD also has proposed rules that are designed to
address the sales practices of day-trading firms. This proposal
will require these firms to disclose up-front risks associated
with this activity and to screen potential day traders to
determine suitability. Eliminating deceptive marketing and
advertising practices is a large part of the solution. Another
is how day-trading firms comply with the law.
The Commission is in the process of completing an
examination sweep of day-trading firms. Our preliminary
findings indicate that many of these firms have extremely lax
compliance practices. The inability of some firms to monitor
their adherence to the capital, margin, and short-sale rules or
to maintain adequate books and records, raises very serious
concerns. These rules, in many ways, go right to the heart of
the integrity of our markets and market participants.
The Commission intends to vigorously pursue any violations
of law and has a number of enforcement investigations underway.
The use of margin in particular raises a number of issues.
We found that many day traders do not fully appreciate
that, by borrowing to buy securities, they can actually lose
substantially more than their initial investments. So when day-
trading firms aggressively promote the lending of equity
between day traders to cover margin deficiencies, I find it
very troubling. We are reviewing the practice to ensure that
firms are following the law and are fully disclosing to
customers the risks of day trading on margin.
The SEC can regulate, and the Congress can probably
legislate if they wish, but if an individual does not take the
personal responsibility to be informed of the risks involved in
day trading, I believe that no rule or law will ever fully
protect him or her.
I do not minimize, in any way, the responsibility of the
firm to fully disclose the risks involved, but day traders
really need to take the time to consider what they are getting
themselves into.
I commit to you that the SEC will do everything it can to
ensure that day-trading firms are operating within the
boundaries of the law, but I sincerely hope that individuals
considering this type of strategy do their homework before
risking their hard-earned money. Thank you.
Senator Collins. Thank you very much, Chairman Levitt.
Day trading has really arisen out of a booming stock market
and an unprecedented access to technology. On some days, it is
the dark side of the booming stock market.
However, the boom is not going to go on forever. What is
going to happen if stock prices plunge to people who have given
up their careers and are day-trading full time when we know
already, on the basis of some preliminary studies, that the
profitability is very questionable in a booming stock market?
Mr. Levitt. Just from my own experience and in our markets,
having lived through more cycles than most present investors
have ever experienced, I would say that my expectation would be
that many day traders will be completely wiped out, and most,
the vast majority of day traders, will endure punishing losses.
But the discipline of the marketplace will do more to dis-abuse
investors of the notion of easy profits by day trading than
almost anything else we can do.
Senator Collins. The day-trading industry has been very
critical of a report that was issued by the State regulators
association, NASAA, and has criticized it as focusing on one
branch office that was badly run of one day-trading firm.
However, we now have considerably more data to look at as a
result of the examinations that NASDR and the SEC have
conducted, which I understand you have some preliminary results
from.
It is my understanding that together you have examined
around 67 day-trading firms. Could you share with us what the
preliminary results of your examinations have been and whether
the findings from those examinations have supported the
conclusions of the NASAA report or not?
Mr. Levitt. I think that the NASAA effort is absolutely
critical to anything that we hope to accomplish in terms of
eliminating some of the really bad practices of day trading.
Our joint investigation and examination done with the NASDR
resulted in approximately 10 referrals to the Enforcement
Division for scrutiny. I find that worrisome. That is a very
high percentage of referrals, and clearly, there is a problem.
Senator Collins. Can you give us some further idea of the
types of problems that your investigators found?
Mr. Levitt. Some of the problems involved the use of
margin. Some involve lending deficiencies, short sale
violations. There were some net capital violations, including
both incorrect computations and net capital deficiencies. We
observed a number of advertising violations, including failures
to obtain NASD approval of advertising and potentially the kind
of misleading advertising that you have cited before.
We noted supervision deficiencies, including instances
where there were no written procedures and deficient
supervision with respect to lending, review of branch offices
and short sale activity. We also found books and records
violations where firms were simply sloppy in basic procedures.
These were the areas that came to light during these recent
examinations.
Senator Collins. Would it be fair to say, then, that many
of the problems uncovered by your examiners were similar to
those that were found by the State regulators?
Mr. Levitt. I think there clearly was some overlap, yes.
Senator Collins. I would like to turn to the issue of
appropriateness or suitability. When a broker in a traditional
brokerage house recommends a stock, the broker has to determine
its suitability for the investor and does a review of the
investor's investment objectives, financial status. Those kinds
of issues are carefully reviewed.
By contrast, it is my understanding that day-trading firms
currently do not do any sort of suitability review. Is that
correct?
Mr. Levitt. I am not aware of any suitability reviews that
are being engaged in by day-trading firms. I can recall, again,
in my days as a stockbroker, when a client came in who was
overly aggressive, we were very concerned about the
appropriateness of their embarking on that kind of activity.
We have asked the NASD to take a look at this issue because
I think--I certainly feel that there is a responsibility on the
part of any firm to see to it that individuals who clearly are
not in a position to engage in that kind of activity, to take
that kind of risk--an individual, for instance, a retired
person, who depended for his or her very survival on a return
from their investments--are not allowed to day trade. That, I
would regard as absolutely irresponsible. The NASD is examining
this, and I believe they will have some very specific
recommendations in that regard.
Senator Collins. I would like to follow up on that point by
showing you an exhibit that suggests to me that some day-
trading firms may actually be targeting people who are not
suitable for day trading, who are unsophisticated investors, or
who simply would be taking risks that they cannot afford to
take.
This particular exhibit is a marketing pitch by All-Tech,
and I think it illustrates my concern. This was on All-Tech's
Web site as of July 26 of this year, and in case it is
difficult to read, I am just going to read through it. It says,
``Electronic day trading attracts people dead-ended or unhappy
in their current field of endeavor and people with a desire to
make trading their life's work.'' \1\
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\1\ See Exhibit No. 4 on page 218 in the Appendix.
---------------------------------------------------------------------------
This is the part that concerns me: ``Electronic day trading
appeals to executives, victims of downsizing or layoffs,
retirees, graduating students, and anyone who recognizes the
unlimited earning potential and quality of life which day
trading may achieve.''
Is day trading generally appropriate for someone who has
been laid off from his job or has just graduated from college?
Mr. Levitt. Absolutely not.
Senator Collins. So would this be the kind of advertising
pitch that would concern the SEC or--I realize the NASDR has
been delegated the authority to review such matters.
Mr. Levitt. Without regard to the Nation's securities laws,
just as a private citizen, I find that kind of advertising
absolutely appalling. It is a plea to the worst instincts of
people who might otherwise be spending their time in casinos
rather than in engaging in that practice. I think it is very,
very bad.
What the NASD is considering is requiring day-trading firms
to determine whether day trading is appropriate for particular
customers.
Senator Collins. And it is my understanding those proposed
rules are now before the SEC or have just been submitted to the
SEC for review. Is that correct?
Mr. Levitt. We have published them for comment.
Senator Collins. So they are now in the public comment
phase?
Mr. Levitt. Yes.
Senator Collins. Unfortunately, we have a vote that has
just begun. I am going to yield to Senator Levin for questions
and go vote, and we will hope to keep the hearing going between
us. Thank you.
Senator Levin [presiding]. Thank you.
While Senator Collins' chart is up there, the unlimited
earnings potential, do you have any comment about unlimited
earnings potential?
Mr. Levitt. Unlimited loss potential would be more
appropriate. [Laughter.]
Senator Levin. I would like to put up another picture from
a Web site of a company called TCI.\1\ You have a provision in
the Securities Act and a rule which prohibits deceptive
practices, including material misstatements and omissions.
---------------------------------------------------------------------------
\1\ See Exhibit No. 3 on page 216 in the Appendix.
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This firm, I do not think actually is a broker. This firm
is a trainer of day traders. It allures people with these
promises here of what day trading can do for them.
It says their potential earnings, 6 to 7 figure income per
year, and then later down on the screen, it says no experience,
no selling, no boss, no employees, no inventory, no traveling,
no invoice collection. All you need is a computer and a small
amount of start-up capital. That is all that you need.
Now, would you agree that is a misleading advertisement?
Mr. Levitt. Yes.
Senator Levin. The Massachusetts Attorney General got a
cease-and-desist order against TCI for that statement. We then
went to the TCI's Web site in preparation for this hearing to
see what they are saying now, and here is what we found. This
is as of yesterday. This is after a cease-and-desist order
against them. ``The absolute best and most mechanical trading
system that we know of in the financial market with a profit-
to-loss ratio of 12 to 1 and an average return better than 18
percent per trade before slippages.''
Do you believe that day trading will produce a profit-to-
loss ratio of 12 to 1?
Mr. Levitt. I think that claim is ridiculous.
Senator Levin. Now, this firm trains people, allegedly. I
do not know if that is the word I would pick, but, nonetheless,
shows people how to day-trade, and, yet, I do not know that it
is subject to SEC enforcement. It is, I think, to State
enforcement, but because they do not do the actual trading for
the person, but train the person, I think we have to find a way
in our law nationally, federally, to get at that kind of
misrepresentation.
I am wondering whether or not there is anything you are
considering which would get to this situation where TCI is not
engaged in the actual brokerage operation, but is misleading
and using deceptive advertising in order to try to lure people
into buying their course. Is there anything you are considering
which would get at this?
Mr. Levitt. As you have noted, because TCI is not a broker,
not registered with the SEC, we would have to prove that the ad
is fraudulent in connection with a securities transaction. We
would certainly examine that connection with this or any other
advertising that really goes beyond the pale as this one does.
Senator Levin. You have to show that there is fraud in
relation to a specific transaction.
Mr. Levitt. Yes.
Senator Levin. But if there is fraud in relation to a
process of trading, then the current law at least would not
seem to cover that. Is that correct?
Mr. Levitt. I believe so.
Senator Levin. And that is one of the issues that we need
to face because these are not specific transactions that are
being promoted.
Mr. Levitt. It is a process.
Senator Levin. It is a process which is being promoted, and
that, it seems to me, is one of the big issues we should
address, to get at that problem that we are now dealing with a
process which is being held out too often as a process of big
returns, and where there are deceptive representations about
that process. We have got to find a way to get at the
representation, even though it does not relate to a specific
stock transaction. Would you agree that would be a----
Mr. Levitt. Yes.
Senator Levin. OK. Now, on the issue of margin--well, no.
Let me go back to the suitability requirement because this
relates to this same process question that we were just talking
about.
Is the current suitability requirement that a broker
determine whether an investment is suitable for a customer--is
that what the suitability requirement is in general?
Mr. Levitt. Yes.
Senator Levin. All right. Would that requirement then apply
to whether a process is suitable for a customer or only whether
a specific transaction is suitable for a customer?
Mr. Levitt. I believe that the process would be covered by
suitability requirements. In other words, again, a broker or a
firm that took an elderly widow with limited resources and
allowed that person to engage in a strategy such as this would
run afoul of----
Senator Levin. Of the current suitability rule.
Mr. Levitt. Yes.
Senator Levin. All right. Now, who makes the determination
on suitability? Is it the broker, or is it the customer?
Mr. Levitt. I think it is the broker that has the
responsibility.
Senator Levin. That responsibility falls on the broker to
make.
Mr. Levitt. Yes.
Senator Levin. OK. Now, on the margin issue, I do not know
that there has been a survey of this, but do you believe that
the average new day trader understands that he or she would be
subject to a margin call if that day trader buys too much stock
on margin during a day even if at the end of the day the day
trader no longer holds that stock and even if the day trader
did not lose money on that stock transaction, indeed maybe made
a profit? Would the average new day trader realize that the
margin rules apply to a position at a moment in time during the
day?
Mr. Levitt. My guess, again, based on my own experience
handling retail customers, is that the typical customer does
not understand and is often surprised by that.
I have also been corrected, Senator, in response to an
earlier question which I would like to call to your attention.
That is, that today's rule requires a broker to make sure the
recommendation of a security is suitable for the investor, but
the NASD is expanding that requirement now to include the
recommendations of a strategy. So the rule today deals with the
security. The rule, as will be expanded if this proposal is
approved by the Commission, would include strategies.
Senator Levin. All right. I think that is a very important
change. I was not sure, but that was my understanding, too. So
I am glad that you have clarified that point because that is a
critical issue. That is now under consideration?
Mr. Levitt. Yes. That has been put out for public comment.
Senator Levin. Now, going back to margin, assume a
situation where someone who has a $50,000 equity capital
investment is allowed to buy $100,000 with that $50,000, so
there is a margin of $50,000 using somebody else's money. They
are in and out in a day. Assume that there is no loss on the
transaction, but at some moment in time during that day, the
person had a purchase of $120,000, more than was allowed, even
for an hour. What does the margin rule provide in that
situation? $50,000 in the account in cash. At a moment in time,
they were--$120,000 purchase, more than is allowed by the
rules, no loss at the end of the day because it was sold, let's
say, for as much as it was purchased for, plus commissions or
whatever. What, then, is supposed to be the result?
Mr. Levitt. That is a violation of the margin rules.
This is Bob Colby who is the head of our division of Market
Regulation. I would like him to respond to that, if I may.
Mr. Colby. The New York Stock Exchange margin rules, which
apply to this trading for day traders, require them to take
margin on the largest position, short or long, outstanding at
any point during the day, even if the trading is flat at the
end of the day.
Senator Levin. What is the effect of that violation that I
just outlined, if it was clear? Was I talking your language?
Mr. Colby. Yes, but I did not get the numbers perfectly.
Senator Levin. Well, they had $120,000 position, I think
you call it.
Mr. Colby. Yes.
Senator Levin. So they only had $50,000, let's say, in the
bank. They are only allowed $100,000 under my hypothetical, but
they were $120,000.
Mr. Levitt. They are in violation.
Senator Levin. Right, there is a violation, but what is the
practical effect? Are they then required to increase their
account to $60,000? What happens?
Mr. Colby. They are required to put into the account enough
margin to cover their largest position.
Senator Levin. But it is done.
Mr. Levitt. During the day, they should be asked for
additional funds.
Senator Levin. As a practical matter, does that happen
where broker firms dealing with day traders will ask people for
funds for an hour or 20 minutes?
Mr. Levitt. It happens in our markets. It happens in the
commodity markets all the time.
Senator Levin. Where people are actually asked right then,
write out a check, give me cash?
Mr. Colby. They are asked at the end of the day.
Senator Levin. Not at the end of the day. The end of the
day, there----
Mr. Colby. They are asked at the end of the day, which
means that they have to have the capability to come up with the
funds at the end of the day to cover that large position.
Senator Levin. And if they do not?
Mr. Colby. If they do not, then the firm is in violation,
and they have to close the customer account down.
Senator Levin. So the customer must at the end of the day
come up with the $60,000, the extra $10,000?
Mr. Colby. Margin to cover its largest position open during
the day.
Senator Levin. And if that customer does not have that
$10,000, under my hypothetical, at the end of the day, put in
that account, the account must be closed?
Mr. Colby. That is right.
Senator Levin. OK. I am going to have to put us in recess
just for a few minutes to go vote.
I note that Senator Cleland wanted to ask you some
questions, and I know that the Chairman is going to be back for
some additional questions. So if we could just ask you to stay
there.
Mr. Colby. Senator, I spoke too concisely on that. They are
required to come up with it at the end of the day. They are
required to have that amount, but they do not have to get it in
for 7 days.
Senator Levin. And if they do not get it in for 7 days----
Mr. Colby. If they do not get it in 7 days, that is when
the account is closed.
Senator Levin. The account must be closed. The word
``closed'' is the word I am emphasizing.
Mr. Colby. I believe it actually has to be frozen.
Senator Levin. At what level? Frozen so you cannot act on
it?
Mr. Colby. Yes, but I--could we supplement this?
Senator Levin. I have got to run. Can you figure out what
the right answer is? \1\
---------------------------------------------------------------------------
\1\ See Exhibit No. 6 on page 221 in the Appendix.
---------------------------------------------------------------------------
Mr. Colby. Yes. [Laughter.]
Senator Levin. Because I think there may not be any
effective penalty, and if there is no effective penalty,
because there was no loss, then it seems to me we have got a
problem we also ought to address as well, but let me run and
come back.
We will stand in recess.
[Recess.]
Senator Cleland [presiding]. The Subcommittee will come to
order.
May I just say that this is a scary moment in American
history with me in charge. [Laughter.]
I am on the Armed Services Committee also, and at one
moment of distress, everyone was gone and I was the last person
sitting. I had decided that instead of declaring war, we would
just adjourn for lunch. So that might be our best course today.
Chairman Levitt, you have decided to have a wonderful staff
person join you at the table. I do not know whether I should
swear in the gentleman there. We will assume--I will make a
command decision. I will assume that you both will be truthful,
as a good staff person always is.
Chairman Levitt, would you just give us a little bit of
insight here on day trading? I thought I knew a little bit
about securities, again having been a securities regulator at
the State level for a dozen years, up until about 1996. I
thought I knew the business fairly well, though not the
technicalities of it. As I mentioned to Wayne Howell, my
current administrative assistant, who was my assistant
administrator, Assistant Secretary of State for Securities
Regulation in Georgia, day trading seems to me a relatively new
phenomenon.
Is it a part of this whole world of e-commerce that we have
learned is revolutionizing our society, and that enables, shall
we say, a consumer, in this case an investor, to directly
access a commodity, cars, books, in this case, stocks, and,
therefore, bring to the table in effect their own needs or
whatever without going through a whole series of professional
standards, laws, regulatory environments that have been set up
since 1934, say since the SEC was created? Do you see this day
trading as risky business, in effect part of e-commerce,
bypassing the normal regulatory environment that was set up for
people accessing the securities industry?
Mr. Levitt. I think we have always had day traders in the
securities industry. We have always had people who were
prepared to take extraordinary and, in some cases, foolish
risks to make a quick dollar. Clearly, a market such as we have
experienced tends to bring the more aggressive, less careful
practices on the part of individuals. We see more bad thinking
and bad decisions than you do during other kinds of markets.
We have also seen the technology changes that you have
referred to making it possible for traders to do what they
never could have done in the past because, with a few strokes
of a key, they can buy or sell hundreds of thousands of dollars
worth of securities.
I think what that implies is kind of an emotional linkage
there. Our literature and our television and movies have
stressed the machismo of the trader, and individuals sitting
behind their computer terminal begin to think that, well, they
are as strong and smart and willing to take risks as that
revered professional trader. What they do not know is that they
lack the resources; they lack the experience, and, perhaps most
importantly, they lack the emotions of a professional.
I think I mentioned before, that of the 30 examinations we
have completed of day-trading firms, a third of them have
resulted in enforcement recommendations. That is a significant
number, and that, I think, substantiates your observations.
Senator Cleland. I do not want to beat that point too much
to death, but I guess I am hypersensitive to the question of,
shall we say, the psychological mood of those who are attracted
to get-rich-quick schemes just in general.
Senator Collins [presiding]. I am glad you did.
Senator Cleland. I am in the middle of a question. Would
you like for me to continue my question?
Senator Collins. I would like you to continue. Thank you.
Senator Cleland. It has to do with one of your charts.
Senator Collins. OK.
Senator Cleland. If we could put that first chart back
up.\1\
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\1\ See Exhibit No. 4 on page 218 in the Appendix.
---------------------------------------------------------------------------
Chairman Levitt, again, I do not want to beat this to
death, but having lived through the Atlanta tragedy where a guy
named Mark Barton took a number of lives and went down with his
ship and ultimately took his own life, all in the space of a
few days, I guess I came onto several words here. It just
jumped out at me. It attracts people who are dead end, unhappy
in their current field, victim, layoffs, then, on the other
side, the flip side, the real get-rich-quick part of it, the
unlimited earnings potential. In other words, on the one side,
you have that kind of psychological profile--but on the other
side is gold.
Now, quickly--and that, as it has come to be discovered,
was basically Mark Barton's psychological profile, dead end,
unhappy in the current field, a victim, and all of a sudden day
trading became his way out, but it was his way down, and he
took his family and his associates--he went right back to the
scene of his day trading and started pulling the trigger. And
as I recall--maybe I am incorrect, but as I recall, before he
pulled the trigger with one of his fellow associates, he said,
``I hope this does not spoil your day.''
I mean, it seems to me that in this world of securities,
there always has been that side of the securities industry that
attracted those who wanted to get rich quick and those things
at the margin, the boiler rooms that prey on the elderly with
the nonexistent gas stocks and oil stocks and so forth and gold
mines, on the phone, the penny stock ripoffs, that maybe this
is in that genre.
I wonder, from your point of view, do you think it is the
role of Congress to require day-trading firms to live under the
same auspices and under the same laws and regulations as, say,
Merrill Lynch?
Mr. Levitt. I do not think so, Senator.
I think that the proposal now out there from the NASD to
address the issue of suitability really goes a long way toward
doing that job.
I think hearings of this kind are terribly important in
terms of alerting the public to the fact that day trading is
not the kind of business that this ad would suggest.
The tragedy in Atlanta was one involving an aberrational
personality that could have occurred with someone who had been
to the racetrack or casinos too often and taken out his
frustrations in a similar way in a different venue.
So I think that the important job that all of us have is to
call public attention to the fact that investors simply have to
be careful; that as far as I am concerned, it is a casino
mentality that brings people to day trading, and that the
overwhelming numbers of people practicing day trading will lose
their money, and it is not easy money. It has always led
investors to a very sorry ending. I do not think legislation
could be sufficiently pointed to go to the emotional depths of
individuals who have a predilection toward making the easy
dollar.
Senator Cleland. I agree that Congress cannot be everyone's
personal psychologist, but the attitude that it is their life
and their choice--I guess in my State the total laissez-faire
attitude resulted in a loss of life and a loss of choices for a
number of people, and somewhere in between, I think we have to
find a reasonable solution.
Mr. Levitt. I agree, Senator. I do not have a laissez-faire
attitude about this, and I think the process that is being
played out today is critically important.
Senator Cleland. You are so kind to comment and state with
such a strong and firm conviction your warning to American
investors as you have done so beautifully.
Madam Chairman, I turn the hearing back to you.
Senator Collins. Thank you very much, Senator Cleland.
Chairman Levitt, I just have two final questions for you
before we move on to our next panel of witnesses.
First, I want to give you the opportunity to respond to
criticisms of the SEC's efforts to crack down on some troubling
marketing and other practices of day-trading firms by giving
you an opportunity to respond to Saul Cohen's previous comments
about the SEC's efforts. We will be hearing from Mr. Cohen
later today.
In his written testimony today, he was very critical of the
NASAA study, but in previous writings, Mr. Cohen wrote an
article called ``The Empires Strike Back, Part Two,'' in which
he also sharply attacks the SEC for its efforts to oversee the
day-trading industry and to correct abuses.
Specifically, he labels the SEC's policy regarding day
trading as ``a war'' and accuses the SEC of resorting to
intimidating examination tactics and of ``coming down with
hobnailed boots on day-trading firms.''
I want to give you the opportunity to address those very
pointed criticisms.
Mr. Levitt. The SEC historically has dealt with a number of
constituencies that make up our great American capital markets,
and it has been the position of this Commission and I expect
our predecessor Commissions, that no constituency is more
important than the individual investor.
At this point in time in the history of our country's
markets, with more investors involved in equities today than
ever before, it is essential that the SEC serve to protect
investors and place their interests above those of firms,
brokers, or anyone else in the system.
Part of the process is the collaboration of the commission
with the NASD and other self-regulatory organizations and State
regulators. I believe that the combined efforts of the SRO's,
the States, and the SEC with a commitment to protecting
investors in the midst of a rapidly proliferating interest in
gambling practices such as day trading, has been a balanced
effort and an important effort. This effort, as part of our
process, is exposed to public comment, protects the interests
of investors, is fair, and, I believe, is reasonable and
balanced.
Senator Collins. Well, I want to go on record as commending
the SEC for its examination and consumer protecting efforts, as
well as the other regulatory bodies involved.
The comments of a prominent representative of the
Electronic Traders Association being so harsh towards the
regulators raises real questions in my mind about their
willingness to correct the problems that you have identified,
and it is something that we are going to continue to watch
closely.
I have just one final question for you, and that is the
question that I raised at the very beginning of this hearing,
and that is, based on your observations to date, do you believe
that day trading is having an impact on the market in terms of
increasing volatility or perhaps in a positive sense increasing
liquidity, or do you think the volume is too small to have an
impact?
Mr. Levitt. As best I can tell, the volume of day trading
probably amounts to not more than 5 percent of total volume in
our markets. I think an argument can be made that it does
represent some modest increase in liquidity. I do not think it
has had a significant impact on volatility in our markets, and
I do not intend to sound a note of doom with respect to
electronics. I think electronics and technological changes in
our markets have been exciting and important, critically
important developments as our markets move ahead. I am very
supportive of technology as being the best, and perhaps only,
way that this Nation's markets can compete in increasingly
globalized markets. It is where we target individuals who are
inappropriate for certain techniques such as day trading that I
take exception. The appropriate response to that, I believe, is
hearings such as this, as well as the kinds of alerts and
warnings that all of us can convey to see to it that we
eliminate bad practices and clamp down hard on fraud.
Senator Collins. Thank you very much, Chairman Levitt. I
want to thank the SEC for its efforts and----
Senator Cleland. Madam Chairman.
Senator Collins. Yes.
Senator Cleland. I would just like to associate myself with
your remarks particularly commending the Chairman with his
strong consumer protection and investor protection role that he
plays in our government.
Thank you very much, Chairman Levitt.
Mr. Levitt. Thank you.
Madam Chairman, Senator Levin, before he left, asked a
number of questions about margins which I would like to
supplement our testimony with. Within the next several days, we
will send follow-up responses to those questions.\1\
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\1\ See Exhibit No. 6 on page 221 in the Appendix.
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Senator Collins. That would be very helpful. I, too, am
very interested in the whole issue of the margin issues and the
borrowing and the increased lending among customers. So I look
forward to getting your replies.
In addition, your full testimony and any additional
information will be included in the hearing record.\1\
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\1\ See Exhibit No. 7 on page 225 in the Appendix.
---------------------------------------------------------------------------
Again, thank you very much for your assistance.
Mr. Levitt. Thank you.
Senator Collins. I would now like to welcome our next panel
of witnesses this morning.
Mary L. Schapiro is the President of NASD Regulation, and
Peter Hildreth is the President of the North American
Securities Administrators Association, known as NASAA.
As the President of the NASDR, Ms. Schapiro is responsible
for regulating member brokerage firms, individual registered
representatives, and overseeing the NASDAQ Stock Market.
We look forward to hearing about her organization's recent
examinations of day-trading firms, as well as NASDR's recent
proposed rules to strengthen disclosure and suitability or
appropriateness determinations for day trading.
Mr. Hildreth testified before the Subcommittee earlier this
year on securities fraud on the Internet and was extremely
helpful to us in that investigation as well.
In addition to serving as President of NASAA, he is Chief
of the New Hampshire State Securities Commission. He is
accompanied by David E. Shellenberger, who is the Chief of
Licensing of the Massachusetts Securities Division. Mr.
Shellenberger took a lead role in preparing NASAA's report on
day trading.
As I have explained earlier, all witnesses are required to
be sworn. So I would ask that you stand and raise your right
hand.
Do you swear the testimony you are about to give to the
Subcommittee will be the truth, the whole truth, and nothing
but the truth, so help you, God?
Senator Collins. Ms. Schapiro, I am going to ask you to
begin, please.
TESTIMONY OF MARY L. SCHAPIRO,\2\ PRESIDENT, NASD REGULATION,
INC., WASHINGTON, DC.
Ms. Schapiro. Thank you very much, Madam Chairman. Good
morning, Senator Cleland.
---------------------------------------------------------------------------
\2\ The prepared statement of Ms. Schapiro appears in the Appendix
on page 79.
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I appreciate very much the opportunity to testify on behalf
of NASD Regulation, Inc., and I also want to commend the
Subcommittee for conducting these hearings which can only serve
to further the education of investors about these important
issues.
NASD Regulation is the world's largest securities self-
regulatory organization. It has responsibility for the
oversight and surveillance of the NASDAQ Stock Market but, more
importantly for these hearings today, we are also responsible
for regulation, licensing, testing and examination for and
enforcing compliance with our rules and the securities laws for
our 5,600 broker-dealer members.
I would like to preface my comments today by emphasizing
that day trading is a legal trading strategy and to the extent
it is conducted in accord with regulatory requirements, by
individuals who are capable of understanding and assuming the
risks involved, we neither encourage nor discourage it.
However, with that said, we see day trading as a highly risky
form of trading that deserves the closest scrutiny of
regulators.
Thus far, NASDR has taken a three-pronged approach to
addressing the investor protection concerns that arise from day
trading. First, we have been disseminating information and
advisories to our members, reminding them of their many
obligations under existing rules, and these advisories are
fully outlined in my written statement. We have also been
emphasizing to investors the risks involved with day trading.
Second, we have enhanced our examination and enforcement
programs and, third, we have proposed new rules in this area
and are exploring additional rulemaking initiatives.
With respect to examination and enforcement activities, we
have been engaged in a cooperative day trading examination
initiative with the SEC, as you have heard from Chairman
Levitt. 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.
During these specialized exams several potential problem
areas surfaced. In the area of advertising, for example, we
found sales materials and advertisements that range from
assertions of immediate execution to statements of profits that
can be generated from day trading.
One practice under review is the dissemination through
public statements or Web sites, training materials and public
statements of what may be materially misleading information
regarding the success rate of customers. Our staff is
investigating whether the firms' claims of customer success
rates can be substantiated as our rules require.
In addition to our ongoing investigations, we have already
filed one formal disciplinary action against Lakeside Trading.
That complaint alleges, in the advertising area, misleading
statements that imply direct access to the markets by their
day-trading customers and the failure to disclose material
risks associated with the trading.
Our examinations also surfaced Regulation T and margin
lending and disclosure practices that are of great concern to
us, particularly when we find firms facilitating and even
encouraging loans from one customer to another customer, loans
from a principal of a firm to a customer, and loans arranged by
the firm from third parties to customers. Absent these
infusions of capital, many of the recipients of the loans would
be unable to continue to trade.
Another area of concern relates to registration issues. Our
exams identified individuals engaged in day trading for firms'
proprietary account who are not qualified and registered. One
disciplinary action has been filed and concluded in that area
in which we fined a day-trading firm $25,000 for failure to
properly qualify and register 14 people.
Problematic short-selling practices at some day-trading
firms have also been identified, including short-sales that are
not properly marked, and where no affirmative determination has
been made that the shares can, in fact, be delivered to the
buyer. We have seen potential violations of our rules
prohibiting customer short-sales on what is commonly known as a
``down-tick.''
Supervision deficiencies were also identified during our
examinations. Our rules require that a firm establish and
maintain a supervisory system that allows them to carefully
supervise the activities of each associated person. We found
that at some day-trading firms, written supervisory procedures
did not adequately address many aspects of their core business
including lending practices, advertising and marketing, and
short-selling.
We are currently reviewing the results of our examinations
and completing 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,
further enforcement actions will be instituted.
In addition to our examination and enforcement activities,
we have been working on several rulemaking initiatives to
address the investor protection concerns associated with day
trading that we believe are not adequately addressed under
existing rules.
As you heard earlier, in April of this year we solicited
comment on and in August filed with the SEC, proposed rules
that would require firms that promote day-trading strategies to
first determine the appropriateness of day trading for each
customer. And, second, to disclose to customers the risk that
are associated with day 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. To do so,
they must obtain and keep information about the customer such
as their financial situation, their tax status, their prior
investment and trading experience and their investment
objectives.
The proposed rules also require that a firm that promotes
day trading deliver a specialized risk disclosure statement to
a customer prior to opening an account, informing investors
that day trading can be extremely risky, that investors should
be prepared to lose all of their funds used for day trading and
that they may lose funds beyond their initial investment.
In addition to this proposed rule, we are looking very
closely at whether changes to existing rules regarding margin
and lending practices are necessary. We have solicited comment
on some of these issues.
Concerns that we have identified include what levels of
margin are appropriate for these types of activities, whether
the timing of the margin deposit requirements should be
changed, and whether minimum initial and maintenance cash
deposits should be required.
We are also addressing the role of firms that arrange loans
between customers. We are particularly concerned about what, if
any, risk disclosures are being made both to the customer
obtaining the loan and the customer who is providing the loan.
We believe facilitation of these lending activities by firms
may pose a fundamental conflict of interest between the firm
and the customer, given that these are the loans that often
allow customers to continue to trade when they would not
otherwise be in a financial position to do so and, thereby,
continue generating commission income to the firm.
We pledge to continue to be very vigilant with respect to
day trading through examinations, regulatory initiatives, and
the prompt completion of ongoing enforcement actions. We intend
to continue to work together with the SEC and the States to
address the many issues raised by day trading.
At this time, we do not see a need for any new legislative
initiatives, but believe that by continuing our current
approach of dissemination of information to our members and
investors, examination and enforcement efforts, and the
development of new NASD rules and other policy initiatives, we
can effectively address investor protection concerns associated
with day trading.
Thank you.
Senator Collins. Thank you, Ms. Schapiro.
Mr. Hildreth, welcome.
TESTIMONY OF PETER C. HILDRETH,\1\ PRESIDENT, NORTH AMERICAN
SECURITIES ADMINISTRATORS ASSOCIATION, WASHINGTON, DC; AND
DAVID SHELLENBERGER, CHIEF OF LICENSING, COMMONWEALTH OF
MASSACHUSETTS SECURITIES DIVISION, BOSTON, MASSACHUSETTS
Mr. Hildreth. Thank you.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Hildreth appears in the Appendix
on page 167.
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Chairman Collins, Senator Levin and Senator Cleland, I am
Peter Hildreth, Director of Securities Regulation for the State
of New Hampshire and President of the North American Securities
Administrators Association.
Thank you for the opportunity to appear before you once
again and to present the views of NASAA as you look into issues
and problems surrounding day trading. We recognize and
appreciate your leadership in focusing attention on the
problems in this area.
Last December, in part because of the enforcement actions
taken by Texas and Massachusetts, the NASAA board of directors
formed a project group to research the industry, prepare a
report of its findings and make recommendations. The project
group, chaired by David Shellenberger, gathered information,
analyzed issues and studied trading records. The NASAA day-
trading project group report, released in August, was the
result of that effort.\2\
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\2\ Exhibit No. 8 is retained in the files of the Subcommittee.
---------------------------------------------------------------------------
We believe there are problems associated with the day-
trading industry, not the least of which is the hype about how
average people can get rich quickly with no experience
necessary. We hope our report, the first of its kind, will help
Congress and the public as well as our fellow regulators better
understand the issues and problems. We believe it will also
help in framing appropriate responses from Congress and
regulators.
Electronic day trading has become part of our culture. It
has captured the national imagination, in part, because it
combines two major developments that characterize America in
the late 1990's: The bull market on Wall Street and the
technology revolution brought about by the personal computer
and the Internet.
Unfortunately, much of the early media coverage tended to
glamorize day trading. The fact is day trading is anything but
glamorous. As our report makes clear, day trading is very risky
and most people who day trade will lose all of the funds they
put into it.
We have not examined all day-trading firms and their
hundreds of offices we believe exist. However, at the firms and
branch offices we have examined, we found problems with
marketing, suitability, loan arrangements, supervision, and
customers trading other people's money without regard to
licensing requirements.
There were several issues you asked us to address in our
testimony. The first was a general discussion of day trading. I
think that Chairman Levitt has already discussed how day
trading is distinguished from other investment strategies. My
written testimony provides NASAA's perspective on this issue.
So, in the interest of time, I will move on to other issues you
asked us to address, such as the risk of day trading.
Trading is, by definition, a form of speculating as
distinguished from investing. Day trading is trading on an
extremely short-term basis and is highly speculative. When
firms promote their services with claims as to the potential
for success and profitability, they have an obligation to tell
their customers the truth about the risks.
We also believe they have an obligation to determine
whether day trading is suitable or appropriate for that
particular customer. That means not accepting just anyone who
comes through the door with a check and wants to sit down at
the computer and trade.
We commissioned an outside expert, Ronald L. Johnson, to
analyze customer account records from a day-trading firm in
Massachusetts that was the subject of an enforcement action.
His analysis suggests the majority of day traders, more than 70
percent, lose money. Only about 12 percent showed the potential
to be profitable.\1\
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\1\ Exhibit No. 8 is retained in the files of the Subcommittee.
---------------------------------------------------------------------------
Mr. Johnson also found that day traders would have to
generate annual returns of 56 percent just to cover commissions
and margin interest, never mind taxes. These are long odds,
indeed, just to break even.
This was the first such analysis of retail day-trading
account data. It was a limited sample but the results are
consistent with what we found in other investigations, such as
evidence from a Block Trading branch office where 67 of 68
accounts lost money.
We urge others, especially academics, to conduct further
research on the profitability of day trading by retail
customers. However, the burden of proof remains on the day-
trading firms. They must justify their claims of customer
profitability in their marketing that suggests that average
people can make a career of day trading.
As to the findings of State regulators' exams, some of the
abuses and problems that the project group has observed
include: Deceptive marketing, including inadequate risk
disclosure. As you noted in your presentation, Chairman
Collins, one firm On-Line Investment Services, Inc., maintained
a Web site claiming that 85 percent of its customers were
profitable. They deleted that claim when Massachusetts asked
for proof.
We also found violation of suitability requirements. In a
case against Landmark Securities, Inc., the complaint alleged
that the manager falsified information on new account forms to
create the impression day trading might be appropriate for that
customer. The customer, a recent college graduate, was a part-
time bartender with an annual income of $15,000, a net worth of
less than $15,000, and no prior investing experience.
Other abuses we noted are questionable loan arrangements,
including promotion of loans from one firm's customers and
loans to customers by brokers, and also failure to supervise.
The next issue is our position on the NASD proposed rule.
In a comment letter to the NASD, the NASAA project group
endorsed the draft rules on appropriateness and risk disclosure
and made suggestions for enhancing the rules. We recommend that
the SEC approve the rules.
As to other legislative or regulatory initiatives, we
believe the NASD should also adopt a rule prohibiting the abuse
of loans I have discussed. We also recommend enhanced
regulatory attention to day-trading firms.
First, the proposed NASD rules on appropriateness and
disclosure. The project group believes that the existing rules
on suitability apply to day trading. The failure by some day-
trading firms to adhere to the existing suitability rules,
however, suggest that specific day-trading rules are warranted.
Day trading is a particularly risky program of trading that
warrants heightened suitability and disclosure requirements.
The NASD already has special suitability requirements for
opening option accounts and the like.
Second, the matter of a ban on loan programs. Day-trading
firms' promotion and arrangement of lending among customers to
meet margin calls is problematic. Firms have promoted the loans
in order to keep accounts open that would otherwise be closed
or restricted for failure to meet margin calls. These loans
serve to undermine margin requirements and encourage customers
to trade beyond their means. Some of these loans come with
interest rates that in some States may exceed legal limits. A
typical rate is a tenth of a percent for an overnight loan or
36.5 percent on an annualized basis. In addition, the loan
programs have invited severe compliance problems including
forgeries and the unauthorized transfer of customers' funds.
We believe the loan programs are highly questionable under
existing law. Nonetheless, we believe the NASD should adopt and
explicit rule prohibiting the programs.
Finally, enhanced focus on day-trading firms. Too many day-
trading firms continue to engage in highly questionable conduct
as you heard from Chairman Levitt's report. More enforcement
actions should be brought.
But let me be clear. State regulators do not have a problem
with day trading per se. It has been around a long time, long
before the personal computer. We believe investors should have
available to them all the latest technologies. Technology and
information have revolutionized investing. They have leveled
the playing field between Wall Street and Main Street.
Our concerns are with day-trading firms that aren't being
honest with their customers about the risks. Firms that
essentially say, ``hey, come on down, we will sell you a
training course, you can sit in front of the computers and you
will get rich.'' This is hucksterism. The odds are that you
will not get rich. The odds are you will lose all the money
with which you trade.
The fact is day trading is not investing, it is gambling.
There are no other words for it. Day traders can lose a lot of
money in a hurry. People should not be gambling with money they
cannot afford to lose.
As Chairman Collins mentioned, All-Tech's recent Web site
illustrates that some firms have held out day trading as an
option for retirees, people laid off from their jobs, even
college graduates just starting out. This sort of marketing is
irresponsible, reckless and predatory.
Day-trading firms need to play by the same rules that the
rest of the brokerage industry has to follow. Frankly, in the
examinations we have conducted of day-trading firms, we have
found a cavalier attitude toward regulatory compliance. Too
many firms either don't know the rules or are flouting them
because they think the rules don't apply to them.
Well, the rules do apply. We expect that more enforcement
actions will be brought and that these will send a message to
the firms that appear to believe they are above the law.
Chairman Collins, I greatly appreciate the opportunity to
chair the NASAA project group's findings with the Subcommittee
today. NASAA and its members stand ready to assist you as you
continue your investigation into the practices and operations
of the day-trading industry.
Senator Collins. Thank you very much, Mr. Hildreth.
Mr. Shellenberger, do you have any formal comments you
would like to make?
Mr. Shellenberger. No, Chairman Collins. I am prepared to
answer any questions that may be asked, though.
Senator Collins. Thank you very much.
Ms. Schapiro, you stated in your written testimony that
NASDR examiners had identified questionable practices,
questionable marketing and advertising practices at nearly 80
percent of the day-trading firms that you have reviewed to
date. Is that correct?
Ms. Schapiro. Yes.
Senator Collins. That is of great concern to me because
that suggests that we are not dealing with isolated examples of
misleading advertisements or exaggerated claims but rather an
industry pattern of deceiving unsophisticated investors.
Could you give us some examples of the kinds of deceptive
marketing practices that your examiners uncovered?
Ms. Schapiro. Sure.
I think as a general matter we have seen extremely
aggressive marketing and promotional campaigns engaged in by a
number of day-trading firms. Some of the advertisements and
sales literature which have been of particular concern to us
includes promises of enormous profit potential, very high
levels of customer success rates without there being any
counter balancing information about either the risks or the
fact that you can lose all of your money and more than your
initial investment.
We have seen ads that suggest that you are guaranteed
immediate execution in the market place. When we all know that
as good as the technology is, you are not guaranteed an
immediate execution.
And, we have seen advertisements that suggest that anybody
can do this with just a little bit of a training or studying a
manual when, in fact, sophisticated understanding of market
operations and how stocks react in different markets and areas
is very important to be successful.
So, generally, I would say exaggeration, potentially
misleading information and wild claims would characterize many
of the ads that we have looked at and are investigating.
Senator Collins. And I would note that the SEC examiners
and the State regulators have also found a similar pattern of
widespread abuse with advertising in this area.
Ms. Schapiro. I think that is right. It is interesting to
me that the examinations done by all three of us are very
similar and largely parallel in their findings.
Senator Collins. That does seem to be a consistent and very
troubling theme or finding of all three regulatory
organizations.
Your examinations also indicated, Ms. Schapiro, that nearly
half of the day-trading firms had established lending programs
whereby day-trading customers who cannot meet the margin calls
can borrow from other day-trading customers. This raises real
concerns in my mind about suitability and appropriateness.
If a day trader can't meet the margin call and is
encouraged by the firm to borrow from a fellow day trader, what
does that say about whether the individual should be day
trading in the first place?
Ms. Schapiro. That is a wonderful question and I think that
my greatest concern in this area is that it is fundamentally a
very severe conflict of interest for a firm to suggest to a
customer who has run out of capital that that customer borrow
money from other customers or from principals of the firm in
order to continue to generate commissions for the firm. We are
looking very closely at this issue and I would hope that in the
next several months we will have taken some action with respect
to the facilitation of lending arrangements by the broker-
dealer.
Senator Collins. Mr. Hildreth, I know this has been of
particular concern to the State regulators. Would you like to
comment on this and should NASDR simply ban this practice?
Mr. Hildreth. Well, I think that certainly the NASD should
look--what they are seeing in these exams is what we talked
about in the report. And I know that Dave Shellenberger has
some things to say about those also. But it would seem to me
that with that widespread, as it appears in the industry,
practice, is something that we have some real grave concerns
about for the same reasons that Ms. Schapiro stated. Keeping
people trading when there are some real concerns if they don't
have the money, perhaps just to generate commissions.
So, I think certainly it should be looked at.
Senator Collins. Mr. Shellenberger.
Mr. Shellenberger. Yes, thank you, Chairman Collins.
One of the problems with the loan programs, and by the loan
programs, of course, what we are referring to is day-trading
firms promoting and arranging loans between customers so that
customers can meet margin calls that they otherwise could not
meet.
The purpose of these loan programs is simply to keep
accounts alive that would otherwise be closed and allow the
brokerage firms to obtain a continuing stream of commissions.
These programs encourage people to lose even more money.
They certainly, as Madam Chairman has recognized, raise
suitability concerns. If people are trading beyond their own
means, don't have enough funds to meet margin calls, should
they be day trading in the first place? To indicate the
magnitude of this issue, we alleged in Massachusetts in the
case against Landmark Securities that with respect to the tiny
retail account held by the part-time bartender and recent
college graduate in that office, $2.7 million in loans flowed
through this person's account in only 9 months.
Senator Collins. I think this is an area where we really do
need to see regulatory action. It just raises all sorts of
concerns.
We also need to do a better job upfront screening out
people for whom day trading is not appropriate. And I think
that is why the NASD's appropriateness regulations are very
important in that regard because we would have fewer people who
would be tempted to borrow from fellow day traders if we were
screening, if the industry was screening potential clients
upfront.
Would you agree with that, Ms. Schapiro?
Ms. Schapiro. Yes, absolutely.
Senator Collins. Mr. Shellenberger, as you are very well
aware the day-trading industry has been extremely critical of
NASAA's report on profitability of day trading in which it was
found that more than, I believe it is, 70 percent of day
traders are going to lose their money, perhaps even more, and
only 12 percent were found to have the capacity to perhaps make
a profit.
The industry has countered with a study on day-trading
profitability that was conducted by Momentum Securities. Have
you reviewed that study and could you give us your thoughts on
it?
It is my understanding that the Momentum study acknowledges
that 56 percent of day traders lose money in the first 3 months
but it claims that after that point 64 percent of day traders
actually make money.
What are your views on the Momentum profitability study?
Mr. Shellenberger. Chairman Collins, on behalf of the NASAA
project group I requested copies from the Electronic Traders
Association of any studies, including Momentum's purported
study. I have yet to receive any documentation, anything
related to that study. So, I am only familiar with the press
clippings concerning it.
Senator Collins. Well, that is problematic in and of
itself, I would say. If you, as a regulator, are making a
request for information that is that vital and are not
receiving the cooperation of the day-trading industry that is
of great concern to me.
Mr. Shellenberger. Yes. I should clarify, Chairman Collins,
that Momentum Securities is not registered in Massachusetts so
we cannot legally force them to produce these records.
Nonetheless, we did request them through the ETA. Claims of
profitability or losses are meaningless unless the data are
subject to scrutiny.
So, I have been unable to scrutinize these claims. However,
on the face of the claims there is a problem. And that is
Momentum has acknowledged that the majority of its customers
did lose money at least for a period of months. They claim that
after that apparently the surviving customers were profitable.
I don't know whether that is true or not.
The question would be, how many people are going to burn
through their capital and still have some money left once they
supposedly learn how to day trade? I suggest that it may be too
late.
For instance, Ron Johnson, in reviewing our sample, found
that the average account was only open 4 months.
Senator Collins. So, in other words, given the high
turnover of day traders, many of them aren't going to still be
able to day trade because they will be broke by the time they
may finally have figured out how to do this profitably?
Mr. Shellenberger. Absolutely. Assuming that it is even
possible for them to learn.
Senator Collins. Have you seen anything, based on your
further examinations, that leads you to question your initial
findings that more than 70 percent of day traders will lose
their money?
Mr. Shellenberger. No, Chairman Collins.
In fact, I believe that the 70 percent figure probably
understates the problem. Ron Johnson concluded that if many of
these people beyond the 70 percent continued to trade, those
that had shown profits would end up losing money because, for
instance, in many instances the profits had been gleaned from
only one trade. Well, if you can make 50 percent of your
profits in one trade, you can lose 100 percent of your capital
in the next trade.
Senator Collins. Ms. Schapiro, has the NASD done any work
on the profitability of day trading?
Ms. Schapiro. We haven't done a broad look at the
profitability. In the context of the specific investigations of
day-trading firms that are ongoing where they have made claims
of customer success rates, we are requiring them to
substantiate that those success rates are, in fact, true.
Through that mechanism we will have a better sense, at
least anecdotally, of what the success rates are and what the
profitability is of day trading at particular firms.
Senator Collins. I hope you will share that information
with the Subcommittee.
Ms. Schapiro. We will be happy to do that.
Senator Collins. The appropriateness regulations that the
NASD has proposed, and which are now pending before the SEC,
apply, it is my understanding, to only new accounts. Is that
correct?
Ms. Schapiro. As the rule was proposed, yes, we applied it
on a ``going forward'' basis to new accounts.
Senator Collins. Would it not be useful to apply it also to
current accounts, so that there at least is a disclosure of the
risks?
Ms. Schapiro. We will certainly revisit that issue.
We targeted it to an account opening because that's a very
definitive event that can trigger the need to do the
appropriateness determination.
To the extent that there are accounts already out there at
firms that aren't even traditional day-trading firms but where
people are, in fact, day trading, we thought it would be very
difficult, as an operational matter, to go back and try to
apply the rules to all of those accounts. But it is something
we will look at very carefully.
In submitting these rules to the SEC, we have said that
this is a first step. And, if we determine there are additional
regulatory initiatives that are needed in this area, we won't
hesitate to recommend those.
Senator Collins. Thank you very much. My time has clearly
expired, and I will now turn to Senator Levin for his
questions.
Senator Levin. Mr. Shellenberger first, I believe you were
the folks who got the restraining order against TCI; is that
correct?
Mr. Shellenberger. Yes, Senator Levin. Specifically, the
cease and desist order applied to what we had alleged in the
licensing section as a Ponzi scheme, beyond what we allege were
false claims as reflected by the advertisement. Then the
hearing officer referred the matter of the deceptive
advertising to the Attorney General's office because he had
concerns regarding our jurisdiction.
Senator Levin. That is the original one, I believe, and I
want to show you the new one that is currently on their Web
site and ask you whether or not those concerns are still real,
when they say that this system is the absolute best that they
know of, and it says a profit to loss ratio of 12 to 1 and an
average return of better than 18 percent per trade before
slippages.\1\
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\1\ See Exhibit No. 3 on page 216 in the Appendix.
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It seems to me it's worse than their first site.
Mr. Shellenberger. Yes. Senator Levin, I would share your
concerns. The response, once regulators have raised questions
regarding specifically Web sites, has been that these Web sites
change. I believe this site has been modified. But I share your
concerns that this remains unacceptable.
You had asked a prior witness, Chairman Levitt, regarding
the SEC's jurisdiction in this matter, and this is a very
technical area. But I would note, if I may, that there are
State consumer protection acts that prohibit deceptive
advertising and, in addition, such matters may be under the
purview of the Federal Trade Commission.
Senator Levin. This is a current Web site, by the way. This
is after the change. So at least as of yesterday, it was their
Web site.
Is this under Massachusetts' jurisdiction if that is false
advertising? Is that what your Attorney General is looking into
now?
Mr. Shellenberger. Senator Levin, the referral was made to
the Attorney General's office from the Massachusetts Division
of Securities, because Massachusetts, I believe, like most
States, has a Consumer Protection Act Chapter 93(a) which,
among other things, prohibits unfair or deceptive acts or
practices, including advertising. So this, in my view, would be
subject to scrutiny under that law.
Senator Levin. If the Attorney General concluded that was
false and deceptive advertising, and if TCI is located--and I
don't know where they're located----
Mr. Shellenberger. In California, Senator.
Senator Levin [continuing]. In California, would you be
able to get at them because the advertising is on a Web site
which obviously comes into Massachusetts? Would you be able to
get a subpoena, for instance, under existing legal theory?
Mr. Shellenberger. Senator Levin, I know that this area of
States being able to obtain jurisdiction in response to Web
site advertisements has been the subject of some brilliant Law
Review articles that I have only skimmed.
I can tell you that TCI has at least closed down its branch
office in Massachusetts, and I don't expect them in my back
yard again. Whether we would be able to enforce a subpoena on a
California corporation that, to our knowledge, did not do
business with any of our citizens, would be questionable.
Senator Levin. Madam Chairman, I think this is an area that
we also want to add to our list of things that we're looking
into, because, given the amount of electronic trading, given
the fact that this kind of a course and strategy is available
electronically, or the touting of it is done electronically, it
would be good to have not just the watchdogs in Washington, the
Federal Trade Commission or others looking into these kind of
phony representations, it would be good to have 50 States being
able to go after them as well. That may require some kind of
change in Federal law to authorize subpoenas. I'm not sure
exactly what the legal complexity is, but I think we ought to
add this, given the amount of electronic trading and the way in
which these courses are advertised, to our list of things that
we're looking into for possible legislation.
I think this question will go to you, Mr. Hildreth. You
indicated in your testimony that the odds are you won't get
rich, and the odds are you'll lose all the money with which you
trade. We will hear testimony later on this morning from Mr.
Cohen that day trading is not gambling. But then he says the
majority of those who do day trade after training do not lose
money.
You're telling us that the odds are you will lose all the
money with which you trade?
Mr. Hildreth. That's right.
Senator Levin. That's about as sharp a conflict as we can
possibly have. I'm just wondering what your reaction is to his
comment?
Mr. Hildreth. My statement is based on the report \1\ that
was produced by Dave Shellenberger's project group, and hiring
an outside consultant. It is based on the data that we have.
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\1\ Exhibit No. 8 is retained in the files of the Subcommittee.
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We also had the testimony of the manager of one of these
sites, who said 67 out of 68 lost money.
Senator Levin. They also will be testifying later on this
afternoon that much of NASAA's report, that this mumble jumble
would be unnecessary if NASAA had accepted ETA's March, 1999
offer to provide current trading information.
Now, we're going to be getting testimony under oath later
on this morning that ETA offered NASAA, in March of this year,
to provide current trading information. I'm wondering, did
they, and if so, what was it?
Mr. Hildreth. Dave Shellenberger is the appropriate person
to respond, since he's the Chairman who would have dealt with
them on that issue.
Mr. Shellenberger. Thank you, Senator Levin.
The answer is that that's a false assertion. What had
happened is that the ETA, through its counsel, asked me to
comment on a possible study that might be done by the ETA. The
project group determined not to make any suggestions or comment
but, rather, to reserve comment. The reason is that we did not
want to endorse a study or survey of which we did not know the
particulars.
I would stress, Senator, if I may, that the burden of proof
is on the industry. Before they make these claims of 85 percent
success rates, before they make the claims that retirees should
make careers of day trading, they should have the facts. It
disturbs me that apparently studies have not been done to date,
other than the alleged Momentum study.
Senator Levin. Can any of you comment on the adequacy of
current laws and regulations to address the problems which we
have identified, and if you would prioritize the new
regulations or laws that are needed in terms of their
importance? Maybe we can start with you, Ms. Schapiro.
Ms. Schapiro. OK. Well, we have identified a lot of
problems, as you've heard. I think, with respect to
advertising, for example, there are adequate regulations in
place, assuming sufficient enforcement resources, to pursue all
of those advertisements and marketing materials in an
aggressive way.
I think we have said, with respect to margin, and
particularly margin lending practices, that we need to do some
more work, as SRO's and the SEC, to look at whether there ought
to be a prohibition and, at a minimum, enhanced disclosure of
the risks of margin lending or some other modification to
address the practices that we have seen with respect to margin
lending.
I think we also ought to look at whether, under the margin
rules--and you asked these questions earlier, Senator Levin--we
should be shortening the time frames by which Regulation T
margin deposits must be made. It's currently 7 days and perhaps
it ought to be shorter, given the kind of mismatch we have of
these trading strategies that are intraday, with margin
payments being required only within 7 days.
I think with respect to short sales or short selling, the
current regulatory and legal structure is adequate.
With respect to supervision, there is a very detailed and
comprehensive supervisory structure in place in the largest
broker-dealers, and the best run small- and medium-size firms.
Day-trading firms need to adopt those kinds of supervisory
structures and hire compliance people who can ensure that they
are following the rules and regulations that apply equally
across the board to all broker-dealers.
Senator Levin. Just very quickly, if I may, does your
organization support the proposed rule on suitability, that it
apply to strategy as well as----
Ms. Schapiro. We wrote it. It is our rule and we are 100
percent behind it.
Senator Levin. Mr. Hildreth.
Mr. Hildreth. We support it, as I said, and filed a comment
letter in support of that.
We wouldn't be here today if the current rules were met by
the industry. What we found is the rules are being broken. I
think that there is a need to look at the loan issues, and
perhaps just ban them outright.
If the current rules were being complied with, I don't
think we would be here. I think the day-trading industry just
has to comply with those.
Senator Levin. But in terms of new regulations and rules,
the first thing would have to be with the loan, and second,
would be suitability or not?
Mr. Hildreth. Well, we have supported the suitability
proposal, and we hope that that's going to be approved quickly.
We would like the NASD and the SEC to look at a ban on the
lending programs.
Senator Levin. Is there anything else from our third
witness?
Mr. Shellenberger. Senator, I concur with Mr. Hildreth's
comments, and I emphasize that the industry seems to be doing a
good job of violating existing law.
Senator Levin. Thank you. Thank you, Madam Chairman.
Senator Collins. Senator Cleland.
Senator Cleland. Thank you very much, Madam Chairman.
Ms. Schapiro, we're glad to have you with us today. I have
spoken to your organization, mostly as Secretary of State in
Georgia, and as a State regulator. Mr. Hildreth, it's nice to
see you. I have great respect for your organization as well.
I mentioned earlier today that Wayne Howell, my AA, has
been very instrumental in my understanding of the regulatory
process, in terms of the world of securities, and he was the
former head of your organization. Mr. Shellenberger, as a
former State regulator, we respect your role immensely.
I think it is fascinating, Madam Chairman, a couple of
things I have gotten out of this today. First, Mr. Hildreth,
you're the second person to sit in that chair today to refer to
day trading as gambling, the first being Arthur Levitt, head of
the SEC, and then you, heading the North American Securities
Administrators Association, referring to it as gambling.
That is certainly far beyond any understanding of
investment or even just speculative investment. It seems to me
that our testimony today has reflected that it is, indeed,
gambling.
As a matter of fact, I started off somewhat quizzically
about the relationship with Las Vegas, that it is now clear you
have better odds in Vegas than in day trading, and that it's
not roulette but it's Russian roulette, where there's a bullet
in the chamber. If you keep playing this roulette game long
enough, you're going to be dead.
To hear the fact that, as a minimum, some 82 percent that
go into day trading don't make anything, and 70 percent lose
money, 12 percent have a potential of maybe making some money,
that's astounding odds against you. So I think something is
broken here. I'm not sure what's broken, but I think some
things need fixing.
What I would like to suggest here, before I leave the
panel, is to ask Ms. Schapiro, Mr. Hildreth, and Mr.
Shellenberger, what is your best shot here and what can this
Subcommittee or Congress do to help get this thing back on
track, to help main street get back in line with Wall Street,
not abandoning the technology and certainly not wiping out the
opportunity for the individual investor to get involved in the
process, but how do we make this work?
Ms. Schapiro.
Ms. Schapiro. I believe, from the perspective of the U.S.
Congress, the most important thing--because we don't have any
recommendations at this point for specific legislative
initiatives--would be to continue to support the regulators
through hearings like this, that help us have an audience to
air some of these issues and concerns, and continue to support
the regulators in their initiatives to enact some new rules
governing this kind of trading, have adequate resources,
particularly for the Securities and Exchange Commission, to do
the kinds of examinations and enforcement cases that will help
protect investors.
Senator Cleland. Mr. Hildreth.
Mr. Hildreth. I would also say that this type of hearing
goes a long way, toward publicizing this issue. When we
released the report, there was a great deal of coverage, and
that's good, because people need to know the real risks. They
are not being told that when they see an ad that says you can
come in here, be trained for a few days, and you can retire--or
you've already retired and you can make extra money.
It is important to get the message out, that day trading is
risky. This kind of hearing, what you're doing here today, I
think goes a long way in that regard. Again, I do think that
the SEC and the NASD need the support of Congress, the SEC more
directly, certainly, with the funds to do it.
I would note once again, as I think Chairman Levitt
mentioned earlier, that the three groups--the SRO's, the SEC
and the States--really do work well together on these kinds of
issues, and we look forward to doing that. We hope you give the
SEC the resources to do it.
Senator Cleland. Mr. Shellenberger.
Mr. Shellenberger. Senator, I concur with the statements of
Ms. Schapiro and Mr. Hildreth. I'm not sure additional
legislation is needed. However, we find hearings of this nature
very helpful in alerting the public, not only to the risks and
problems, but reminding them that, as one of the Senators noted
earlier today, if something sounds too good to be true, it
probably is.
Senator Cleland. That was me. [Laughter.]
Mr. Shellenberger. It was a brilliant remark, with which I
concur. [Laughter.]
Thank you.
Senator Cleland. Help me understand day trading just a
little bit. First of all, I'm an individual citizen. Can I buy
stocks through the Internet?
Ms. Schapiro. Absolutely.
Mr. Hildreth. Yes.
Ms. Schapiro. Without day trading, you may open an on-line
account at any one of hundreds of brokerage firms----
Senator Cleland. But you've got to go through a brokerage
firm to do that?
Ms. Schapiro. Yes. Well, you do, if you're not going to
engage in day trading. If you're going to engage in day
trading, you have a couple of options. You can go on site, at a
brokerage firm that is an NASD member and sit at what is the
equivalent of a work station that one might see on a trading
desk in a NASDAQ trading room at a big firm, and you may access
the market through that terminal at the brokerage firm.
You may also go into a limited liability company that might
not be a member of the NASD and, therefore, not subject to all
the rules and regulations of the NASD, but perhaps a member,
for example, of the Philadelphia Stock Exchange, and trade as a
limited partner of that LLC. You would deposit your own
capital, which becomes part of the firm's capital, and trade as
a partner, not as a customer and, therefore, not benefit from
suitability and a number of other rules that protect customers.
You would also have the benefit of even greater leverage,
because you wouldn't be subject to the Regulation T margin
requirement of 50 percent initial margin and 25 percent
maintenance margin but, rather, whatever margin level is
arranged between that limited liability company and their
clearing firm. It could be as low as 15 percent margin. So you
have several alternatives on how you want to approach day
trading.
Senator Cleland. Thank you. The panel has been most
gracious with their time.
Madam Chairman, thank you for holding this hearing. It is
obviously a very fascinating part of the world in which we
live, and certainly day trading is very risky business and
these people are trying to help. Thank you very much.
Senator Collins. Thank you very much, Senator.
I want to thank our panel for their very helpful testimony.
We look forward to continuing to work with you as we continue
our investigation as well.
Our final witness this morning is Saul Cohen, the
consulting counsel to the Electronic Traders Association, which
is known as ETA. Mr. Cohen has extensive experience in
securities regulation and is currently a partner in the law
firm of Proskauer, Rose in New York City.
ETA is a nationwide association of firms and individuals
which promote the interests of the day-trading industry.
Mr. Cohen, before you get too comfortable, I do need to
swear you in.
Do you swear the testimony you are about to give will be
the truth, the whole truth, and nothing but the truth, so help
you, God?
Mr. Cohen. I do.
Senator Collins. Thank you very much. You may proceed.
TESTIMONY OF SAUL S. COHEN,\1\ CONSULTING COUNSEL, ELECTRONIC
TRADERS ASSOCIATION, NEW YORK, NEW YORK
Mr. Cohen. Thank you, Senator. I'm the notorious Mr. Cohen
referred to before.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Cohen appears in the Appendix on
page 178.
---------------------------------------------------------------------------
For those who are interested, the quote is from a much
larger and broader article on philosophical concepts of
regulation. It appears in two parts, in the Wall Street
Lawyer.com, and it really deals with the threats of the
Internet.
But, in any event, I thought I would start with two quick
quotes from Chairman Levitt's written testimony, because they
are so much at odds at what anything else anybody has said
here.
``To date, however--'' page 7 ``--we have not found marked
and widespread fraud by these firms.'' Page 13, ``The staff has
found isolated instances where day-trading firms appear to have
failed to comply with margin requirements or properly disclose
terms and conditions of loans in contravention of SEC rules.''
Mr. Levitt was also kind enough to say that day traders don't
add to volatility.
Senator Levin had asked a very perceptive question before,
he never got an answer, and that had to do with margin. It was
perceptive in two ways. One was what would happen if you didn't
come up with money, and the answer is, if you didn't come up
with money, then after 7 days your account would be frozen and
you will not be able to do anything but liquidating
transactions. That's a universal rule.
The part that I thought was interesting was that it
indicated that it was possible to make a profit on a margin
trade. All we've heard today so far is people going to margin
because otherwise they're going to go broke sooner. But the
point is that you can go into margin, and lots of people go
into margin transactions because they want to keep profitable
trades.
On-site traders will emphatically tell you that they're not
gamblers and day trading is not gambling. ETA traders have an
extremely high percentage of college and professionally
educated people. The New York Times pointed out just in August
that ``many former professional traders, brokers and financial
service professionals are becoming full-time day traders.''
Successful day trading requires skill, hard work, and
access to state-of-the-art technology.
And while I'm at it in regards to this, in terms of risk
disclosure, ETA has supported risk disclosure much broader and
deeper than the NASD risk disclosure. It has been in place for
months. And it requires that the particular individual involved
sign the risk disclosure statement.
Senator Levin, because I know margin is of interest to you,
there is language in here that says you may sustain a total
loss of the initial margin funds and any additional funds you
deposit with your broker, and you may incur losses beyond your
initial investment. There is lots and lots of disclosure in
that form.
You may well be, to go back to the subject of gambling,
aware of people who are called ``quant'' traders. These are
people who invest millions of dollars in computers, special
phone lines and software, so that they can day trade
successfully. They're not gamblers. They are market
professionals.
Day trading is not a cult, although sitting here today, I
wondered about that, from a regulatory view, and there is
nothing new about day traders. They have always existed on
exchange floors. They're still there today. At least since the
advent of Thomas Edison's stock ticker, there have been day
traders in what are called upstairs offices.
Now, I have repeated on-site day traders several times to
differentiate these 4,000 or so individuals who Mr. Levitt also
mentioned in his written statement have a very limited reach,
so it's important to understand what we're looking at. From the
estimated 250,000 people encouraged to trade on line through
such household names, including the one the Chairman mentioned,
Charles Schwab and Discover. You may have seen the Discover ad
which shows a pig farmer who trades on line. The copy for the
ad runs, ``Gorden Gekko, Eat Your Heart Out. Wall Street used
to be about greed. Now it's about brains, about taking control
of your money. So go ahead. Yup.'' That's a New York advertiser
trying to be a farmer. ``Just a mouse click away.''
Now, contrast the pig farmer with the on-site trader. ETA
members get almost instantaneous executions, very often
instantaneous executions. The farmer doesn't. ETA traders get
price improvement. And if we're talking about consumer issues--
and that's the most important consumer issue this Subcommittee
ought to be concerned with--the pig farmer does not get price
improvement. His order goes to a market maker in a preferencing
arrangement. ETA traders take advantage of the firm's
intellectual capital. That is, the people around them, the
experience of the other traders--well, I guess the pig farmer
has his pigs.
It's very important, when we talk about on-site trading and
risk, to understand that you would have to be totally oblivious
to the world to not understand the risk because you are sitting
in that office, cheek by jowl, with other traders.
Now, there are, of course, lots of complaints by day
traders, but they're from the on-line day traders. ``Why is the
system down? Why did it take so long for my order to get
executed?'' There are virtually no complaints from on-site day
traders, so we've got a mystery on our hands. If there are no
complaints, why is NASAA, not the SEC or NASD, seeking to
isolate on-site day-trading brokerages from every other part of
the securities industry?
According to NASAA, on-site firms are a public danger in
three respects. On-site firms routinely violate securities
regulations. To quote Mr. Hildreth, ``day-trading firms need to
play by the same rules the rest of Wall Street follows. If they
don't get their act together, they'll be under increasing
regulatory pressure.''
The NASAA report charges on-site firms with order entry
failings, short sale, margin and books and record violations,
even omissions to disclose the risk of loss, and false
marketing. But NASAA, in its survey of regulatory cases,
apparently hasn't noticed that just over the past 18 months,
and just looking at the top 100 well-capitalized firms by the
SIA, not the hundreds of others--that Merrill Lynch and half a
dozen other firms were disciplined for order entry matters.
Piper Jaffray fined for short sale violations. Schroder, Cowen,
and Fahnestock cited for margin. Salomon Smith Barney and three
other firms, books and records. Merrill Lynch fined $2 million
for sales materials which ``omitted material facts in the risks
of investment losses.'' And Prudential Securities was fined
$500,000 for false marketing information regarding CMO's.
The Subcommittee also, I think, is aware that institutional
investors have been buying interests in on-site firms. I think
you're aware then that these investments are made after
considerable due diligence and simply would not be made if day-
trading firms were securities industry rogues. That's one of
the reasons why I think Mr. Levitt felt comfortable in writing
that there's no widespread fraud.
The second charge against day-trading firms by the NASAA
was that on-site firms engage in deceptive advertising. But it
should be noted that no advertising, even as compelling as the
Discover ad about the pig farmer that I just went through, can
withstand reality. And, by the way, ETA has a statement of
principles that decries in any sense deceptive advertising. It
talks about giving a full picture to people and so forth.
Day traders, as I have said before, are intelligent and
well educated. They are on site. They can quickly observe from
the traders around them what the range of risks and rewards
are. To go back to Senator Levin for a minute, his comment
about ``well, isn't this a surprise when you get the margin
notice?'' Well, if it's a surprise, it's a surprise once. It's
not going to be a surprise the second time.
It is important to understand, by the way, with regard to
risk and the risk of loss, that if this market collapses,
you're much better off being a day trader holding securities
for 4 minutes than people who are holding securities for months
and years, as I am in some of my accounts.
ETA members need not advertise for customers. Most
prospects are references from customers.
A third charge, on-site day traders lose money in wholesale
lots. We have heard over the last year all kinds of numbers. We
have heard 7 out of 10, 8 out of 10, 9 out of 10 lost money.
Massachusetts--and they were here before, Mr. Shellenberger--67
out of 68 lost money at one firm. Well, if that happened, you
would think the Boston press would pick it up and they would
notice 67 people running out of the office yelling ``plague.''
No one is that dumb.
Now the report is out, and I've got to tell you, as
somebody who is a professional in this business, this is an
amateurish report. NASAA's expert, Mr. Johnson, turns out to be
a former commodity trader who earns his living as a plaintiff's
witness, and whose resume, which we have put in our materials,
lists with pride that, for 2 years, he ``published daily hot
line trading recommendations,'' a fancy way, Senator, of saying
that he gave option tips, and that he ``developed a low-price
stock strategy that returned over 30 percent.'' You would think
NASAA would be going after him for that kind of advertising.
This expert, who operates out of his apartment, studied a
grand total of 17 day-trading accounts. These, on average,
traded for 4 months, 2 years ago, one office, on non-ETA firms.
His conclusion? Sixty-five percent of the accounts had a risk
of ruin; that is, if they kept going, never learned anything
but just kept making the same mistake they made before, they
were going to lose money. They would never stop and would never
quit before they lost all their money. They would lose all
their money.
We tried to avoid the numbers game. We tried, no matter
what Mr. Shellenberger is telling you--and there is
correspondence on this and I will supply it to this
Subcommittee afterwards, supply the Blue Sky people with
current information for use in an independent survey. We
provided them with a methodology of four pages. NASAA demurred.
He told you why they demurred. They didn't want to endorse an
independent study.
We estimate, without any claim of scientific accuracy--but
I can tell you that I spoke to a half-a-dozen on-site firms--
that most customers will lose money or break even in the first
3 to 5 months. They're not going to wipe themselves out in the
first 3 to 5 months. They'll lose some money. And that
thereafter nearly two out of three are going to net $28,000 a
month, with the odd man out losing $6,000 to $8,000.
But, hopefully, to put this particular matter to rest,
because it is so important, ETA is in the process of retaining
KPMG to conduct a day-trading profitability study.
Let me go back to another point that was made before,
Senator--and you've really made a number of perceptive points.
One of them had to do with--I think this was asked of Mary
Schapiro--would you allow somebody right out of college to day
trade? A good question. How about right out of Wharton? I
interviewed somebody right out of Wharton in January, who was
out day trading for a year, and he made $750,000 in January. I
felt very foolish being a lawyer.
Given these facts, why has NASAA sought to demonize on-site
day traders? The reason, quite frankly--and they said it here--
is that they want the publicity. This is what Mr. Hildreth said
last January. ``We need to reposition ourselves to cultivate
media contacts. The news media is hungry for good crime
stories, and with a little imagination, we can find them
stories to write about.''
Now let me move finally to something that is more positive.
ETA members seek to meet all regulatory requirements and to
foster high standards of ethics. We have statements of
principles and we have risk disclosure that goes well beyond
the NASD. ETA members tell prospects that day trading is not
for everyone. In fact, ETA's own risk disclosure statement is
broader and deeper than NASD requires, and acknowledging
signature by the customer. We frankly urge that in the NASD's
risk disclosure that they get it signed by customers. ETA's
statement of principles reads, ``We will not make misleading or
exaggerated claims, and will provide a balanced perspective in
our presentation.'' We think you ought to consider asking the
entire securities industry to adopt the statement of principles
along these lines.
The hardest issue to deal with is the appropriateness
issue. It is very, very difficult. It's difficult because it
undercuts what has been years and years of suitability theory.
The security industries association has taken the position
opposed to the NASD proposal because, in the past, all
suitability decisions--and this was spoken to before by Mr.
Colby--dealt with particular trading recommendations, not
overall strategy. So this is a strategy.
We have been working very hard to get to the point where we
can agree with the kind of appropriateness standard. We think
that, in doing that, one of the ways to do it is there are
existing--and you might ask Ms. Schapiro about this--the NASD
has existing rules on option trading. Option trading is a lot
like day trading. It's a collection of different strategies.
It's an approach to the market, not a particular recommendation
thing. It starts off with somebody being approved, getting a
risk disclosure statement and then being approved to trade
options, or in this case, to day trade. We think that's a much
better approach to appropriateness. It's much more focused than
the generalized language they've been using.
Senator Collins. Mr. Cohen, I'm going to ask you to wrap up
your comments.
Mr. Cohen. I will wrap up. OK.
Let me wrap up with what I know is a particular concern of
this Subcommittee, and that is consumers. Day traders help
consumers. Day-traders' activities drive electronic
communication networks, the ECN's. These ECN's provide market
transparency. They are real competitors to market makers. The
market makers are the group disciplined by the SEC and the
Justice Department for collusive pricing, so the result for the
small investor, the consumer, is better quote information and
better handling of retail size orders.
Day traders add importantly to liquidity and depth in the
market without adding to volatility, so the small investor will
find another side when he's ready to buy or sell.
Last, day traders limit orders--and day traders put in a
large amount of limit orders--compete directly with market
makers. The result of that is that dealer spreads are narrowed
and the small investor, the proverbial ``Aunt Janet in
Portland,'' who is selling stock to pay for her daughter's or
her niece's first year in college, is going to get a better
price on her trade because there's a day trader in between the
market maker's spread.
This is the way the SEC intended it, and this is how it's
working.
Thank you very much.
Senator Collins. Thank you, Mr. Cohen.
We are going to take a 10-minute recess because,
unfortunately, we have another vote on.
[Recess.]
Senator Collins. The Subcommittee will come back to order.
Mr. Cohen, I think it's important for the record that I
clarify that the SEC has confirmed to us that the reference in
Chairman Levitt's testimony to the absence of widespread fraud
in the industry was referring to such things as forgeries and
other kinds of outright fraud, as opposed to the widespread
pattern of deceptive advertising.
Mr. Cohen. Did you also ask him about the isolated
instances of margin problems?
Senator Collins. I think, Mr. Cohen, that I'm the Chairman
and you're not.
Mr. Cohen. OK. I'm sorry. I had the belief we were going to
have a discussion of these issues.
Senator Collins. I did want to set the record straight in
that regard.
Mr. Cohen, in your testimony this morning you cited ETA's
statement of ethical principles to support your contention that
day-trading firms do not make exaggerated or misleading
statements regarding trading results. Indeed, the statement of
ethical principles indicates that ETA members ``will not make
misleading or exaggerated claims about our services or the
benefits of day trading, and will provide a balanced
perspective in our advertisements and presentations.'' It goes
on to say, ``We will not obscure the reality that most people
lose money in their initial training period and that many will
not ultimately become successful day traders.''
I would like to show you two statements that were taken off
the Web site of On-Line Investment Services, Inc. It is my
understanding that this company is a member of your board of
governors. Is my information correct on that?
Mr. Cohen. They're an ETA member. I don't know whether
they're a member of the board.
Senator Collins. On-Line Investment Services was one of the
five members of ETA, it is my understanding, who adopted the
statement about the principles from which you quoted in your
testimony. Is that correct, to your knowledge?
Mr. Cohen. Yes.
Senator Collins. I want to show you this first statement,
which says, ``We have a successful rate of about 85 percent
with customer traders, meaning people who come here and
actually make money at this over time.'' \1\
---------------------------------------------------------------------------
\1\ See Exhibit No. 5 on page 219 in the Appendix.
---------------------------------------------------------------------------
Is that consistent with the ethical principles?
Mr. Cohen. It would be consistent if it's accurate. I don't
know whether it's accurate. But the point I would make, because
I have no information on it, is that the language on the
bottom--and I can just about read it without my glasses--
``Cited information is no longer found on Web site.''
The statement of principles is a learning curve for all
industries. The statement of principles was adopted a couple of
months ago. I don't know when this statement was made or when
it came off, but it's conceivable that it's as long ago as a
year or more.
But the two parts to it, that somebody ought to ask again,
is whether or not this is accurate as a statement, and second,
when it was on and when it came off and what the circumstances
were. But I don't know.
It's important to understand----
Senator Collins. Let me understand. Are you saying that
this statement is OK if it was before the statement of
principles?
Mr. Cohen. I'm saying it's OK if it's correct. I'm saying
it shouldn't have been there if it's incorrect, but in any
case, it's before the statement of principles.
What I would say is--and this is important to understand--
ETA represents something like 54 percent of all day traders who
enter a majority of orders. It does not represent all day-
trading firms, nor does it have the power of government to say
do this or do that. The fact that someone may or may not
subscribe to ethical principles doesn't mean they're going to
do it. On the other hand, the ethical principles were
formulated and the discussion was formulated over the past few
months, as this industry continues to learn and to grow,
because it's very important to this industry--and I will now go
back to what the Blue Sky people said, that this industry gain
community acceptance. So the purpose of us being here is to
dispel a number of misconceptions with the hope that we will
get a fair hearing, so that a number of these misconceptions,
in fact, can be dispelled.
Senator Collins. Well, one reason you're being asked to
testify today, and were given the opportunity to make your
opening statement, was to make sure that the industry's
viewpoint was represented.
Mr. Cohen. I'm sorry, Senator. I'm not making it clear, and
it's my fault, not yours.
We represent 54 percent of the day traders. I cannot tell
you we represent the entire day-trading industry.
Senator Collins. I understand that, Mr. Cohen, and that is
why we selected examples of deceptive advertising to show you
that are from members of your association. We're not asking you
about nonmembers.
Mr. Cohen. Well, I appreciate that. I have seen just one,
and what I've said with regard to it first is that I don't know
whether it's deceptive because I don't know what the number is,
from an accuracy standpoint, and I don't know what the date is
and whether it reflects the statement of principles that was
adopted 2 to 3 months ago.
Senator Collins. My point is that a company should not be
making deceptive statements----
Mr. Cohen. If it's deceptive. I agree with you. There is no
dispute----
Senator Collins [continuing]. Regardless of whether it's
before or after the statement of principles.
Mr. Cohen. If it is deceptive, it shouldn't be on there. If
it's not----
Senator Collins. Let me show you a similar statement, again
by On-Line Investment Services, which is a member of your board
of directors. I have confirmed that----
Mr. Cohen. Again, can you tell me when these were? Are you
talking about 1998?
Senator Collins. I believe that these were within the last
year. I am uncertain when they were removed.
But that is not my point. My point is that it is troubling
if it is misleading consumers at any point.
Can I ask you about this statement: ``On-Line's trading and
mentoring programs boast an 85 percent success rate for new
traders.'' \1\ Do you think that is accurate? Could it possibly
be accurate?
---------------------------------------------------------------------------
\1\ See Exhibit No. 5 on page 219 in the Appendix.
---------------------------------------------------------------------------
Mr. Cohen. Could it possibly be accurate? I don't know
whether it is accurate or not accurate. I just wouldn't hazard
a guess as to whether it's----
If it is not accurate, it should not be used. I don't think
there's any doubt. And I agree with you. Whether you have a
statement of principles or not, you should not use statements
that are inaccurate. I just can't tell you whether it's
accurate or inaccurate.
Senator Collins. You noted in your testimony--you said in a
very straightforward way that disclosure of risk is simply not
an issue. That's on page 6 of your testimony.
Mr. Cohen. That's right.
Senator Collins. The problem with that is the preliminary
results of the joint examinations, the results announced by the
SEC and NASD today, suggest otherwise. We have written
testimony from Chairman Levitt saying that the SEC staff
examined the Web sites of 40 day-trading firms and discovered
that half of those Web sites today--I'm not talking about last
year--had little or no risk disclosure, and many of them
downplayed the risk associated with day trading.
Do the SEC's preliminary findings that you've heard today
change in any way your view that the disclosure of risk is not
a problem with this industry?
Mr. Cohen. I don't believe disclosure of risk is a problem,
and I'll tell you why.
First, ETA members, although we're 54 percent of the
industry, six firms, I don't know what the other 34 firms are
doing. But beyond that--and this is the important point, and I
don't seem to be able to get it across--no matter what the risk
disclosure was, you could put it in neon lights, when you show
up at a day-trading firm, if you're there a day, 2 days, 3
days, you will know every risk. You don't have to have it
spelled out.
I'm not suggesting there shouldn't be risk disclosure, or
that people shouldn't sign off on it. What I'm saying is that
common sense will tell you that if you spend 24 hours in day-
trading firms, you're going to know what's going on. This is
very different from where people are in the rest of the
brokerage business. Because in the rest of the brokerage
business, you're isolated. You are one customer with one
broker, or one customer with an on-line firm, and you don't
know what's going on. You don't know what the risks are.
But here you're present and viscerally you know what the
risks are. You cannot miss the risks if the guy next to you is
losing a lot of money. You will know what's happening, or
someone else will.
Senator Collins. Do you support the NASD's appropriateness
rule?
Mr. Cohen. I have gone through that before. I think the
difficulty with it is that the Securities Industry Association
has pointed out--and it's important to understand, that day
trading, as a group, is just a small part of the securities
industry, that there has never been a test like that in
general, that all tests have dealt with specific securities.
That was the testimony, the recommendation as to specific
securities.
ETA would like to have some form of appropriateness test.
It doesn't think the model that's been given is a good one. The
model we're suggesting that people look at is the option rule,
2860, the NASD option rule, which says that first you give
people risk disclosure, they sign off on the risk disclosure,
and then they sign up for particular strategies. Because what
day trading is, just like option trading, it is a series of
strategies. All risky, some riskier than others.
Senator Collins. I don't see what you could object to in
the appropriateness rule. All it is doing is requiring a day-
trading firm to sit down with the customer, to get basic
financial information, to look at whether or not day trading
might be an appropriate strategy for this individual, to look
at their investment goals.
What's wrong with that? Wouldn't that screen out some of
the people----
Mr. Cohen. Senator, I----
Senator Collins [continuing]. Who should not be engaging in
this practice?
Mr. Cohen. Senator, what I heard----
Senator Collins. Mr. Cohen, I would appreciate you letting
me finish my question.
Mr. Cohen. I'm sorry. I thought you had. I apologize.
Senator Collins. My point is, what is wrong with having an
up-front screen that would screen out some people for whom day
trading is clearly inappropriate because of their financial
status?
Mr. Cohen. May I answer now?
Senator Collins. I would appreciate your answer.
Mr. Cohen. I was one of those who watched Chairman
Greenspan's testimony on the long-term capital management
disaster. He made a number of points, one of which was
regulation for the sake of regulation really doesn't do much
good.
An appropriateness test, in general, is not going to do
much good if it's blurry and is completely generalized, which
is why we have suggested focusing on an options test. What I
will tell you is that these things can have an unfortunate
effect, what is known as regulatory ``creep,'' which is that
when you start off with regulations that are blurry to begin
with--if you look at the NASDR's regulation, for example, they
say we don't define the word ``promote.'' We're not saying who
promotes day trading. That's very important. They don't define
it. They say we're not going to define it. Leave it open.
Well, I think it's a lot less of concern to on-site day-
trading firms than it is to on-line firms, who I think are in
an impossible position, because one of the tests the NASDR has
in its suitability proposal is that you are promoting day
trading, even if you do not advertise. I think I indicated
before from the Discover ad, where the advertising is, that
even if you don't advertise, if you have any day traders. Well,
there are on-line firms with a million and a half customers. If
one percent of them, one percent, are day trading, doing two or
three trades a day, that's triple the amount of day traders in
the day-trading industry.
So this is a much broader and wider question, which is why
the Securities Industry Association is opposed to this. What we
have tried to do is look at it constructively and say let's get
something that can work. We think the options model is the one
that works.
It's a little hard, frankly, to be criticized--I'm not
suggesting you're criticizing--but to ask pointed questions
when we're saying look at something more focused than more
general with regard to this.
Senator Collins. Let me turn to another practice that
troubles me. Many day-trading firms have customer lending
programs and they, in fact, promote and arrange loans from 1
day trader and customer to another.
Isn't the result of that practice to encourage people who
are losing money to keep on trading?
Mr. Cohen. Senator, you may have been out for a vote when I
answered that before, with regard to Senator Levin. He had used
a very good example of somebody who made money, and I pointed
out to him that yes, in fact, there are perfectly good reasons
why one would lend money to someone else.
First of all, this loan was no risk. These are closed
transactions. They're not open transactions. So the risks are
known.
The practice of lending money from account to account has
gone on as long as the securities industry has gone on. It is
noted. There's a New York Stock Exchange rule, 431(f)(4) that
deals with it. There are letters of authorization forms that
have existed since I've been in practice. So there is nothing
special about it.
One of the problems that this Subcommittee seems to be
having is building on an edifice that I don't think is there,
on a base that's there. You're focusing and trying to turn this
part of the securities industry into something separate from
the rest of the industry. But every regulation you write has an
impact on the rest of the industry, and that's why you get
opposition from the Securities Industry Association.
Senator Collins. I think the problem the Subcommittee is
having is that we're very concerned when we hear from State
regulators, from the SRO, from the SEC, that day trading is a
real problem and that we do need effective new regulations in
order to ensure that small, unsophisticated investors realize
what they're getting into, realize how highly risky this
practice is, and realize, in fact, that they are likely to lose
their money.
Mr. Cohen. I'm sorry. If I may just finish----
Senator Collins. You may respond.
Mr. Cohen. I'm in agreement with you up to the last five
words, and that is, yes, it's risky, they should have these
disclosures made, there are disclosures. I don't think there's
a certainty that people will lose money in on-site day trading.
But hopefully, when the study, the real study is done and
it's over, there will be a much better feel of statistics to
argue about than we have now.
Senator Collins. Senator Levin.
Senator Levin. One of the day traders that we're familiar
with says the following in their literature, the material that
they hand out. ``Prior experience in trading is not essential
to be successful in this business, although it is important to
understand that all forms of investing involve risk in the loss
of capital. An investors lack of familiarity with securities
trading can even be a strong asset, not a liability.''
Do you agree with that?
Mr. Cohen. Yes.
Do you want an explanation?
Senator Levin. If you want, sure.
Mr. Cohen. Mr. Levitt and I, I guess, share one thing,
which is age. We were around in the Sixties when there were
``gunslingers,'' people who traded the market successfully
because they hadn't learned any of the lessons of the past,
because each market is different and each thing changes. So not
having previous experience can be an advantage because you're
starting fresh.
I have gone to day-trading firms. I have sat down with the
people. They are more or less uniform, the ones I have seen.
They are young, they are computer types, people who have grown
up with video games, and they sit there in half-darkened rooms,
like a movie theater, looking at screens--it's not something I
could do for 10 minutes, and they can do it endlessly, looking
at it. And up until the end of the day, they count it as
counting points.
Now, whether or not that is a comfortable style of
investing for people of my age, I can't tell you. But that's
where the world is. It's taking advantage of the information
edge that is provided by this technology in the same way that
people took advantage of the information edge of Mr. Edison's
stock ticker 110 years ago.
Senator Collins. Senator Levin, would you allow me to
intervene on just one point on that, because I think you've
raised a very interesting point, and Mr. Cohen's response is
interesting to me.
The NASD has proposed as part of the risk disclosure
statement that potential clients of day-trading firms receive a
statement saying that day trading requires knowledge of
securities markets. So would you oppose that statement being
included?
Mr. Cohen. By the time you start day trading, you will have
knowledge of the securities markets. I don't think we're
talking about----
Let's see what we're talking about. I don't think Ms.
Schapiro is going to say we expect you to have taken courses in
finance or have an MBA, and no one is going to start day
trading in an on-site firm, day one, without any knowledge of
how the business works. So I don't think that's a problem for
anyone in terms of how the markets work.
Does it mean you could get a job at Goldman Sachs as an
analyst or a technical analyst somewhere? No. But I don't think
that's anybody's test.
Senator Collins. Senator Levin.
Senator Levin. Do you think these day traders are
investors?
Mr. Cohen. No.
Senator Levin. Pardon?
Mr. Cohen. No. It's an approach to the market to make
money. Some are going to be successful and some won't.
Senator Levin. Then you don't agree with the part of the
statement I read, which says an ``investor's'' lack of
familiarity----
Mr. Cohen. Senator, the trouble is, when somebody writes
articles, you can only use so many words for the same thing. An
investor is one of these----
Senator Levin. This isn't an article. This is the day
trader's literature.
Mr. Cohen. ``Investor'' is a word that is used commonly for
anybody who trades in the market. It's an old----
Senator Levin. You would agree they're not investors?
Mr. Cohen. They're not investors. These are people who are
traders.
Senator Levin. Are you telling your members not to describe
themselves as investors?
Mr. Cohen. I'm sorry?
Senator Levin. Are you telling your members not to describe
these folks as investors?
Mr. Cohen. If I'm asked, I'll tell them to try to find
better phrasing. Traders would be better.
Senator Levin. You're telling your members a number of
things, though, aren't you?
Mr. Cohen. When I'm asked. I should point out----
Senator Levin. Aren't you asking them to get risk
disclosure statements signed?
Mr. Cohen. Let me answer it in two ways, OK?
First, I have been counsel to ETA only since August,
although my views and theirs are the same broad identification.
Second, I don't see a reason why you wouldn't have them sign
risk disclosure statements.
Senator Levin. You are asking them to do that?
Mr. Cohen. The ETA is asking them.
Senator Levin. Your client.
Mr. Cohen. ETA, as my client, is asking its members to have
day traders sign risk disclosure forms.
Senator Levin. So when I say ``you,'' I mean you or your
client.
Mr. Cohen. The client. I don't see anything wrong with it,
so if you want me to identify with it, I will.
Senator Levin. Good. Your client then is asking its members
to sign this risk disclosure statement, which is Appendix C in
your materials. Is that correct?
Mr. Cohen. Yes.
Senator Levin. But your client is not asking people to
avoid the use of the word ``investor''?
Mr. Cohen. Senator, what we will do is, when the NASDR
approves its appropriateness rule, which I assume is going to
happen, we will send this to NASDR advertising for review and
ask them to sign off on it. I don't think they're going to have
a problem with the word ``investor,'' but if that's a problem
for anyone, it will be changed to ``trader.''
Senator Levin. Relative to that disclosure statement,
Appendix C, is this something which is required for signature
by your members of their customers, or is this just something
which is recommended to----
Mr. Cohen. It's a trade association recommendation. We
don't have the power to enforce it.
Senator Levin. You have the power to do anything you want
and say ``you're not going to be a member of this association
unless you follow our rules.'' You can do that, can't you?
Mr. Cohen. Pardon?
Senator Levin. Any association can say its members have got
to live up to the rules.
Mr. Cohen. Trade associations--and I was at various times
associated with membership of the Securities Industry
Association--basically provide recommendations to their
members, and beyond that, as long as the member is in good
standing, the member stays in good standing. So that is a
wonderful example, and perhaps you ought to apply it to a group
that represents hundreds of brokers rather than six.
Senator Levin. My question, though, is this, that you can
make the adoption of this risk disclosure statement a condition
of membership of the association.
Mr. Cohen. I assume we could if somebody thought that was
crucial to life, yes.
Senator Levin. All right. Do you know how many of your
members in fact require their customers to----
Mr. Cohen. I don't.
Senator Levin. Do you care?
Mr. Cohen. Do I care? Yes. I would certainly like to know
later on.
Senator Levin. Could you find out for us?
Mr. Cohen. Oh, absolutely.
Senator Levin. How many members do you have again?
Mr. Cohen. We have 6--we have 40-something members, but 6
are----
Senator Levin. I'm sorry. Forty?
Mr. Cohen. Forty-something firms. Six are on-site trading
firms. Those on-site trading firms represent 54 percent of all
traders, day traders, so far as we know.
Senator Levin. So----
Mr. Cohen. It is, again, our estimates.
Senator Levin. I understand. Your estimate is that you
represent a majority of the day traders.
Mr. Cohen. Right, and a majority of the day-trading orders
being placed.
Senator Levin. I would like to ask you about the informal
survey that you referred to on page 11 of your testimony.
Mr. Cohen. Right.
Senator Levin. You have surveyed certain of its members to
obtain a rough estimate of customer profitability.
Mr. Cohen. Right.
Senator Levin. Then you said these estimates were that
after an initial period of 3 to 5 months of losses, 60 to 65
percent netted in the range of $28,000 per month, but the
balance of customers losing $6,000 to $8,000 per month.
What was the capital investment that that represents?
Mr. Cohen. I'm sorry. I don't understand the question.
Senator Levin. Well, how much of $28,000 is what percentage
of their investment that they have put down in the firm of
their capital?
Mr. Cohen. Anywhere between, I would say, 28 and 56
percent.
Senator Levin. Of their what?
Mr. Cohen. Twenty-eight and 56 percent.
Senator Levin. Of their capital?
Mr. Cohen. Of their capital. I am talking $28,000 a month,
300 percent a year, current, if you make that kind of money, on
$100,000.
Senator Levin. Let me say that the--let's talk about that
initial period of 3 to 5 months of losses. Let's just focus on
that. What was the average loss in that 3 to 5----
Mr. Cohen. I didn't--and I apologize for this. I didn't
take it down to a number, but the understanding I had when I
was finished was that it was not a significant number. It was a
loss number, but it wasn't a wipe-out loss number. It was a
loss number.
Senator Levin. Can you provide that to the Subcommittee?
Mr. Cohen. From our six firms? Yes.
Senator Levin. Well, whoever you did this informal survey
of.
Mr. Cohen. Yes, absolutely.
Senator Levin. I mean, you have told us----
Mr. Cohen. Senator, yes.
Senator Levin. Were you asked for this information by
Massachusetts or by the NASAA?
Mr. Cohen. I don't--I really have nothing to do with
Massachusetts. I'm not sure. You are talking about ETA being
asked by Massachusetts?
Senator Levin. Yes.
Mr. Cohen. The Massachusetts thing is fascinating in
itself.
Senator Levin. Without getting into that, we had testimony
this morning that you were specifically asked for the backup
information here.
Mr. Cohen. And we were willing--not with regard to--we are
talking apples and oranges.
Senator Levin. Relative to this survey of yours.
Mr. Cohen. Let me see if we can define it, OK?
Massachusetts is talking about some comments that the Los
Angeles Times ran in an article in January in which--and then
there was correspondence back and forth, and I was not the
counsel involved in it, between Massachusetts acting, I guess,
for ETA, acting for the Blue Sky people from NASAA and ETA.
That correspondence is apparently subject to two
interpretations. I think the Subcommittee ought to look at the
correspondence. My understanding of it is that the--and that is
what is reflected in the written submission--is that ETA
offered to submit current information to NASAA with the
methodology, which I have actually seen the methodology, we can
supply it, and NASAA said no. And I think Mr. Shellenberger
told you why he said no, because they did not want to endorse,
as he put it, what the results would be.
So the second survey that we are talking about is one that
is at a later point, that I participated in, in this past
summer--and I don't recall. I think it was in August--in which
I spoke to a number of the firms and got those responses.
Senator Levin. I am referring to the informal survey. Were
you asked by them for any information relative to that informal
survey that you refer to page 11?
Mr. Cohen. ETA--I should look at the statement because I
think we are talking about different things.
Senator Levin. That is what I want to find out. Are you
saying to us that that informal survey that you have taken,
that you refer to on page 11, is not the subject of any request
by the----
Mr. Cohen. It says there are--it is actually clearly
written as I look at it: Earlier this year ETA informally
surveyed certain of its members to obtain a rough estimate of
customer profitability. Its members considered these numbers
still to be representative in August. My understanding was that
earlier this year, membership--one or two of the members had
been asked about it--these were their numbers. For the purpose
of dealing with this as an issue, there was a--as part of a
phone conference, the subject came up, what are the numbers,
can I get a feel for the numbers. I raised the question. These
are the responses I got from the particular people. So I am
comfortable that is what I was told, and these are estimates.
And the only way anybody is ever going to get comfortable with
this is to do what ETA now proposes to do, and that is to get
KPMG or someone else to do a study.
Senator Levin. But I want to go back to my question.
Mr. Cohen. OK. Senator, I am told the information has been
supplied both to the Subcommittee and to the Texas regulator
that asked the questions. That's what counsel for----
Senator Levin. All right. That answers it. My time is up
for this round.
Mr. Cohen. All right. Sorry.
Senator Levin. Thank you.
Mr. Cohen. Is that what these lights mean?
Senator Collins. I apologize for not giving you an
explanation, and I assumed the staff had done so.
Mr. Cohen. I thought I was almost boiled.
Senator Collins. I have another commitment that I have to
keep. I have asked Senator Levin to proceed with the hearing
because there are a number of additional areas that we are both
eager to pursue with you, Mr. Cohen. So I am going to turn over
the Chairman's gavel to Senator Levin with my thanks.
I do want to take this opportunity to thank our staffs for
their very hard work on this hearing and to let people know
that the Subcommittee's interest, if anything, has only been
strengthened by the overview hearing today. We will be
continuing in an ongoing investigation to look at the specific
practices of selected day-trading firms to gain a better
understanding of this day-trading phenomenon.
So, with that, I would thank Senator Levin for his
willingness to continue the hearing in my absence.
Senator Levin [presiding]. Thank you, Madam Chairman.
I want to go back to page 11 to understand what it is you
are telling the Subcommittee. What is the average amount of
capital that was put up at risk that this net of $26,000 is
based on? Is that the capital investment of $100,000, 60 to 65
percent, in the range of $28,000 a month? Give us an update.
Mr. Cohen. The $28,000 is a P&L number. Capital is a
balance sheet number. I mean, they are different things.
Senator Levin. Right.
Mr. Cohen. My understanding of capital is that--and this is
based simply on my understanding, having worked with day
traders over a period of months, is that capital runs from
$50,000 to $100,000.
Senator Levin. So you are saying that this informal survey
demonstrated that after an initial period of 3 to 5 months of
losses that 65 percent profited, in the range of $28,000 per
month based on an average capital investment of perhaps $50,000
or $100,000.
Mr. Cohen. Yes.
Senator Levin. You are going to supply us the data to
support that estimate?
Mr. Cohen. I understand data regarding those estimates have
been supplied to the Subcommittee, but if they have not, I will
find out from counsel who is doing it.
Senator Levin. Now----
Mr. Cohen. I would also think it would be useful to wait
for the KPMG study.
Senator Levin. That may or may not be useful, but the basis
of this representation would be very useful to me.
Mr. Cohen. The representation----
Senator Levin. People who have $50,000 or $100,000 at risk
and are making $300,000 a year profit, that is an absolutely
incredible representation that you are making.
Mr. Cohen. Here is what we wrote. In August, ETA's
executive committee members considered these numbers still to
be representative. Please note that these are only estimates.
Unlike the NASAA report, they do not purport to be scientific.
No one is purporting or representing these are scientific. This
was the feel of the people who are running these firms that
these were the numbers.
Senator Levin. You are representing to this----
Mr. Cohen. Absolutely. I am representing that I was
informed by the----
Senator Levin. Well, let me finish my statement now.
You are representing to this Subcommittee that the
estimates, the estimates of certain of your members to get an
estimate of customer profitability demonstrates that after an
initial period of 3 to 5 months of losses, 60 to 65 percent of
those day traders netted in the range of 28,000 per month which
is over $300,000 a year, based on a capital investment of
$50,000 to $100,000. Now, that is what you are representing.
Mr. Cohen. Absolutely. And let me say further that the
capital issue really is not important because it----
Senator Levin. It may not be to you.
Mr. Cohen. If the average trade is 700 shares and the
average NASDAQ stock is $27.15, according to the SIA
statistics, you are talking about an average trade of $20,000
that somebody holds for 4 minutes.
Senator Levin. I understand.
Mr. Cohen. OK.
Senator Levin. I am only talking about a return on how much
money you are putting at risk. That is what I am talking about.
Mr. Cohen. Well, we have not done it as a return on
capital, but we have put it as P&L numbers, the way it was
written here.
Senator Levin. I understand.
I will tell you again, I find that estimate incredible, and
I would like to see the data that supports it, and I think it
is the kind of touting----
Mr. Cohen. Well, it will either be or it will not be.
Senator Levin. I think it is.
Mr. Cohen. Well, let's wait for the numbers.
Senator Levin. Yes. But I think it is the kind of touting--
I am stating my opinion. I am giving you my estimate now. You
are telling the world----
Mr. Cohen. Well, as a lawyer, when I speak to clients----
Senator Levin. Well, now, let me finish. Keep $50,000 here
or $100,000 at risk. Play with it for a year. You will make
$300,000--no. Two-thirds of you will make $300,000.
Mr. Cohen. I don't----
Senator Levin. That is what you are saying the estimate of
your members are.
Mr. Cohen. I think that is what you are saying it says.
Senator Levin. No, that is what you said.
Mr. Cohen. Can I use my own words?
Senator Levin. Now it is your turn.
Mr. Cohen. Thank you very much.
What this says is that there is a period of time in which
people will lose money. It is part of the normal learning
curve, and that after that period, people will make money, and
two out of three will average something like $28,000 net a
month. That is based on discussions I have had with people
running on-site firms, and I have no reason to believe that
since they are there every day and more or less have a feel for
it that those are not correct estimates, but we do not
represent they are scientific and it says here they are not
scientific, which is why we are going out to get KPMG to get
these numbers.
Senator Levin. You are also representing that they consider
these numbers to be representative?
Mr. Cohen. Yes.
Senator Levin. That is a tout.
Mr. Cohen. It is a tout--if it is inaccurate, I am saying
what it says here.
Senator Levin. OK.
Mr. Cohen. We consider them to be representative. We spoke
to our people. They believe they are representative.
This is a document produced for this Subcommittee.
Senator Levin. It still ought to be accurate.
Mr. Cohen. It is accurate, so far as I know, and I would
think you would want us to give you the broadest possible read
we can, which is what we tried to do.
Senator Levin. Yes.
Mr. Cohen. Apparently, Senator, you have less problems with
the NASAA report written by this guy out of his apartment.
Senator Levin. Yes. I have a lot of problems with this
report here because I do not believe you can put $50,000 to
$100,000 at risk and then over a period of a year, two-thirds
of the people who do that get back a return of over $300,000. I
do not believe it.
Mr. Cohen. Senator----
Senator Levin. OK? I just do not believe it.
Mr. Cohen. Well, that is fair. You----
Senator Levin. You apparently do believe it.
Mr. Cohen. You certainly----
Senator Levin. Do you believe it?
Mr. Cohen. I believe it. I certainly feel you are free not
to believe it, but you also might ask yourself the question why
haven't there been any complaints. Why if in fact something
like 70 percent of people lose money in 6-month periods which
mean 20,000 over 3 years, NASAA, this Subcommittee, the SEC,
and the NASD have not been inundated with complaints by losing
day traders?
Senator Levin. I think maybe people want to gamble.
Mr. Cohen. Well----
Senator Levin. If people want to gamble, you say they ought
to be free to do so.
Mr. Cohen. The American--I haven't said that at all. What
we have said is this is not gambling, that the people who trade
in this market--Senator, I do not know what your previous
profession was. You are good at it. I assume you were a lawyer.
But this is not gambling.
Senator Levin. See, you made another assumption here. That
I was good at it. [Laughter.]
Mr. Cohen. I have often been criticized for criticizing
people, but to be criticized for praising somebody is a little
different, but it is Washington and I am not used to it.
I do not know if you were here when we talked about it, but
the opening of my statement, I said that day traders do not
regard this as gambling. That is a quote that is in the
newspapers. That is something you can find. The people who do
it do not think they are gambling. They think they are using
informational edges in order to trade successfully.
Senator Levin. I would like to go to another statement of
yours on page 17 of your testimony, where you say day trading
is not gambling.
Mr. Cohen. Yes.
Senator Levin. You say the majority of those who day-trade
after training do not lose money.
Mr. Cohen. Yes.
Senator Levin. What is that based on?
Mr. Cohen. That is based on the same survey.
Senator Levin. This same unscientific survey?
Mr. Cohen. This same unscientific survey.
Senator Levin. I do not see all of those qualifiers next to
your statement here.
Mr. Cohen. Senator, I kind of feel that when people read
the document, they read it as a whole, but that may well be a
failing, and I will footnote things in the future.
Senator Levin. No, I think----
Mr. Cohen. When I write Law Review articles, I put
footnotes after every sentence, so----
Senator Levin. That is the kind of unqualified statement
which people believe.
Mr. Cohen. Well, if they don't read the whole thing.
Senator Levin. Most people do not read 25 pages of
testimony. They will look at one flat-out statement. The
majority of those who day-trade after training do not lose
money. That is what they hear.
Mr. Cohen. I was here this morning sitting in the audience
when somebody quoted something out of context that I said in an
article that I wrote. So I know people on this Subcommittee
certainly don't read entire articles.
Senator Levin. Well, are you saying that that is out of
context, what I just read?
Mr. Cohen. What I am saying is that my article was out of
context as it was quoted, and what this says, if you refer back
to part of the summary--it is part of the summary, which I
think fairly said means if it is part of a summary, you go back
to the full text where it is referred to.
Senator Levin. OK. You are going to let the Subcommittee
know what percentage of your members require your Exhibit C to
be signed by their members. Is that something you are going to
give us?
Mr. Cohen. Yes, sir.
Senator Levin. If you have not already given us the
material that supports this unscientific survey of yours, you
are going to let us have the background material for your
conclusion about netting $28,000, two-thirds of the people per
month.
You also indicated that you would supply to the
Subcommittee what were the losses during the 3-to-5-month
period.
Mr. Cohen. I don't recall you asking that, but if it is
part of the same stuff, it is all the same material. So it
should be----
Senator Levin. Would you do that----
Mr. Cohen. Yes.
Senator Levin [continuing]. If I did not ask for it? I will
ask for it now.
One other question. You said that after training, you
indicate that the majority of those who day-trade based on that
informal survey are now saying that they do not lose money.
Does that training include the 3 to 5 months of losses?
Mr. Cohen. Yes.
Senator Levin. You consider that part of training?
Mr. Cohen. Yes. That is part of the learning process. I
could have used a different phrase. I apologize for the
phrasing. It could have been after the learning process, but
everybody is always learning.
Senator Levin. You also have training before the 3 to 5
months begins, don't you?
Mr. Cohen. Senator, let me answer it this way. A lot of
people who come into day trading have traded previously. There
was a New York Times article that said professionals are coming
to the business. So they presumably start trading day one with
a vast amount of skill and experience. If we are talking about
people who have not traded before, what we are talking about in
their case is this 3-to-5-month period, which includes training
and actual trading.
Senator Levin. I guess my question is: You do training
prior to the actual trading? Does some of the training that you
are referring to take place before the actual----
Mr. Cohen. I believe firms train people who have not been
in the market before, that they have training programs. They
certainly have training programs. I cannot tell you whether
every on-site firm has got one.
Senator Levin. If in fact your survey is accurate that most
people lose money in the first 3 to 5 months, assuming you are
accurate on that, would you be willing to have your risk
disclosure statement notify people that most people lose money
for 3 to 5 months?
Mr. Cohen. I think it says it now, but I haven't gone back
over it.
Senator Levin. No. I do not think it says quite that. It
says you can lose money. I am asking----
Mr. Cohen. I thought it says--well, I apologize. I am not
able to find it, but I do not have a problem if that is your
question that people lose money in the first 3 to 5 months.
Senator Levin. That most people.
Mr. Cohen. That most people.
Senator Levin. You do not have any problem in modifying
your statement?
Mr. Cohen. I don't see a reason not to.
Senator Levin. Good.
Mr. Cohen. By the way, that, of course, goes well beyond
the risk disclosure of the NASDR, but we are well beyond where
the NASDR is.
Senator Levin. I think that would support that claim if you
did that.
We want to thank you and the other witnesses for appearing
today. The hearing will be recessed. We will now adjourn this
hearing because it is the first of a series of hearings.
Again, I want to thank our Chairman for her leadership
here. We are getting into an area which I think all of us would
acknowledge as an extremely important area to consumers, and I
think you also would acknowledge that, Mr. Cohen, even though
there is obviously a difference here that this is a very
important area to consumers. I think that on that, you would
not disagree.
Mr. Cohen. What I would say--thank you for the opportunity
at least to comment on it. The consumers I would be concerned
about are the online as opposed to the on-site people, and what
I would say is it depends where you look in the telescope. What
I am looking at the telescope is the on-site day traders are
providing enormous benefits to consumers, the average guy
throughout the market.
Senator Levin. I thank all of our witnesses for coming
forward.
One other question, just for you and the other witnesses,
if we still have them here. If we have additional questions for
the record, whether you would be willing to answer those
questions?
Mr. Cohen. Of course. \1\
---------------------------------------------------------------------------
\1\ See Exhibit No. 9 on page 228 in the Appendix.
---------------------------------------------------------------------------
Senator Levin. I do not know if our other witnesses are all
here.
Mr. Hildreth. Yes.
Senator Levin. Thank you all.
Mr. Cohen. Thank you.
Senator Levin. We will stand adjourned.
[Whereupon, at 1:10 p.m., the Subcommittee was adjourned.]
A P P E N D I X
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