[Federal Register Volume 66, Number 44 (Tuesday, March 6, 2001)]
[Notices]
[Pages 13608-13618]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-5402]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-44009; File Nos. SR-NYSE-99-47 and SR-NASD-00-03]
Self-Regulatory Organizations; New York Stock Exchange, Inc., and
National Association of Securities Dealers, Inc.; Order Approving
Proposed Rule Changes Relating to Margin Requirements for Day Trading;
Notice of Filing and Order Granting Accelerated Approval of Amendments
No. 1 to Each Proposed Rule Change
February 27, 2001.
I. Introduction
On December 13, 1999, the New York Stock Exchange, Inc. (``NYSE''
or ``Exchange'') filed with the Securities and Exchange Commission
(``Commission''), pursuant to section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ a
proposal to amend NYSE Rule 431, Margin Requirements. The proposed rule
change would establish margin requirements for day trading in customer
accounts of the Exchange's member organizations. On January 25, 2000,
the NYSE rule proposal was published for public comment in the Federal
Register.\3\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ Securities Exchange Act Release No. 42343 (January 14,
2000), 65 FR 4005.
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On January 13, 2000, the National Association of Securities
Dealers, Inc. (``NASD''), through its wholly owned subsidiary, NASD
Regulation, Inc., also filed a proposed rule change to establish day
trading margin requirements by amending NASD Rule 2520, Margin
Requirements. On February 18, 2000, the NASD proposal was published for
comment in the Federal Register.\4\ Although the NYSE and NASD rule
proposals were substantially similar, they diverged on certain
issues.\5\ To reconcile the differences between, and provide for
uniform application of, the two proposals, the NYSE and NASD each filed
amendments to their respective proposals. The NYSE filed its amendment
on September 8, 2000.\6\ The NASD filed its amendment on October 3,
2000.\7\ The Commission received 49 letters regarding the NASD proposal
and 214 letters regarding the NYSE proposal.\8\ The NYSE provided a
response to comments on September 20, 2000.\9\ The NASD filed its
response to comments on October 3, 2000.\10\ This order approves the
NYSE and NASD rule change proposals, as amended.
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\4\ Securities Exchange Act Release No. 42418 (February 11,
2000), 65 FR 8461.
\5\ The NYSE and NASD rule proposals were the result of
deliberations by the 431 Committee, which convenes regularly on
margin issues. The Committee is generally comprised of NYSE and NASD
staff, attorneys from the NYSE's outside counsel, the Board of
Governors of the Federal Reserve System, and representatives from
several clearing firms and broker-dealers. See letter from Alden
Adkins, Senior Vice President and General Counsel, NASD, to
Katherine England, Assistant Director, Division of Market Regulation
(``Division''), Commission, dated October 3, 2000 (``NASD Response
to Comments'').
\6\ See letter from James Buck, Senior Vice President, NYSE, to
Nancy Sanow, Assistant Director, Division, Commission, dated
September 8, 2000 (``Amendment No. 1 to the NYSE Proposal''). The
amendment clarified that the proposed ``knows or has a reasonable
basis to believe'' standard not only applies in the situation where
a customer seeks to open an account, but also in the case where he
or she seeks to resume day trading in an existing account. For
further discussion of the ``knows or has a reasonable basis to
believe'' standard, see infra, Section II, ``Description of the
Proposed Rule Changes.''
\7\ See letter from Alden Adkins, Senior Vice President and
General Counsel, NASD, to Katherine England, Assistant Director,
Division, Commission, dated October 3, 2000 (``Amendment No. 1 to
the NASD Proposal''). The amendment: (1) Deleted a provision
relating to a 90-day period in which a day trader could be
designated as a Pattern Day Trader; (2) clarified that the proposed
``knows or has a reasonable basis to believe'' standard would apply
not only where a customer seeks to open an account, but also where a
customer seeks to resume day trading in an existing account; (3)
clarified that a two-day funds deposit requirement would apply only
to customers who have been designated Pattern Day Traders; and (4)
extended from 30 days to six months the proposed period for
implementing the proposed rule change.
\8\ Some commenters sent letters in response to both the NYSE
and NASD rule proposals. The public files for the NYSE and NASD rule
proposals, including all comment letters received on the proposals
and a List of Commenters that was prepared by Commission staff, are
located at the Commission's Public Reference Room, 450 Fifth Street,
NW., Washington, DC 20549-0609. See infra, footnote 28.
\9\ See letter from James Buck, Senior Vice President and
Secretary, NYSE, to Nancy Sanow, Assistant Director, Division,
Commission, dated September 20, 2000 (``NYSE Response to
Comments'').
\10\ NASD Response to Comments.
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II. Description of the Proposed Rule Changes
A. Margin Trading and Regulation
Trading securities on margin involves the use of credit to finance
securities purchases. A margin transaction takes place where a customer
purchases a security in reliance on an extension of credit (i.e., a
loan) from his or her broker-dealer. Use of a margin loan increases
both the customer's potential return on investment and his or her
financial risk.\11\
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\11\ Since trading securities on margin permits a customer to
purchase securities valued at an amount greater than the equity
available to his or her account, an increase in the value of those
securities yields a higher return on equity than is possible if the
size of the customer's purchases is limited to his or her available
equity. On the other hand, trading securities on margin also makes
it possible for a customer to generate losses that exceed his or her
available equity.
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Section 7(a) of the Act grants authority to the Board of Governors
of the Federal Reserve System (``Federal Reserve'') to regulate the use
of margin credit in order to prevent the excessive use of credit for
the purchase or carrying of securities.\12\ Pursuant to this authority,
the Federal Reserve promulgated Regulation T \13\ to govern extensions
of credit by brokers and dealers. Regulation T contains ``initial''
margin requirements, which limit the amount of credit that can be
extended by a broker-dealer on certain securities transactions.
Briefly, Regulation T generally allows broker-dealers to
[[Page 13609]]
extend credit to customers on ``margin equity securities'' \14\ at 50
percent of the particular security's market value.\15\
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\12\ 15 U.S.C. 78g(a).
\13\ 12 CFR 220 et seq. Regulation T ``imposes, among other
things, obligations, initial margin requirements, and payment rules
on securities transactions.'' 12 CFR 220.1(a).
\14\ The definition of ``margin equity security'' includes any
equity security (as defined in Section 3(a)(11) of the Act) which is
registered or has unlisted trading privileges on a national
securities exchange or the Nasdaq Market. 12 CFR 220.2.
\15\ 12 CFR 220.12(a).
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Regulation T establishes minimum margin requirements, but expressly
does not preclude any registered securities exchange or registered
national securities association ``from imposing additional requirements
or taking action for its own protection. ''\16\ Accordingly, the NYSE
and NASD have, consistent with Regulation T, established their own
maintenance margin requirements, including special maintenance margin
requirements pertaining to ``day-traders.''
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\16\ 12 CFR 220.1(b)(2)
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B. NYSE Proposal
According to the NTSE, the primary purpose of its rule proposal is
to require that certain levels of equity be deposited and maintained in
day trading accounts, and that these levels be sufficient to support
the risks associated with day trading activities. The proposal would
amend NYSE Rule 431, Margin Requirements, to establish special
maintenance margin requirements for customers who engage in day
trading, and to specify minimum equity requirements and buying power
limitations for customers who demonstrate a pattern of day trading. The
Exchange observed that advances in technology have contributed to a
dramatic increase in day trading by customers. In the Exchange's view,
these advancements have also contributed to the establishment of
broker-dealers whose primary business is to provide customers with
direct links to the securities markets, allowing customers to trade
their respective portfolios on-line. According to the Exchange, in this
environment, day traders attempt to profit from intra-day price
movements of securities.
Under current NYSE rules, certain margin requirements must be
calculated based on a customer's ``open'' positions \17\ at the end of
the trading day. If a customer only day trades, he or she has no
``open'' positions at the end of the day upon which a margin
calculation would otherwise yield a margin call. Nevertheless, the same
customer has generated financial risk throughout the day. The NYSE's
rules for day trading address this risk by imposing a margin
requirement for day trading that is calculated based on a day trader's
largest open position during the day, rather than on his or her open
positions at the end of the day. A customer who meets the NYSE
definition of ``day-trader'' \18\ must deposit in his or her account
the amount of margin that would have been required had he or she not
closed his or her largest open position before the end of the trading
day (i.e., generally 50 percent of the largest open position). If a
customer day trades, but does not satisfy the definition of ``day-
trader,'' he or she is still required in general to deposit 25 percent
of the amount of his or her open positions during the day.
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\17\ A customer has an ``open'' position in a security if, for
example, he or she has purchased, but not resold it.
\18\ The rules define ``day-trader'' as ``any customer whose
trading shows a pattern of day-trading.'' NYSE Rule 431(f)(8)(B).
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The NYSE proposes to amend its margin rules covering day trading
because, among other things, the current rule does not adequately
address the risks inherent in certain patterns of day trading \19\and
has encouraged practices, such as the use of cross-guarantees, which do
not require customers to demonstrate actually financial ability to
engage in day trading.
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\19\ NYSE Response to Comments.
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1. Proposed Definition of ``Day Trading''
Proposed NYSE Rule 431(f)(8)(B) generally would redefine ``day
trading'' as ``purchasing and selling or selling and purchasing the
same security in the same day in a margin account.'' An exception to
this proposed definition is provided where a customer: (1) carries a
long position in a security overnight and sells the security the next
day prior to any new purchases of the security; or (2) carries a short
security position in a security overnight and purchases the security
the next day prior to any new sales of the security (i.e., closing
transactions to wrap-up the previous day's activities before any new
purchases or sales of the same security).
2. Proposed Definition of ``Pattern Day Trader''
A customer would be considered a ``pattern day trader'' if the
customer made four or more day trades within five business days in his
or her account, provided that the number of day trades was more than
six percent of the total trades in the account during that period
(``Pattern Day Trader''). The NYSE represented that the six percent
threshold is designed to ensure that customers who engage in a large
number of transactions overall are not inappropriately deemed Pattern
Day Traders solely because there are four or more day trades in their
accounts over the five-day period. Accordingly, a customer that, for
example, transacts four day trades within five business days and also
has a total of 100 transactions during that period, would not be deemed
a Pattern Day Trader, since less than six percent of that customer's
total trades would have been day trades.
Proposed Margin Requirement for Pattern Day Traders
The NTSE's rule proposal would require Pattern Day Traders to
maintain special maintenance margin commensurate with their levels of
day trading activity (``Day Trading Margin''). For day trades in equity
securities, the required Day Trading Margin (``Day Trading Margin
Requirement'') would be 25 percent of either: (1) The cost of all day
trades made during the day; or (2) the largest open position during
that day. If a customer's Day Trading Margin Requirement is to be
calculated based on his or her largest open position during the day,
the customer's firm must maintain ``time and tick'' records documenting
the sequence in which each day trade is completed. For non-equity
securities, the amount of Day Trading Margin would be computed using
applicable special maintenance margin requirements pursuant to other
provisions of NYSE Rule 431.
4. Proposed Time To Meet Margin Calls
The NYSE's rule proposal also would reduce the time allowed for
Pattern Day Traders to meet special maintenance margin calls from seven
business days to five business days. If a Pattern Day Trader did not
meet a Day Trading Margin call within five business days from the time
his or her Day Trading Margin deficiency occurred, the customer would
be restricted to executing transactions on a cash available basis for
90 days, or until he or she had met the Day Trading Margin call. The
NYSE member organizations would incur a one-time capital charge for the
amount of any unmet deficiency on the sixth business day after a
customer receives a Day Trading Margin call.
5. Proposed Day Trading Minimum Equity Requirement
Currently, NYSE rule 431 requires $2,000 minimum equity for a
customer to open a margin account. The NYSE rule proposal would require
that accounts of Pattern Day Traders maintain minimum equity of $25,000
(``Day Trading Minimum Equity Requirement''). If the account of a
Pattern Day Trader fell below its Day Trading Minimum Equity
Requirement, the account would be restricted from further day trades
until the Day Trading Minimum Equity Requirement was satisfied. In
addition, if an NYSE
[[Page 13610]]
member organization knew, or had reasonable basis to believe, that a
new account would pattern day trade, or that a customer would resume
day trading in an existing account, the member organization would
require the customer to deposit the minimum $25,000 equity into his or
her account before he or she began trading.\20\
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\20\ As originally filed, the NYSE proposal would require the
member organization to obtain from a customer seeking to open a new
account a deposit in satisfaction of the Day Trading Minimum Equity
Requirement if the firm ``knows or has a reasonable basis to
believe'' that the customer will pattern day trade. Amendment No. 1
to the NYSE rule proposal would expand the application of the
``knows or has a reasonable basis to believe'' standard to customers
who resume pattern day trading in an existing account.
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6. Proposed Day Trading Buying Power
Under the proposed Rule 431 revisions, the accounts of Pattern Day
Traders would be restricted based upon their ``Day Trading Buying
Power.'' For equity securities, Day Trading Buying Power would be equal
to the equity in the customer's account at the close of business of the
previous day, less any maintenance margin, multiplied by four. For non-
equity securities, Day Trading Buying Power would be computed using
applicable special maintenance margin requirements pursuant to other
provisions of NYSE Rule 431.
7. Proposed Account Restrictions
The NYSE's rule proposal also would restrict the accounts of
Pattern Day Traders who trade in excess of their Day Trading Buying
Power. If a customer exceeded his or her Day Trading Buying Power, he
or she would generate a Day Trading margin call. Until the customer
meet the margin call, the NYSE member organization would be required
to: (1) Margin the account based on the cost of all day trades made
during the day; and (2) limit the customer's day trading buying power
to the equity in the customer's account at the close of business on the
previous day, less any maintenance margin, multiplied by two. If the
Day Trading Margin call were not met within 5 business days, the NYSE
member organization would then be required to restrict the account to
trading on a cash available basis only.
8. Proposed Non-Withdrawal Requirement
The NYSE represented that, in order to provide greater financial
stability to the accounts of Pattern Day Traders, its rule proposal
would require that: (1) a day trading customer deposit into the day
trading account a sufficient amount of money to meet the Day Trading
Minimum Equity Requirement or a Day Trading Margin Requirement; and (2)
such deposits not be withdrawn for at least two business days (``Non-
Withdrawal Requirement'').
9. Proposed Prohibition on Cross-Guarantees
In addition, the NYSE's rule proposal would require the NYSE member
organizations to prohibit Pattern Day Traders from using guarantees
between customer accounts at the same broker-dealer (``Cross-
Guarantees'') to meet the Day Trading Minimum Equity Requirement or a
Day Trading Margin Requirement. According to the NYSE, this change is
designed to address those instances where maintenance margin calls for
day trading accounts would be avoided by having guarantees from the
accounts of other customers at the same broker-dealer. Under the NYSE
proposal, each Pattern Day Trader account would be required to meet its
applicable requirements independently by using funds on deposit in that
account.
10. Proposed Implementation
The NYSE proposal would become operational six months after
Commission approval of the proposed rule change.\21\
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\21\ Telephone conversation among Donald Van Weezel, Managing
Director, Credit Regulation, NYSE; Albert Lucks, Director, Credit
Regulation, NYSE; Mary Anne Furlong, Director, Rules and
Interpretive Standards, NYSE; Olga Davis, Principal Specialist,
Credit Regulation, NYSE; and Nancy Sanow, Assistant Director; Thomas
McGowan, Assistant Director; Joseph Morra, Special Counsel; and
Steven Johnson, Special Counsel, Division, Commission, January 23,
2001 (``January 23, 2001 Call with NYSE Staff'') (confirming
operative date of proposed rule change).
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C. NASD Proposal
Although the NYSE and NASD proposals differ somewhat in their
structure, they are fundamentally comparable in their substance. The
NASD rule proposal would amend NASD Rule 2520, Margin Requirements, to
impose stricter margin requirements for customers who are Pattern Day
Traders. The NASD observed that the expansion of day trading activity
has brought increased scrutiny of margin requirements by self-
regulatory organizations (``SROs''). The NASD asserted that its rule
proposal would help to protect the safety and soundness of member firms
and ensure the overall financial well being of the securities markets.
The NASD's current rules on day trading are similar in substance to
those of the NYSE.\22\ In its proposal, the NASD describes that initial
margin requirements under Regulation T \23\ and certain standard
maintenance margin requirements under the NYSE and NASD rules currently
are calculated only at the end of each day. Therefore, a day trader
with no outstanding positions, including losses, in his or her account
at the end of the day currently does not incur either an initial margin
or maintenance margin requirement.
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\22\ See explanation of NYSE's current rules in Section II.B.,
supra.
\23\ 12 CFR 220 et seq.
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Although a day trader may end the day without any positions, the
day trader and the member firm are nonetheless at risk during the day,
if credit is extended. To address the risk, the NASD currently requires
day traders to demonstrate that they have the ability to meet margin
requirements for at least their open positions during the day.
Specifically, a customer who meets the definition of ``day-trader''
\24\ under the current rules must deposit in his or her account the
margin that would have been required had the customer not liquidated
his or her open positions during the trading day (i.e., generally 50
percent of the largest open position). Under current rules, if the
customer day trades, but does not fit the definition of ``day trader,''
the customer is still required to deposit 25 percent of his or her open
position during the day. The NASD proposed to amend its margin rules
covering day trading because current rules are not adequate to address
added risks in leveraged pattern day trading.\25\
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\24\ Current NASD Rule 2520 defines a ``day-trader'' as ``any
customer whose trading shows a pattern of day-trading.'' The rule
defines ``day-trading'' as ``the purchasing and selling of the same
security on the same day.'' NASD Rule 2520(f)(8)(b).
\25\ NASD Response to Comments.
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1. Proposed Definition of Pattern Day Trader
The NASD stated that its proposal would define Pattern Day Trader
to cover ``true'' day traders only, not merely incidental or occasional
day traders. According to the NASD, the current definition of a day
trader is overly broad: it includes customers, such as institutions and
other large individual accounts, that have a high volume of trading
activity and that occasionally day trade not as a strategy, but in
response to a specific investment decision or in response to particular
events. Accordingly, the NASD's proposal, like the NYSE proposal, would
define as Pattern Day Traders those customers who execute four or more
day trades within five business days, unless the number of their day
trades is six percent or less of their total trades for that period.
[[Page 13611]]
The NASD's proposed rule change would also require a firm that
knows or has a reasonable basis to believe that a customer is a Pattern
Day Trader to designate the customer as a Pattern Day Trader
immediately. Under the NASD proposal, a firm would have a reasonable
basis for believing that a customer is a Pattern Day Trader if, for
example, the firm provided training to the customer on day trading in
anticipation of the customer opening an account. Amendment No. 1 to the
NASD Proposal deleted the provision that would have required a Pattern
Day Trader to cease trading for 90 days before he or she would be free
of that designation. According to NASD Regulation, the provision
originally proposed is unnecessary because, even without the provision,
a Pattern Day Trader could, under the proposed rules, shed the Pattern
Day Trader designation by informing his or her broker-dealer that he or
she would not day trade. This amendment also clarified that if a
Pattern Day Trader claimed he or she was no longer a day trader, but
then resumed day trading, he or she could be designated as a Pattern
Day Trader based on the firm's knowledge or reasonable belief that the
customer fit the proposed definition of a Pattern Day Trader.\26\
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\26\ Amendment No. 1 to the NASD Proposal. Telephone
conversation between Stephanie Dumont, Counsel, NASD Regulation, and
Steven Johnston, Special Counsel, Division, Commission, January 31,
2001 (clarifying the purpose of Amendment No. 1).
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2. Proposed Day Trading Minimum Equity Requirement
The NASD's proposed rule change also would establish a Day Trading
Minimum Equity Requirement that is identical to that proposed by the
NYSE. The NASD represents that the current minimum equity requirement
of $2,000 may not be large enough to prevent day traders from
continuing to generate losses, without any additional deposit of funds
into their accounts. Under the NASD proposal, a Pattern Day Trader, in
order to meet the Day Trading Minimum Equity Requirement, would be
required to maintain $25,000 in his or her account on any day in which
he or she day trades. The NASD represents that the Day Trading Minimum
Equity Requirement more appropriately addresses the additional risks
inherent in leveraged day trading activities and ensures that customers
cover losses incurred in their accounts from the previous day before
continuing to day trade.
3. Proposed Day Trading Buying Power
Like the NYSE proposal, the NASD proposal would permit the use of
Day trading Buying Power at a level up to four times the difference
between the equity in a customer's account at the close of business on
the previous day and any maintenance margin required. The NASD
represents that this limitation on a customer's Day Trading Buying
Power, along with the Day Trading Minimum Equity Requirement, more
appropriately addresses the intra-day risks created by customer day
trading. At the firm's option, the Day Trading Margin Requirement could
be calculated based on either the largest open position at any time
during the day (if the customer's firm maintains ``time and tick''
records) or the aggregate total of the customer's day trades during the
day.
4. Proposed Account Restrictions
In addition, the NASD proposed rule change would impose a Day
Trading Margin call if a customer exceeded his or her Day Trading
Buying Power. Customers would have five business days to deposit funds
to meet Day Trading Margin calls. Until the customer met the Day
Trading Margin call, his or her Day Trading Buying Power would be
limited to the equity in his or her account at the close of business on
the previous day, less any maintenance margin, multiplied by two for
equity securities. The Day Trading Margin Requirement would be
calculated based on the aggregate cost of the customer's total day
trades in a day. If the customer did not meet the Day Trading Margin
call by the fifth business day, the account would be further restricted
to trading on a cash available basis for 90 days or until the margin
call was met.
5. Proposed Non-Withdrawal Requirement
A deposit made to meet the Day Trading Minimum Equity Requirement
or a Day Trading Margin Requirement would have to remain in a
customer's account for two business days following the close of
business on any day when the deposit is required. Amendment No. 1 to
the NASD proposal clarified that the non-Withdrawal Requirement would
apply only to the accounts of Pattern Day Traders and not to the
accounts of all day traders.\27\
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\27\ Amendment No. 1 to the NASD Proposal.
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6. Proposed Prohibition on Cross-Guarantees
Under the NASD proposal, Cross-Guarantees could not be used when
calculating the Day Trading Minimum Equity Requirement or the Day
Trading Margin requirement. Each day trading account would be required
to satisfy independently the proposed rule's requirements, based solely
on the financial resources available in the account.
7. Proposed Change to Definition of ``Day Trade''
Finally, the NASD rule proposal would amend provisions of NASD Rule
2520, which currently requires that the sale and repurchase on the same
day of a position held from the previous day be treated as a day trade.
Under the NASD proposal, the sale of an existing position would be
treated as liquidation, and a subsequent repurchase would be viewed as
the establishment of a new position. Therefore, the sale of an existing
position and subsequent repurchase would not be subject to NASD rules
affecting day trades. Similarly, if a short position were carried
overnight, the purchase to close the short position and the subsequent
new sale would not be considered a day trade under the NASD's proposal.
8. Proposed Implementation Date
Amendment No. 1 to the NASD Proposal would change the proposed
operational date of the proposal from 30 days after the date the NASD
issues a notice to NASD members announcing that the proposal has been
approved by the Commission to six months from the date of such notice.
III. Summary of Comments
The Commission received 214 letters commenting on the NYSE proposal
and 49 letters commenting on the NASD proposal.\28\ Comment letters
expressed various degrees of opposition or support to the approach
taken by the proposed rule changes, although most commenters opposed
the proposals. The commenters generally addressed issues
[[Page 13612]]
falling into one or more of the categories discussed below. In
addition, the NYSE and NASD submitted responses \29\ to the comments
received by the Commission regarding the proposed rule changes. These
responses are also incorporated below.
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\28\ The public files for the NYSE and NASD rule proposals are
located at the Commission's Public Reference Room, 450 Fifth Street,
N.W., Washington, D.C. 20549-0609. The public files for both rule
proposals contain: (1) All comment letters on the proposals,
including a list of all commenters on the proposals, which was
prepared by Commission staff; (2) ``Report of Examinations of Day-
Trader Broker-Dealers,'' Office of Compliance Inspections and
Examinations, Commission (``OCIE Report'') dated February 25, 2000;
and (3) ``Securities Operations: Day Trading Requires Continued
Oversight,'' the U.S. General Accounting Office, dated February 24,
2000. The public file for the NYSE rule proposal also contains: (1)
The original NYSE Proposal; (2) Amendment No. 1 to the NYSE
Proposal; and (3) NYSE Response to Comments. The public file for the
NASD rule proposal also contains: (1) The original NASD proposal;
(2) Amendment No. 1 to the NASD Proposal; and (3) NASD Response to
Comments.
\29\ NYSE Response to Comments; NASD Response to Comments.
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A. Definition of Pattern Day Trader
The proposed rule changes would define as Pattern Day Traders
customers who execute four or more day trades \30\ within five business
days, unless the number of day trades is six percent or less of the
total day trades for that five-day period. The NYSE stated that this
definition is directed toward active Pattern Day Traders and the risk
surrounding their activities.\31\ A relatively small number of
individuals raised specific objections to this definition. These
individuals, along with a broker-dealer \32\ and the Industry Day-
Trading Advisory Task Force (``Task Force''),\33\ expressed concern
that the proposed definition could encourage customers to hold
positions overnight that they might otherwise have liquidated, thus
giving rise to additional risk of financial loss.\34\
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\30\ Under the proposed rules, a day trade is, generally, the
purchase and sale or the sale and purchase of the same security on
the same day.
\31\ NYSE Response to Comments.
\32\ Letter from Cornerstone Securities Corporation
(``Cornerstone Letter'').
\33\ The Task Force is comprised of representatives from 15
firms: Advanced Clearing, Inc.; All-Tech Direct, Inc.; Ameritrade,
Inc.; Charles Schwab & Co., Inc.; EDGETRADE.com, Inc.; E-Trade
Group, Inc.; iClearing Corporation; Momentum Securities; NextTrend,
Inc.; On-Line Investments Services, Inc.; Southwest Securities,
Inc.; Spear, Leedst & Kellog; Terra Nova Trading LLC; Tradescape
LLC; and US Clearing (Division Fleet Securities). Letter from the
Task Force (``Task Force Letter'').
\34\ See, e.g., E-mail from Steven Petrizzi, E-mail from M.
Spetman; Cornerstone Letter; Task Force Letter.
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In addition, a broker-dealer, the Task Force, and the Discount
Brokerage Committee (``Brokerage Committee'') and Ad Hoc Committee on
Technology and Regulation (``Technology Committee'') of the Securities
Industry Association (``SIA'') \35\ (collectively, the ``SIA Brokerage
and Technology Committees'') indicated concern over the impact that the
proposed definition could have upon professional or institutional
investors. These commenters stated that the definition lacks adequate
exclusions for those types of investors.\36\ Broker-dealers also
opposed the definition of Pattern Day Trader because it would encompass
so-called ``incidental'' or ``inadvertent'' day traders.\37\ In this
regard, a few firms proposed exceptions for customers who, as a result
of ``inadvertent'' or ``non-willful'' error, temporarily met the
proposed definition of Pattern Day Trader.\38\ The SIA Brokerage and
Technology Committees and SIA Office of General Counsel recommended
that the proposed definition be revised to explicity exempt specific
types of trading activity, such as the exercise of a profitable options
position.\39\ A law firm commenting on the proposed rule changes
recommended exceptions to the proposed definition of Pattern Day Trader
for certain institutional investors, arguing that sophisticated
investors with large accounts do not need to be protected by the
proposed rule changes.\40\ The NASD responded to this comment by
reasserting its belief that the proposed six percent exception
adequately addresses institutional trading. The NASD argued that this
exception was not intended to exempt all institutions that frequently
day trade, but only those whose day trading represented a small
proportion of their overall trading activity.\41\
---------------------------------------------------------------------------
\35\ According to the SIA, the organization ``brings together
the shared interests of more than 740 securities firms to accomplish
common goals.'' Letter from SIA Brokerage and Technology Committees
(``SIA Brokerage and Technology Committees Letter'').
\36\ Letter from Momentum Securities, LLC (``Momentum Letter'');
Task Force Letter; SIA Brokerage and Technology Committees Letter.
\37\ See, e.g., Momentum Letter.
\38\ See, e.g., Letter from Empire Programs.
\39\ SIA Brokerage and Technology Committees Letter; Letter from
the SIA Office of General Counsel (``SIA General Counsel Letter'').
The SIA Brokerage and Technology Committees and SIA General Counsel
recommended adding the following exceptions to the proposed
definition of day trading: (1) Exercising a profitable option
position; (2) reopening a long option position that had been closed
out earlier the same day; (3) reopening a short option position that
had been closed out earlier the same day; and (4) the purchase of a
security by a customer and the sale of the same security by the
customer in a repurchase or other financing transaction.
\40\ Letter from Brunelle and Hadjikow.
\41\ NASD Response to Comments.
---------------------------------------------------------------------------
Finally, the Task Force opposed the definition because it is based
on transactional activity instead of the amount of available leverage.
The Task Force asserted, for example, that a customer that completed
five day trades within a ``week'' \42\ would meet the definition of
Pattern Day Trader ``even though the customer ha[d] not taken on any
greater level of financial risk or leverage.'' \43\
---------------------------------------------------------------------------
\42\ Status as a Pattern Day Trader is determined on a rolling
five-business-day basis. Telephone conversation among Donald Van
Weezel, Managing Director, Regulatory Affairs, NYSE; Albert Lucks,
Director, Credit Regulation, NYSE; and Nancy Sanow, Assistant
Director; Thomas McGowan, Assistant Director; Joseph Morra, Senior
Special Counsel; and Melinda Diller, Attorney; Division, Commission,
January 7, 2000.
\43\ Task Force Letter.
---------------------------------------------------------------------------
B. ``Knows or Has a Reasonable Basis to Believe'' Standard
Several securities industry commenters opposed the requirement to
treat as Pattern Day Traders current or new customers whom a trading
firm ``knows or has a reasonable basis to believe'' will engage in
pattern day trading.\44\ One securities firm opposed the ``knows or has
a reasonable basis to believe'' standard because it calls for a firm to
``subjectively consider the manner of trading a new customer might
pursue.'' \45\
---------------------------------------------------------------------------
\44\ See, e.g., Momentum Letter.
\45\ Momentum Letter.
---------------------------------------------------------------------------
The NYSE responded to these criticisms by explaining that a firm
could have a reasonable basis to believe that a customer would engage
in Pattern Day Trading if this were indicated by information obtained
from a customer's representations or by prior trading patterns of the
customer at the firm.\46\ The NASD responded that the proposed standard
is based on a firm's knowledge or reasonable belief only, and would not
require a firm to anticipate a new customer's activity unless the firm
had knowledge or a reasonable belief that the customer would engage in
pattern day trading. The NASD stated that if, for example, a firm
provided a customer with training on day trading in anticipation of
that customer opening an account with that firm, then the firm would
have a reasonable basis to believe that customer would pattern day
trade in his or her account.\47\
---------------------------------------------------------------------------
\46\ NYSE Response to Comments.
\47\ NASD Response to Comments.
---------------------------------------------------------------------------
This standard was supported by comments from the North American
Securities Administrators Association (``NASAA''). NASAA contended that
brokerage firms have an affirmative duty to assess a prospective
client's suitability to trade, and therefore firms should determine
whether the client fits the definition of Pattern Day Trader. According
to NASAA, this assessment should not be overly burdensome to make.
NASAA noted as an example that where a firm trains a customer in day
trading techniques, that firm would be presumed to know or have a
reasonable basis to believe that such a customer would engage in
pattern day trading.\48\
---------------------------------------------------------------------------
\48\ NASAA is a voluntary association of state, provincial, and
territorial securities administrators in the 50 states, the District
of Columbia, Puerto Rico, Canada, and Mexico. Letter from NASAA
(``NASAA Letter''). See also Section II., Description of the
Proposed Rule Changes, supra, for further discussion of ``knows or
has a reasonable basis to believe'' standard.
---------------------------------------------------------------------------
[[Page 13613]]
C. Day Trading Minimum Equity Requirement
The majority of comments the Commission received on the proposals'
Day Trading Minimum Equity Requirement were from individuals, many of
whom identified themselves as day traders. Nearly all of these
individuals characterized the Day Trading Minimum Equity Requirement as
unfair to small investors.\49\ Individual commenters asserted that the
Day Trading Minimum Equity Requirement would act as a barrier to
persons seeking to enter the day trading market.\50\ Individual
commenters also asserted that the requirement was designed to exclude
small investors from a type of trading traditionally dominated by
professional traders.\51\ A securities firm, as well as a significant
number of individual commenters, argued that the proposed Day Trading
Minimum Equity Requirement would be ``paternalistic.'' These commenters
asserted that the risks of day trading are widely known; therefore, it
is unnecessary for the NYSE or NASD to protect investors from those
risks.\52\ The SIA Brokerage and Technology Committees stated, however,
that they had no objection to the proposed dollar amount of the Day
Trading Minimum Equity Requirement (i.e., $25,000).\53\
---------------------------------------------------------------------------
\49\ See, e.g., E-mail from Susie Brown (``Brown Letter'').
\50\ See, e.g., Letter from Serg Palanov.
\51\ See, e.g., E-mail from Brent Aston.
\52\ Datek Online Holdings Corporation Letter (``Datek
Letter''); See also May letter.
\53\ The SIA Brokerage and Technology Committees are opposed,
however, to imposing the Day Trading Minimum Equity Requirement when
a firm ``knows or has a reasonable basis to believe'' a customer
will in engage in pattern day trading. SIA Brokerage and Technology
Committees Letter.
---------------------------------------------------------------------------
Most securities firms commenting on the proposed rule changes
opposed the Day Trading Minimum Equity Requirement wholly or
partially.\54\ For example, one firm challenged the premise that there
is a relationship between the size of a customer's account and his or
her investment success. The same firm argued that the imposition of a
higher equity requirement could encourage investors to put more of
their capital at risk than they would absent the proposed rules.\55\
Securities firms also took the position that imposing the Day Trading
Minimum Equity Requirement on Pattern Day Traders would fail to protect
either member firms or the securities markets.\56\ One of the firms
argued that the health of the securities markets is not threatened by
accounts that have only small equity balances, and there is no data to
suggest that a higher equity requirement for day trading would reduce
the risk to securities firms.\57\ As an alternative, one securities
firm recommended applying a $25,000 minimum equity requirement to
customers who seek and receive approval to trade at a 4:1 margin ratio,
but not to customers who trade at a 2:1 ratio.\58\
---------------------------------------------------------------------------
\54\ See, e.g., Cornerstone Letter.
\55\ Datek Letter.
\56\ See, e.g., Momentum Letter.
\57\ Datek Letter.
\58\ Momentum Letter. The Task Force also recommended that the
day trading rules differentiate between customers who trade at a 4:1
ratio and those who trade at a 2:1 ratio. Task Force Letter.
---------------------------------------------------------------------------
In response to this alternative, the NASD stated that it believes
an objective standard based on the level of day trading activity, which
can be applied uniformly to all customers, is an important component to
regulation in this area. In this regard, the frequency of day trading
is a relevant indicator of intra-day risk, which in turn is important
in determining whether additional requirements, such as the Day Trading
Minimum Equity Requirement, are necessary. The NASD further stated that
it believed requiring minimum equity of $25,000 would provide a
significant ``cushion'' to prevent day traders from continuing to
generate losses in their accounts and, at the same time, avoid
imposition of excessive restrictions on day traders with limited
capital.\59\
---------------------------------------------------------------------------
\59\ NASD Response to Comments.
---------------------------------------------------------------------------
In response to comment letters objecting to the proposed imposition
of the Day Trading Minimum Equity Requirement,\60\ the NYSE stated that
the current equity requirement of $2,000 does not sufficiently address
the speculative nature and potential volatility of pattern day trading.
Further, the NYSE stated that the amount of the proposed minimum Day
Trading Minimum Equity Requirement appropriately addresses the
financial exposure of firms and the potential for significant monetary
losses by customers. In the NYSE's view, the Day Trading Minimum Equity
Requirement should provide some ``staying power'' to day traders (i.e.,
enable them to continue day trading) should they incur trading
losses.\61\ The NASD added that the current equity requirement of
$2,000 does not adequately address day trading risks.\62\ The NASD
represents that given the speculative nature of day trading the
proposed Day Trading Minimum Equity Requirement would provide a better
``cushion'' in case of financial losses by customers.\63\
---------------------------------------------------------------------------
\60\ See, e.g., Brown Letter.
\61\ NYSE Response to Comments.
\62\ NASD Response to Comments.
\63\ NASD Response to Comments.
---------------------------------------------------------------------------
NASAA and the U.S. Senate Permanent Subcommittee on Investigations
(``Senate Subcommittee'') supported substantial increases in the size
of the equity requirement for day trading.\64\ Following increased
public and private sector concern over the risks associated with day
trading, the Senate Subcommittee conducted an eight-month investigation
of the day trading industry. Based on the investigation, the Senate
Subcommittee found that ``[securities] industry leaders agreed that a
day trader's chance of success is directly and proportionally related
to the amount of capital with which a person starts trading.'' \65\
NASAA stated that the Day Trading Minimum Equity Requirement should
reduce the frequency of margin calls, increase the chances that day
traders will be able to independently meet margin calls, and provide a
``cushion'' when market corrections occur.\66\
---------------------------------------------------------------------------
\64\ NASAA Letter; Senate Subcommittee Letter.
\65\ Senate Subcommittee Letter.
\66\ NASAA Letter.
---------------------------------------------------------------------------
Finally, the Senate Subcommittee submitted detailed alternative
proposals regarding, among other things, the required level of equity
and suggested restrictions on accounts that do not meet the equity
requirement. For example, the Senate Subcommittee proposed that day
trading rules establish a rebuttable presumption ``such that a firm
must initially presume that a day trading customer who does not have
$50,000 with which to open an account in inappropriate for day
trading.'' The presumption could be overcome if a firm concluded that
other factors outweighed the fact that the customer did not have
$50,000 with which to open an account. Under the Senate Subcommittee's
proposal, a firm would be required, among other things, to state its
reasons for concluding that a day trading strategy was appropriate for
such a customer.\67\
---------------------------------------------------------------------------
\67\ Senate Subcommittee Letter.
---------------------------------------------------------------------------
In response to recommendations by the Senate Subcommittee that the
equity requirement for Pattern Day Traders be increased to $50,000,\68\
the NYSE stated that it believes $25,000 is a sufficient level of
equity, given the fact that firms may further increase equity
requirements based on their own policies and procedures, known as
``house requirements.'' \69\ The NASD stated that the proposed Day
Trading Minimum Equity Requirement should
[[Page 13614]]
provide protection against continued losses in day trading accounts
while refraining from excessive restrictions on day traders with
limited capital. The NASD also observed that firms have the option of
increasing equity requirements on day traders by imposing house
requirements.\70\
---------------------------------------------------------------------------
\68\ Id.
\69\ NYSE Response to Comments.
\70\ NASD Response to Comments.
---------------------------------------------------------------------------
In addition, the Senate Subcommittee recommended that customers who
fail to maintain sufficient funds in their accounts be restricted to
trading on a cash basis only.\71\ In response to this suggestion, the
NASD stated that if a customer continued to day trade in his or her
account without maintaining the proposed Day Trading Minimum Equity
Requirement, the NASD would expect that the customer's firm would
restrict that account to trading on a cash available basis.\72\
---------------------------------------------------------------------------
\71\ Senate Subcommittee Letter.
\72\ NASD Response to Comments.
---------------------------------------------------------------------------
D. Margin Ratio
A small number of individual commenters expressed opposition to
increasing to a 4:1 ration the amount of leverage available to
customers who satisfy the Day Trading Minimum Equity Requirement.\73\
These individual commenters, as well as the Senate Subcommittee,
expressed concern that increasing the margin ratio would multiply any
losses of, and increase speculation by, those persons who trade at the
higher ratio.\74\ On the other hand, securities firms generally did not
object to allowing customers to trade at a 4:1 ratio.\75\
---------------------------------------------------------------------------
\73\ See, e.g., Letter from Jay Marting (``Marting Letter'').
\74\ See, e.g., Marting Letter; Senate Subcommittee Letter.
\75\ See, e.g., Momentum Letter.
---------------------------------------------------------------------------
In response to concerns about increasing the amount of leverage
available to Pattern Day Traders,\76\ the NYSE and NASD represented
that permitting the use of leverage at a 4:1 ratio is appropriate when
considered in conjunction with other provisions of the proposed rule
changes.\77\ The NYSE stated that as a whole, its proposal would
encourage customers to avoid margin calls by trading only within their
Day Trading Buying Power. The NYSE and NASD also indicated that
allowing pattern Day Traders to trade at the 4:1 ratio would bring day
trading accounts into parity with ordinary margin accounts, where the
standard maintenance margin is also 25 percent.\78\
---------------------------------------------------------------------------
\76\ See, e.g., Letter from Matthew Panza (``Panza Letter'');
Letter from EDGETRADE.com (``EDGETRADE Letter'').
\77\ NYSE Response to Comments; NASD Response to Comments.
\78\ NYSE Response to Comments; NASD Response to Comments.
---------------------------------------------------------------------------
E. Method of Computing Margin Calls
A substantial number of individuals and securities firms commenting
on the rule proposals were opposed to the proposed method of computing
the Day Trading Margin call.\79\ Some of these commenters objected to
calculating the margin call based on all day trades during a day, once
a Pattern Day Trader had exceeded his or her Day Trading Buying
Power.\80\ Individual commenters asserted that using this method would
result in customers receiving margin calls many times larger than the
amount of equity in the customer's account. A few of these comments
apparently believed that a customer with no outstanding Day Trading
margin calls who exceeded his or her Day Trading Buying Power would,
under the proposed rules, face a Day Trading Margin call equal to 50
percent of the total cost of all day trades executed on the day in
which the customer exceeded his or her Day Trading Buying Power.\81\
The NYSE has clarified that if a Pattern Day Trader had no outstanding
Day Trading Margin calls, his or her Day Trading Margin Requirement
would equal 25 percent of either (1) the customer's highest open
position during the day,\82\ or (2) 25 percent of the total cost of the
customer's day trades during the day.\83\ Many of the individual and
industry commenters lodging concerns regarding the calculation of Day
Trading Margin calls stated that such margin calls would be unfairly
punitive to day traders.\84\
---------------------------------------------------------------------------
\79\ See, e.g., Panza Letter; EDGETRADE Letter.
\80\ See e.g., Panza Letter; Letter from Ed Naylor (``Naylor
Letter'').
\81\ See e.g., Naylor Letter.
\82\ For the Day Trading Margin Requirement to be based on a
customer's highest open position, the customer's firm must maintain
``time and tick'' records documenting the sequence in which each day
trade was completed.
\83\ NYSE Response to Comments. January 23, 2001 Call with NYSE
Staff (clarifying that this formula applies solely to Pattern Day
Traders who have no outstanding day trading margin calls).
\84\ See e.g., Ray Letter; Momentum Letter.
---------------------------------------------------------------------------
The NYSE and NASD explained the calculation of Day Trading Margin
calls as follow.\85\ In accounts not subject to restrictions under the
proposed rules, Day Trading Margin calls would be calculated based on a
customer's highest open position in a day.\86\ For example, assume that
a customer who is a Pattern Day Trader had $30,000 cash equity and no
security positions in his or her account at the close of business on
Day 0. The customer's Day Trading Buying Power for Day 1 would be
$120,000 (four times the equity in the customer's account at the close
of business on Day 0).\87\ Also assume that the customer executed two
day trades on Day 1--a $50,000 purchase and sale, followed by a
$200,000 purchase and sale.\88\ Under these conditions, the customer's
highest open position on Day 1 is $200,000.\89\ Since the customer's
highest open position exceeds her or her Day Trading Buying Power, the
customer incurs a Day Trading Margin call of $20,000, calculated as
followings:
---------------------------------------------------------------------------
\85\ January 23, 2001 Call with NYSE Staff (clarifying operation
of NYSE proposed rules). Telephone conversation between Susan
Demando, Director, of Finance/Operations, Member Regulation, NASD
and Thomas McGowan, Assistant Director, Division, Commission,
January 24, 2001 (``January 24, 2001 Call with NASD Staff'')
(clarifying operation of NASD proposed rules).
\86\ For a customer's Day Trading Margin Requirement to be based
on his or her highest open position, the customer's firm must
maintain ``time and tick'' records of the customer's transactions;
otherwise, the customer's Day Trading Margin Requirement must be
calculated based on the total cost of a customer's day trades during
the day.
\87\ The proposed rules would define Day Trading Buying Power
for equity securities as the equity available in a customer's
account as of the close of business on the previous day less any
maintenance margin requirement, multiplied by four. Because, in this
example, the customer has no open positions in his or her margin
account, the customer has no maintenance margin requirement.
\88\ The example assumes that the customer closes one position
before opening the next. This would be the case, for example, if the
customer: (1) Purchased ``Security A'' for $50,000 at 10:00 a.m.;
(2) sold ``Security A'' for $50,000 at 11:00 a.m.; (3) purchased
``Security B'' for $200,000 at 1:00 p.m.; and (4) sold ``Security
B'' for $200,000 at 3:30 p.m.
\89\ Had the customer not closed the position in ``Security A''
before purchasing ``Security B,'' the customer's highest open
position would have been $250,000, the sum of positions open
simultaneously.
$200,000 (largest open position on Day 1)
-120,000 (Day Trading Buying Power)
-----------
80,000
x .25 (Day Trading Margin)
-----------
$20,000 (Day Trading Margin call)
In addition to incurring a Day Trading Margin call on Day 1, the
customer's account is restricted until the margin call is met. On Day
2, for example, the customer's Day Trading Buying Power is restricted
to $60,000 (two times the assumed equity \90\ in the customer's account
at the close of business on Day 1). Further, the customer's account is
margined based on the total cost of all day trades executed on Day 2.
For example, assume that on Day 2 the customer executes two day
trades--a $40,000 purchase and sale and $30,000
[[Page 13615]]
purchase and sale. Since the total cost of the customer's day trades
($70,000) exceeds his or her Day Trading Buying Power ($60,000), the
customer incurs a second Day Trading Margin call of $5,000, calculated
as follows:
---------------------------------------------------------------------------
\90\ The example assumes that there are no profits or losses in
the account, no commission or interest charges, and no other items
that would affect the account balance. Therefore, the amount of
equity in the account at the end of Day 0.
$70,000 (cost of all day trades on Day 2)
-60,000 (Day Trading Buying Power)
----------
10,000
x \91\. .............................................................
50
----------
$5,000 (Day Trading Margin call)
F. Time Allowed to Meet Margin Call
Some \91\ commenters stated that they were opposed to the
requirement that, once a customer receives a Day Trading Margin call,
he or she must meet the margin call within five business days.\92\ One
commenter, for example, protested that along with other provisions of
the proposed rule changes, this requirement would force customers to
liquidate positions based on non-market considerations.\93\ In response
to objections to reducing the time to meet a margin call from seven to
five business days, the NYSE stated that this change was made to
conform its proposed rule revisions to the time frame included in
Regulation T for standard margin accounts.\94\
---------------------------------------------------------------------------
\91\ The Day Trading Margin rises to 50 percent because the
customer has an outstanding Day Trading Margin call. January 23,
2001 Call with NYSE Staff; January 24, 2001 Call with NASD Staff
(both clarifying use of 50 percent margin under proposed rules).
\92\ See, e.g., Letter from Terry Laughlin (``Laughlin
Letter'').
\93\ Laughlin Letter.
\94\ NYSE Response to Comments; 12 CFR 220.2; 12 CFR
220.4(c)(3)(i).
---------------------------------------------------------------------------
G. Actions Required When Day Trading Buying Power Is Exceeded
A significant number of comment letters from individuals, and
roughly half of the letters from securities industry commenters,
addressed the subject of the actions to be taken if a customer exceeds
his or her Day Trading Buying Power.\95\ For example, individual
commenters objected to the provisions restricting use of leverage to a
2:1 ratio once a Pattern Day Trader has incurred a Day Trading Margin
call.\96\ A securities firm and the SIA Brokerage and Technology
Committees criticized provisions that would reduce the degree of
leverage available to customer who has received a Day Trading Margin
call because, they argued, it departs from the approach used in
Regulation T.\97\ This firm and the SIA Brokerage and Technology
Committees were opposed to the imposition of immediate restrictions on
the accounts of individuals who exceeded their Day Trading Buying
Power, and the SIA Brokerage and Technology Committees favored imposing
as few restrictions as possible during the five-business-day period for
meeting a Day Trading Margin call.\98\ Finally, the Task Force proposed
that no restrictions be imposed on the account of a Pattern Day Trader
during the five business days specified for meeting a Day Trading
Margin call.\99\
---------------------------------------------------------------------------
\95\ See, e.g., Naylor Letter; Cornerstone Letter (addressing
imposition of 2:1 ratio).
\96\ See, e.g., E-mail from Jeff Landau.
\97\ Cornerstone Letter; SIA Brokerage and Technology Committees
Letter. 12 CFR 220 et seq.
\98\ SIA Brokerage and Technology Committees Letter; Cornerstone
Letter.
\99\ Task Force Letter.
---------------------------------------------------------------------------
In response, the NYSE stated that the proposed actions are
appropriate and will help to minimize financial risk to securities
firms and markets.\100\ In response to concerns that the companion
actions required may ``penalize'' customers,\101\ the NASD represented
that immediate consequences are necessary to discourage customers from
exceeding their Day Trading Buying Power.\102\
---------------------------------------------------------------------------
\100\ NYSE Response to Comments
\101\ See, e.g., Letter from Brent Johnson.
\102\ NASD Response to Comments.
---------------------------------------------------------------------------
The Senate Subcommittee supported the proposed restrictions on
Pattern Day Traders who exceed their Day Trading Buying Power.\103\
NASAA also supported the Day Trading Margin call provisions and other
restrictions imposed by the proposed rule changes. NASAA described the
proposed measures as the placement of regulatory ``speed bumps'' to
ensure compliance with reasonable margin risk levels and to enforce
penalties for day trading in accounts with little or no equity.\104\
---------------------------------------------------------------------------
\103\ Senate subcommittee Letter.
\104\ NASAA Letter
---------------------------------------------------------------------------
H. Non-Withdrawal Requirement
Most securities firms, and The Rules and Regulations Committee of
the SIA's Credit Division (``SIA Rules and Regulations Committee''),
opposed the requirement that funds deposited into a customer's account
to satisfy the Day Trading Margin Requirement or Day Trading Minimum
Equity Requirement of the proposed rule changes must remain in the
account for two business days.\105\ One trading firm, for example,
stated that the Non-Withdrawal Requirement is unnecessary because
positions are not held overnight and, therefore, funds are not at risk.
The firm also contrasted the proposed Non-Withdrawal Requirement with
the treatment of deposits made to satisfy Regulation T \106\ margin
calls. The firm observed that customers are permitted to withdraw those
deposits the day after the deposits have been made.\107\
---------------------------------------------------------------------------
\105\ See, e.g., Cornerstone Letter. Letter from SIA Rules and
Regulations Committee (``SIA Rules and Regulations Committee
Letter'').
\106\ 12 CFR 220 et seq.
\107\ Cornerstone Letter.
---------------------------------------------------------------------------
The SIA Rules and Regulations Committee argued that the Non-
Withdrawal Requirement is overly restrictive, and that customers should
be able to use funds available in their accounts, absent a pattern of
activity demonstrating that they lack sufficient financial resources to
engage in Pattern Day trading.\108\ The NYSE, however, represented that
the effectiveness of other provisions of its proposed rule change could
be limited if a customer were permitted to withdraw funds prior to
trading on the day after that customer had been required by the
proposal to deposit them. The NYSE explained that if a customer is
permitted to withdraw such funds prior to the next day's trading, he or
she could shield the funds from day trading losses through overnight
borrowing. The NYSE observed that overnight borrowing to meet margin
calls does not demonstrate a customer's fitness to engage in Pattern
Day Trading.\109\
---------------------------------------------------------------------------
\108\ SIA Rules and Regulations Committee Letter.
\109\ NYSE Response to Comments.
---------------------------------------------------------------------------
The NYSE and NASD stated that they believe the Non-Withdrawal
Requirement would result in greater caution by entities lending funds
to customers who must meet Day Trading Margin calls. In their view,
this is because funds deposited to meet Day Trading Margin calls would
be placed at risk of day trading losses.\110\ This, the NYSE argued,
may encourage entities lending funds to more carefully evaluate the
creditworthiness of Pattern Day Traders. The NYSE believed that this
increased caution should provide a better foundation for reducing
financial risk to the securities industry and to individual
investors.\111\ The NASD believed that the Non-Withdrawal Requirement
would also force Pattern Day Traders to more frequently rely upon their
own funds and assets in meeting margin requirements and thereby
decrease financial risk to securities firms.\112\
---------------------------------------------------------------------------
\110\ NYSE Response to Comments; NASD Response to Comments.
\111\ NYSE Response to Comments.
\112\ NASD Response to Comments.
---------------------------------------------------------------------------
I. Cross-Guarantees
Many individual commenters, as well as a significant number of
firms, expressed opposition to the exclusion of Cross-Guarantees from
the calculation of
[[Page 13616]]
the Day Trading Margin Requirement.\113\ In addition, one commenter
proposed to exclude accounts trading at the 2:1 ratio from the
application of the proposed provisions on Cross-Guarantees.\114\ The
NYSE believes that the provision in its rule proposal on Cross-
Guarantees ``suitably addresses concerns of whether [a] customer has
the financial resources to day trade, and allows for separate
evaluation of customers' day trading risks.''\115\ The NASD also
believes that its proposed provision on Cross-Guarantees is necessary
to address those concerns.\116\
---------------------------------------------------------------------------
\113\ See, e.g., Momentum Letter.
\114\ Momentum Letter. See also Task Force Letter.
\115\ NYSE Response to comments.
\116\ NASD Response to Comments.
---------------------------------------------------------------------------
NASAA also expressed support for the proposed provisions on Cross-
Guarantees. NASAA suggested that Cross-Guarantees circumvent the
purpose of margin requirements. In addition, NASAA expressed concern
regarding the potential harm to investors if securities firms that are
strongly recommending an investment or an investment strategy to a
customer also take steps to arrange margin guarantees for that same
customer.\117\ Similarly, the Senate Subcommittee stated that Cross-
Guarantees would ``undermine margin requirements'' and could ``evade
the purpose'' of equity requirements as well.\118\
---------------------------------------------------------------------------
\117\ NASAA Letter.
\118\ Senate Subcommittee Letter.
---------------------------------------------------------------------------
J. Burdens on Firms
Most securities industry commenters expressed concern over the
implementation, administration, and enforcement burden that they
believed would be placed upon securities firms by the proposed rule
changes.\119\ The SIA Brokerage and Technology Committees argued, for
example, that the system enhancements required to monitor such
parameters as Day Trading Buying Power and to impose restrictions on
accounts would be ``significant, complicated, and costly.'' The SIA
Brokerage and Technology Committees asserted that such burdens should
not be imposed on firms that do not promote day trading strategies. The
committees also expressed particular concern regarding the burden of
implementing provisions of the proposed rule changes that would exclude
from the definition of Pattern Day Trader those customers whose day
trades represent six percent or less of their total trades.\120\ In
addition, the Task Force argued that the proposed rule changes would
require firms to classify and monitor their entire customer base on a
daily basis.\121\ As an alternative, one firm proposed that customers
desiring to trade at a 4:1 ratio should be required to apply for
approval to trade at that level, and that broker-dealers should only be
required to monitor the accounts trading at a 4:1 ratio. The firm
believed this would reduce a firm's burden of implementing day trading
margin rules.\122\
---------------------------------------------------------------------------
\119\ See, e.g., SIA General Counsel Letter.
\120\ SIA Brokerage and Technology Committees Letter.
\121\ Task Force Letter.
\122\ Datek Letter (referring to Task Force recommendations).
---------------------------------------------------------------------------
Responding to these concerns, the NYSE stated that the programming
and monitoring of its proposed rule would not be unduly burdensome, and
stated that it would delay the operative date by six months from the
date of commission approval, in order to allow firms to implement its
proposed rule.\123\ In response to specific concerns regarding the
burden of implementing the proposed exclusion from the definition of
Pattern Day Trader for customers whose day trades represent six percent
or less of their total trades, the NYSE stated that the exclusion is
not mandatory, i.e., members may choose not to exclude such investors
from the operation of the NYSE's proposed rules.\124\ With regard to
the same concern, the NASD responded that its staff consulted with
members of the Rule 431 Committee who advised that programming and
monitoring the exception would not be overly burdensome.\125\
---------------------------------------------------------------------------
\123\ NYSE Response to Comments. January 23, 2001 Call with NYSE
Staff (confirming operative date of proposed rule change).
\124\ NYSE Response to Comments.
\125\ NASD Response to Comments.
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IV. Discussion of the NYSE and NASD Proposed Rule Changes
Day trading generally refers to a kind of trading system involving
frequent, rapid-fire purchase and sale transactions (or sale and
purchase transactions) in securities in a single day. Day trading
transactions are often effected by persons who typically have
computerized links to market centers and who attempt to capture small
differences in stock prices.\126\ As day trading activity increased, so
did media attention and public concern over the risks inherent in day
trading.\127\ Given the potential for significant losses to those
persons who engage in day trading activities, legislators and
regulators have scrutinized the practice and have taken steps to
protect investors and limit financial risks to investors, broker-
dealers, and securities markets.
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\126\ A day trading strategy is ``an overall trading strategy
characterized by the regular transmission by a customer of intra-day
orders to effect both purchase and sale transactions in the same
security or securities.'' Senate Subcommittee Letter (Citing
definition in proposed NASD Rule 2360(e)).
\127\ See, e.g., ``State Securities Regulators Investigate
Practices of Securities Firms as Part of a Broad-Based Inquiry Into
Day Trading,'' The Wall Street Journal, Sec. C., pp. 1, col. 6,
August 25, 1999; ``Critical Report by North American Securities
Administrators Association,'' The Wall Street Journal, Sec. A, pp.
26, col. 1; ``Senators Lambaste Actions by Day Traders,'' USA Today,
Sec. B, pp. 2, February 25, 2000; ``Day Trading: A Study in
Temptation; Senate Panel to Investigate Risk Disclosure,'' The
Washington Post, February 24, 2000, Sec. E., pp. 1.
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For example, from October 1998 through September 1999, the
Commission's Office of Compliance Inspections Examinations (``OCIE'')
examined 47 registered broker-dealers that were providing day trading
facilities to the general public. In February 2000, OCIE issues a
report of its findings and recommendations, addressing risk disclosure,
net capital compliance, lending arrangements, supervisory
infrastructure, and other issues associated with day trading.\128\
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\128\ OCIE Report.
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In addition, the Senate Subcommittee held hearings on day trading
that focused on investor suitability, the use of margin, advertising,
and profitability.\129\ Moreover, various SROs filed, and the
Commission approved, other rule proposals regulating day trading
practices.\130\ The NYSE and NASD rule proposals relating to margin
requirements for day traders represent further regulatory responses to
issues raised by day trading.
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\129\ Day Trading: An Overview: Hearing Before the Permanent
Subcommittee on Investigations of the Committee on Governmental
Affairs, 106th Cong., 1st Sess. 106-285 (1999). The Senate
Subcommittee also reviewed and provided recommendations concerning
the NYSE and NASD rule proposals on the use of margin. Senate
Subcommittee Letter.
\130\ See e.g., Securities Exchange Act Release No. 43021 (July
10, 2000), 65 FR 44082 (July 17, 2000) (File No. SR-NASD-99-41)
(approving new rules pertaining to the opening of day trading
accounts and delivery of a risk disclosure statement).
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The rule proposals submitted by the NYSE and NASD were the result
of collaborative efforts by these SROs, through the Rule 431
Committee--comprised of NYSE and NASD staff, attorneys from the NYSE's
outside counsel, staff of the Board of Governors of the Federal
Reserve, and representatives from several broker-dealers and clearing
firms--to develop special margin rules that better reflect the risks
inherent in day trading. Because initial margin requirements under
Regulation T and standard maintenance margin requirements under current
NYSE and NASD rules are calculated only at the end of the day incurred,
a day trader with no
[[Page 13617]]
outstanding positions, including losses, in his or her account at the
end of the day currently incurs neither an initial margin nor a
maintenance margin requirement. Although current NYSE and NASD special
maintenance margin requirements apply to day traders, those
requirements do not adequately address the potential financial risks
posed by day trading, and may have encouraged practices, such as the
use of Cross-Guarantees, that do not require customers to demonstrate
actual financial ability to engage in day trading.
The Commission has reviewed the NYSE and NASD proposed rule
changes, and has considered carefully the comment letters submitted in
response to these proposals, as well as the NYSE and NASD responses to
the comment letters, and finds that the proposed rule changes are
consistent with the requirements of the Act and the rules and
regulations thereunder applicable to a national securities exchange and
national securities association, respectively. The Commission finds
that the NYSE proposal is consistent with section 6(b)(5) of Act,\131\
which requires the rules of a national securities exchange to be
designed to prevent fraudulent and manipulative act and practices, to
promote just and equitable principles of trade, and, in general, to
protect investors and the public interest. Section 15A(b)(6) of the
Act\132\ imposes the same requirement on a national securities
association. The Commission also finds that the NASD proposal is
consistent with section 15A(b)(6) of the Act.
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\131\ 15 U.S.C. 78f(b)(5).
\132\ 15 U.S.C. 78o-3(b)(6).
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In addition, the Act specifically grants to SROs the authority to
establish and enforce standards of financial responsibility among their
members. Section 6(c)(3)(A) of the Act\133\ provides, among other
things, for a national securities exchange to deny or condition
membership privileges on compliance with the exchange's own financial
responsibility rules. Section 15A(g)(3)(A) of the Act\134\ grants the
same authority to national securities association. Pursuant to this
authority, the SROs are authorized to promulgate rules governing the
financial responsibility requirements of their members. The Commission
finds that the NYSE proposal is consistent with goals of section
15a(g)(3)(A) of the Act and the NASD proposal is consistent with the
goals of section 15A(g)(3)(A) of the Act.
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\133\ 15 U.S.C. 78f(c)(3)(A).
\134\ 15 U.S.C. 78o-3(g)(3)(A).
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The Commission finds that the NYSE and NASD proposals are designed
to protect Pattern Day Traders, the firms where those traders have
their accounts, and the markets on which they trade. The intra-day risk
of substantial losses to both the customer and the firm increases in
day trading accounts that do not have sufficient equity capital.
Moreover, customers' and firms' reliance on cross-guarantees among
customer accounts to meet margin requirements exacerbate these risks.
These potential losses can be magnified if a sudden and substantial
adverse movement were to occur in the prices of securities popular
among day traders or in the markets as a whole. In the Commission's
view, the integrity of U.S. financial markets will be better protected
through appropriate margin and similar requirements on customers who
engage in day trading practices.
The proposed NYSE and NASD rules are not designed to prevent day
trading, but to reduce the risk of financial losses by Pattern Day
Traders and their firms. For example, by increasing the minimum equity
requirement for Pattern Day Trades, the proposed rule help ensure that
day traders have an appropriate amount of equity for the potential
losses that may be incurred through day trading. Finally, the
Commission finds that overall market integrity is increased by rules,
such as those here proposed by the NYSE and NASD, that are designed to
reduce excessive and unnecessary risk of financial loss to market
participants.
The Commission finds that the proposed definition of Pattern Day
Trader takes a reasonable approach to specifying the type of trading
activity for which the use of margin should be further regulated. In
particular, the definition focuses on day trading behavior, while
providing an exception for accounts where the number of day trades
executed represents only a small percentage of all trading activity.
The Commission finds that it is reasonable for the NYSE and NASD to use
objective standards to identify and regulate accounts that may be at
greatest risk as a result of day trading.
The Commission also finds that the proposed Day Trading Minimum
Equity Requirements strikes a balance between, and responds to, the
diverging concerns of the various commenters on this issue. While there
was a range of views regarding the dollar amount of equity that should
be required in connection with day trading, the Commission finds that
the proposed rule changes are designed to accomplish the objective of
assuring the financial well-being of broker-dealers, which in turn
promotes the integrity of the securities markets.
Regarding the imposition of Day Trading Margin calls on Pattern Day
Traders, the Commission notes that the proposed rules would impose
relatively larger margin calls for accounts that have already generated
but not yet satisfied a Day Trading Margin call. In those accounts, Day
Trading Buying Power would be limited to a 2:1 ratio for leverage and
Day Trading Margin would be calculated based on the aggregate cost of
all day trades that occurred in a single day. The Commission finds that
provisions would reduce Day Trading Buying Power, and those that would
produce relatively larger Day Trading Margin calls for accounts already
under restrictions, are in keeping with the NYSE and NASD's stated
objectives of reducing risk by encouraging Pattern Day Traders to
assume increased financial responsibility for their trading
activities.\135\
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\135\ For further discussion of Cross-Guarantees, see, Section
II, supra. Description of the Proposed Rule Charges.
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The Commission also finds that the proposed rule changes take
reasonable steps to require investors who day trade to assume a greater
obligation for the intra-day financial risks associated with Pattern
Day Trading. The Commission observes, for example, that the use of
Cross-Guarantees in the calculation of Day Trading Margin calls could
dilute the impact of proposed provisions designed to encourage greater
independent financial responsibility. The Commission finds that this
approach is consistent with Regulation T, which does not permit initial
margin requirements to be met through the use of a guarantee for a
customer's account.\136\
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\136\ 12 CFR 220.3(d).
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Finally, the Commission recognizes the concerns of commenters
regarding the burden on securities firms of implementing the proposed
rules. The Commission understands that practical implementation of the
proposed rules may require systems changes by firms. However, the
Commission finds that, by the NYSE and NASD delaying the operative
dates of the proposed rule changes for six months, there should be
sufficient time for securities firms to institute measures for
monitoring and enforcing the new rules and to bring any interpretive
issues to the attention of the NYSE or NASD.
The Commission finds good cause for approving Amendment No. 1 to
the NYSE proposal and Amendment No. 1 to the NASD proposal prior to the
[[Page 13618]]
thirtieth day after the date of publication of notice of filing thereof
in the Federal Register. Amendment No. 1 to the NYSE proposal ensures
that the NYSE and NASD approaches to the regulation of day trading
margin rules are consistent so that they can be applied and interpreted
uniformly. Amendment No. 1 to the NASD's rule proposal also ensures
that the NASD's and NYSE's approaches to the regulation of day trading
are consistent and provides for additional time for firms to implement
its proposed rule change. For these reasons, the Commission finds good
cause for accelerating approval of both amendments.
V. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the Amendment No. 1 to each proposed rule change,
including whether they are consistent with the Act. Persons making
written submissions should file six copies thereof with the Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW., Washington,
DC 20549-0609. Copies of the submission, all subsequent amendments, all
written statements with respect to the proposed rule change that are
filed with the Commission, and all written communications relating to
the proposed rule changes between the Commission and any person, other
than those that may be withheld from the public in accordance with the
provisions of 5 U.S.C. 552, will be available for inspection and
copying in the Commission's Public Reference Section. Copies of
Amendment No. 1 to the NYSE proposed rule change will also be available
for inspection and copying at the principal office of the NYSE. Copies
of Amendment No. 1 to NASD proposed rule change will also be available
for inspection and copying at the principal office of the NASD. All
submissions should refer to File Nos. SR-NYSE-99-47 or SR-NASD-00-03
and should be submitted by March 27, 2001.
VI. Conclusion
It is Therefore Ordered, pursuant to section 19(b)(2) of the
Act,\137\ that the proposals SR-NYSE-99-47 and SR-NASD-00-03 as
amended, be and hereby are approved.\138\
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\137\ 15 U.S.C. 78s(b)(2).
\138\ In approving the proposals, the Commission has considered
their impact on efficiency, competition, and capital formation.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-5402 Filed 3-5-01; 8:45 am]
BILLING CODE 6717-01-M