    Securities Operations: Day Trading Requires Continued Oversight (Letter
    Report, 02/24/2000, GAO/GGD-00-61).

    Pursuant to a congressional request, GAO reviewed day trading, focusing
    on: (1) the nature and extent of day trading; (2) regulatory actions
    taken to address the day trading risks; and (3) the actions day trading
    firms have taken to address regulatory concerns.

    GAO noted that: (1) day trading among less experienced investors is an
    evolving segment of the securities industry; (2) day traders, who
    represent less than one-tenth of 1 percent of all individuals who bought
    or sold securities, accounted for a growing part of trading on Nasdaq,
    estimated by industry officials to be about 10 to 15 percent of Nasdaq
    volume; (3) these traders all did their trading at specialized day
    trading firms, but the firms employed various structures and operating
    strategies that affected the risks the traders faced; (4) some firms
    encouraged any individual who wanted to be a day trader, and had the
    capital to begin trading, to use the firm's systems and facilities to
    trade, risking the trader's own capital; (5) others emphasized that they
    wanted only people who were qualified and able to be professional
    traders to trade, risking the firms' capital; (6) these traders could be
    fired if they suffered significant loss, but they do not lose their own
    capital; (7) some firms employed a combination or variations of these
    strategies; (8) the effects of day trading on both individuals who
    engage in it and the markets as a whole are uncertain; (9) federal
    regulators have taken some actions to address the risks of day trading;
    (10) the regulatory arm of the National Association of Securities
    Dealers (NASD), called NASD Regulation (NASDR), and the Securities and
    Exchange Commission (SEC) have made a special effort to target their
    examination resources during the last 2 years on day trading firms,
    performing 67 examinations of day trading firms and their branches; (11)
    the rule violations found most frequently in their examinations of firms
    related to supervisory procedures, net capital computations, and
    advertising; (12) they also found violations involving margin and
    lending issues; (13) NASDR has recently submitted proposed rule changes
    to SEC that require day trading firms to assess the appropriateness of
    day trading for each potential customer and to fully disclose the risks
    of day trading; (14) NASDR and the New York Stock Exchange have also
    submitted proposed rule changes to SEC to tighten margin requirements;
    (15) some of the day trading firms GAO visited recognized these
    regulatory concerns and told GAO that they have already taken steps to
    provide better disclosure, screen prospective traders, and restrict
    certain activities, such as customer-to-customer lending; and (16)
    determining the adequacy and extent of oral disclosures, screening, and
    planned restrictions presents a difficult challenge because neither the
    regulators nor GAO could directly observe the interactions between the
    firms and traders or potential traders.

    --------------------------- Indexing Terms -----------------------------

     REPORTNUM:  GGD-00-61
         TITLE:  Securities Operations: Day Trading Requires Continued
    	     Oversight
          DATE:  02/24/2000
       SUBJECT:  Securities
    	     Securities regulation
    	     Stock exchanges
    	     Brokerage industry
    	     Information disclosure
    	     Risk management
    	     Regulatory agencies
    	     Internal controls
    	     Capital
    IDENTIFIER:  National Association of Securities Dealers Small Order
    	     Execution System

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    United States General Accounting Office
    GAO

    Report to Congressional Requesters

    February 2000

    GAO/GGD-00-61

    SECURITIES OPERATIONS
    Day Trading Requires Continued Oversight

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    Contents
    Page 341                 GAO/GGD-00-61 Day Trading
    Letter                                                                      1

    Appendix I                                                                 36
    Comments From SEC

    Appendix II                                                                38
    Comments From NASD

    Appendix III                                                               39
    GAO Contacts and Staff
    Acknowledgments

    Figures                    Figure 1: Typical Trading Screen for            12
                               Day Traders
                                                                               13

    Abbreviations

    ECN       Electronic Communications Networks
    ETA       Electronic Traders Association
    LLC       Limited Liability Corporations
    NASD      National Association of Securities
    Dealers
    NASDR     National Association of Securities
    Dealers, called NASD Regulation
    NYSE      New York Stock Exchange
    SEC       Securities and Exchange Commission
    SIA       Securities Industry Association
    SOES      Small Order Execution System

    B-283097

    Page 2                   GAO/GGD-00-61 Day Trading
    B-283097

    February 24, 2000

    The Honorable John D. Dingell
    Ranking Minority Member
    Committee on Commerce

    The Honorable Ron Klink
    Ranking Minority Member, Subcommittee on Oversight
    and Investigations Committee on Commerce

    The Honorable Edward J. Markey
    Ranking Minority Member, Subcommittee on
    Telecommunications,
      Trade, and Consumer Protection
    Committee on Commerce

    The Honorable Edolphus Towns
    Ranking Minority Member, Subcommittee on Finance
      and Hazardous Materials
    Committee on Commerce
    House of Representatives

    The Honorable Carl Levin
    Ranking Minority Member, Permanent Subcommittee on
    Investigations Committee on GovernmentalAffairs
    United States Senate

    This report responds to your February 11 and March
    26, 1999, requests that we review a number of
    issues regarding day trading. Day trading is a
    strategy that generally involves making multiple
    purchases and sales of the same security during
    the day to profit from short-term price movements.
    You were concerned that day trading raises serious
    investor protection and market integrity issues,
    particularly that investors have lost large
    amounts of money from the questionable practices
    of day trading firms. You were also concerned
    about the adequacy of risk disclosures to
    investors by firms that specialize in day trading
    and the actions taken by regulators in overseeing
    day trading. As agreed with your offices, our
    objectives were to (1) determine the nature and
    extent of day trading, (2) assess regulatory
    actions taken to address the day trading risks,
    and (3) assess the actions day trading firms have
    taken to address regulatory concerns.

    To address these objectives, we focused our work
    on seven of the largest day trading firms. These
    firms have about 5,300 day traders, or nearly 80
    percent of the 7,000 day traders whom regulators
    estimate trade in the United States. An industry
    representative estimated that these seven firms
    accounted for over 80 percent of all day trading
    volume. We also reviewed the results of 67
    examinations of day trading firms and their branch
    offices done by federal regulators.

    Results in Brief
    Day trading among less experienced investors is an
    evolving segment of the securities industry. Day
    traders, who represent less than 1/10th of 1
    percent of all individuals who bought or sold
    securities, accounted for a growing part of
    trading on Nasdaq, estimated by industry officials
    to be about 10 to 15 percent of total Nasdaq
    volume. These traders all did their trading at
    specialized day trading firms, but the firms
    employed various structures and operating
    strategies that affected the risks the traders
    faced. Some firms encouraged any individual who
    wanted to be a day trader, and had the capital to
    begin trading, to use the firm's systems and
    facilities to trade, risking the trader's own
    capital. Others emphasized that they wanted only
    people who were qualified and able to be
    professional traders to trade, risking the firms'
    capital. These traders could be fired if they
    suffered significant loss, but they do not lose
    their own capital. Some firms employed a
    combination or variations of these strategies.

    The effects of day trading on both the individuals
    who engage in it and the markets as a whole are
    uncertain. For example, day trading is risky, and
    state regulators have reported that most
    individual day traders they investigated lost
    money. However, officials at day trading firms we
    visited said that although most people lose money
    initially, the majority of their experienced
    traders (those that traded longer than 6 months)
    made money. Two firms supplied us records that
    showed many of their traders were extremely
    profitable; however, other firms did not supply
    records, and we could not verify the extent of
    profitability in the industry as a whole. From a
    market standpoint, day traders' access to the
    markets provides direct competition for market
    makers and institutional traders that may benefit
    all individual investors, but day traders'
    frequent trading during the day also could
    potentially make market prices more volatile.
    Gaining a better understanding of the effects of
    day trading on individuals as well as the markets
    could help regulators better ensure that investor
    protection and market integrity objectives are
    met.

    Federal regulators have taken some actions to
    address the risks of day trading. The regulatory
    arm of the National Association of Securities
    Dealers, called NASD Regulation (NASDR), and the
    Securities and Exchange Commission (SEC) have made
    a special effort to target their examination
    resources during the last 2 years on day trading
    firms, performing 67 examinations of day trading
    firms and their branches.1 They were concerned
    that these firms were advertising day trading as a
    profitable strategy without fairly representing
    the risks associated with day trading. The rule
    violations found most frequently in their
    examinations of day trading firms related to
    supervisory procedures, net capital computations,
    and advertising. They also found violations
    involving margin and lending issues.2 In addition
    to these examinations, NASDR has recently
    submitted proposed rule changes to SEC that
    require day trading firms to assess the
    appropriateness of day trading for each potential
    customer and to fully disclose the risks of day
    trading.  NASDR and the New York Stock Exchange
    (NYSE) have also submitted proposed rule changes
    to SEC to tighten margin requirements.

    Some of the day trading firms we visited
    recognized these regulatory concerns and told us
    that they have already taken steps to provide
    better disclosure; screen prospective traders; and
    restrict certain activities, such as customer-to-
    customer lending. The risk disclosure statements
    from all of the firms we visited contained
    language the same as or similar to that in NASDR's
    proposed risk disclosure statement. Determining
    the adequacy and extent of oral disclosures,
    screening, and planned restrictions presents a
    difficult challenge because neither the regulators
    nor we could directly observe the interactions
    between the firms and traders or potential
    traders. However, ongoing implementation of such
    controls by firms and oversight by regulators are
    important for ensuring that potential day traders
    understand that they are directly competing with
    professional market makers and institutional
    traders and can lose as much as, or more than,
    they have invested.

    We are making a recommendation to the Chairman,
    SEC, in conjunction with NASD, to evaluate the
    implications of day trading on the integrity of
    the markets after decimal trading is implemented.
    We are also recommending that the Chairman, SEC,
    do at least one more cycle of targeted
    examinations of day trading firms to ensure that
    the firms take the corrective actions they propose
    in response to previous examination findings.

    Background
    Day trading requires a continuous stream of
    current market data and the ability to trade
    without delay. Numerous day trading firms have
    developed sophisticated order routing and
    execution systems as well as software that can be
    used on computerized workstations. These systems
    enable day traders not only to monitor the market
    on a real-time basis, but also to trade on a real-
    time basis-similar to practices followed by
    professional traders at proprietary firms. The
    order routing and execution systems of these firms
    allow day traders to be linked directly to the
    stock markets, enabling the traders to send orders
    to a particular market or market maker without
    involving an intermediary firm. As a result, day
    traders have the tools to employ the trading
    strategies and techniques that were previously
    available only to market makers.

    SEC has stated that over the last 3 years some day
    trading firms have focused on marketing day
    trading as a strategy to investors, and these
    firms have emphasized the opportunity for
    individuals to profit from day trading without
    fully disclosing the risks. Reports have surfaced
    about day traders who have lost money and claimed
    they were not informed of the risks. SEC and NASDR
    are focusing their efforts on trying to ensure
    that day traders completely understand not only
    the risks associated with day trading, but also
    that there are high costs that can result from
    frequent trading.

    Although investing in securities always involves
    some degree of risk, day trading involves a higher
    degree of risk of loss because of the way it is
    conducted. Day traders try to anticipate market
    movements and profit from short-term price
    movements in individual stocks. Using this
    strategy, day traders trade frequently, incurring
    commissions and fees for computer and electronic
    services provided by the day trading firm that can
    significantly reduce a trader's earnings.
    Furthermore, unlike investing through a full-
    service broker-dealer, who may be responsible for
    determining whether a particular trade is suitable
    for the investor, day traders typically are the
    only ones accountable for their trading decisions.

    Day trading typically requires direct electronic
    access to the markets. Day trading firms provide
    order entry terminals to Nasdaq as well as NYSE.
    Day trading is primarily transacted through
    Nasdaq, which is an electronic communications
    system where market makers display prices at which
    they are willing to buy or sell stocks for their
    own accounts or for their customers. In the last
    few years, day trading has also been transacted
    through electronic communications networks (ECNs),
    which allow customers to display their orders to
    other customers and also allow customer orders to
    be paired. ECNs are primarily used to access
    Nasdaq. However, they may also be used to trade
    stocks listed on exchanges. Day traders also have
    electronic access to listed stocks through the
    Superdot system, which is an electronic order
    delivery system that links NYSE member firms to
    individuals on the floor of an exchange who
    execute their orders.

    Electronic Day Trading Has Changed
    Regulatory changes to Nasdaq spurred the
    development of electronic day trading. Nasdaq
    first introduced electronic executions when it
    developed the Small Order Execution System (SOES)
    in 1985.3 The system was not fully implemented
    until 1988 when SEC required all market makers to
    participate.4 Nasdaq also introduced SelectNet in
    1990 as a system for market makers to communicate
    and to execute transactions electronically with
    each other.

    Shortly after market maker participation in SOES
    became mandatory, a few firms realized that they
    could profit from using SOES. These firms became
    known as SOES day trading firms, and market makers
    called them SOES Bandits.5 Nasdaq market makers
    did not like losing profits to SOES day traders.
    As a result, NASD proposed various SOES rule
    changes to limit the activity of day traders.
    However, a series of events between 1993 and
    1996-including an investigation of market makers'
    possible collusion-affected how SOES day traders
    were viewed in the market. As a result of these
    events, NASD and SEC implemented several rules
    changes. In January 1997, NASD implemented SEC's
    order handling rules.6 These rules required Nasdaq
    market makers to display customer limit orders and
    to disseminate the best prices placed by market
    makers in ECNs, which previously were not included
    in the Nasdaq market.7 NASD also implemented
    actual size rules that allowed market makers to
    display quotes in minimum sizes of 100 shares for
    certain stocks, which had the impact of limiting
    the use of SOES by day traders because the trade
    size fell from 1,000 shares to 100 shares. As a
    result, SOES day trading firms began to develop
    and use ECNs in order to continue to provide day
    traders access to the market without the
    limitations of SOES that resulted from the rule
    changes. 8

    With the decline in the use of SOES, day trading
    firms began to evolve into customer-based firms
    that offered their traders direct access to ECNs,
    SelectNet, Nasdaq, and the major stock markets.
    Moreover, the inclusion of ECNs in the Nasdaq
    market enabled ECNs to explode in popularity, and
    these networks have become the choice of trading
    for day traders, according to industry officials.9
    According to industry statistics, ECNs account for
    30 percent of the Nasdaq trades. In fact, one of
    the largest ECNs was created by a day trading
    firm.

    Day traders' use of ECNs has meant that not only
    has the venue they use to trade changed, but whom
    they trade with has also changed. ECNs allow
    orders to be paired or traded with each other. By
    trading on ECNs, day traders are trading more and
    more with each other and less and less with market
    makers.10 For instance, one firm estimated that 35
    percent of its order flow would match internally
    if was conducted within a single ECN.

    ECNs are also designed to handle limit orders, and
    the increased use of ECNs has resulted in the
    increased use of limit orders.11 Before 1997, day
    traders were submitting most of their orders as
    market orders through SOES. The Electronic Traders
    Association (ETA) estimated that limit orders
    constitute nearly one-half of day trader orders,
    which they said helps to improve prices. They
    stated that if a market maker quoted a stock at 50-
    50-�, a customer limit order of 50-1/8 would
    effectively narrow that spread, thereby improving
    prices for all investors. Industry and regulatory
    officials have stated that limit orders are now a
    part of the quote montage (all listed quotes), and
    the inside price (best price) may well be set by a
    public order from a day trader.

    Scope and Methodology
    To determine the nature and extent of day trading,
    we collected data from day trading firms, SEC,
    NASDR, and ETA. We identified the largest day
    trading firms through industry and regulatory
    sources and focused our study on the seven largest
    firms. Officials from another large firm told us
    that officials from a firm we visited could speak
    for them, and they chose not to talk to us. We
    obtained data on the number of day traders from
    the firms that we visited. When possible, we also
    cross-checked those numbers with any data found in
    SEC and NASDR's examinations of those firms. To
    determine the nature of day trading, we
    interviewed officials of the seven day trading
    firms about how day trading was conducted at their
    firms. We also spoke to ETA about the overall
    nature of day trading, and we reviewed the
    regulatory examinations of day trading firms for
    information on the nature of day trading. To
    obtain opinions and data on the profitability of
    day traders, we interviewed officials from the
    seven largest firms about the profitability of
    their traders, and we reviewed data from two of
    the firms. We did not assess the reliability of
    data gathered from these sources.

    To identify regulatory actions taken to address
    the risks of day trading, we reviewed the 67
    examinations that NASDR and SEC did during 1998
    and 1999. We determined the frequency of the
    violations and the actions SEC and NASDR were
    taking against day trading firms for the
    violations. We also interviewed state securities
    officials from Texas and Massachusetts, the two
    states that had taken action against day trading
    firms, and an official from the North American
    Securities Administrators Association (NASAA) who
    was the main author of that Association's report
    on day trading. Additionally, we interviewed NASDR
    and SEC officials about the proposed rules for day
    trading firms, and we reviewed the rules and
    public comment letters relating to the rules.
    Lastly, we reviewed related congressional
    testimonies of NASD, SEC, and ETA officials.

    To identify actions day trading firms have taken
    to address regulatory concerns, we interviewed
    officials from the seven day trading firms we
    visited about the initiatives they were taking
    pertaining to issues regulators were concerned
    about such as customer-to-customer lending, risk
    disclosure, margin issues, and appropriateness
    determinations. We also obtained each firm's risk
    disclosure statements and compared them to NASDR's
    proposed disclosure statement to determine if they
    appeared to be line with NASDR's proposal.
    Additionally, we talked to ETA, the Securities
    Industry Association (SIA), and legal
    representatives of day trading firms to get their
    views about the firms' initiatives. We also talked
    to Federal Reserve officials about current margin
    requirements that pertained to securities firms.

    We requested comments on a draft of this report
    from SEC and NASDR. Their comments are discussed
    near the end of this letter and reprinted in
    appendixes I and II. We did our work in accordance
    with generally accepted government auditing
    standards between July 1999 and January 2000 in
    Washington, D.C.; Houston and Austin, TX; New
    York, NY; and Montvale and Jersey City, NJ.

    Nature and Extent of Day Trading
    Day trading is different from on-line trading or
    trading through a full service broker. Day trading
    is usually conducted on-site at firms that offer
    technology that is superior to the technology
    offered by on-line trading firms. These firms have
    developed order routing and execution systems that
    allow day traders to trade directly into the
    market with no intermediary, which is something an
    individual has never before been able to do. The
    firms that we visited had different structures and
    operating strategies, with the common
    characteristic that their traders used day trading
    strategies. Although state regulators have
    reported that most day traders lose money,
    officials at six of the firms we visited said that
    most of their experienced traders were profitable.
    The effects of day trading on the markets have
    been controversial, but we found no overall
    analysis of the benefits and costs of day trading.

    How Day Trading Is Conducted
    Day traders attempt to profit from small movements
    in the prices of stocks over a short time period.
    For example, they try to anticipate the likely
    move of a stock in the next few minutes or hours,
    buying and selling quickly, and generally hoping
    for a small profit (this could be as little as 25
    cents a share) on a large number of shares
    (averaging about 1,000). Day traders are generally
    momentum traders-hoping to buy when prices are
    increasing and sell before prices fall or sell
    when prices are decreasing and buy back before
    prices rise. Most day traders also try not to
    carry positions overnight.

    As a result of their trading strategies, day
    traders are not considered to be investors. They
    do not pay close attention to such factors, as
    price/earnings ratio or investing and earnings
    models, which investors are taught to follow. They
    do not hope to gain by buying and holding shares
    over extended periods of time.

    Day trading is also different from trading on-
    line, although the distinctions between them are
    beginning to blur. On-line trading provides
    investors a cheaper, faster way to place orders
    with their brokerage firms than contacting them by
    telephone. On-line traders may use any number of
    trading strategies designed to profit from either
    short-term or long-term favorable price movements
    in the stocks they buy and sell. On-line traders
    may also employ day trading strategies, but these
    traders generally lack the access to the markets
    and instantaneous updated prices that day traders
    have.

    Direct Access to the Markets Versus Payment for
    Order Flow
    A day trading firm provides its traders with
    direct access to the markets through the firm's
    order router, which instantaneously sends orders
    to the market location with the best price by
    interfacing directly with the major stock markets
    and ECNs. As a result, day traders send their
    orders to a particular market without having an
    intermediate firm involved in routing the order.
    In doing so, day traders can receive a trade
    execution within seconds of placing their orders,
    which is necessary for them to be able to
    capitalize on small price movements in stocks.

    Day traders' direct access is different from the
    access to the markets provided by many on-line
    trading firms. These on-line trading firms may
    take customer orders and either match them
    internally or sell them to a specific market maker
    in return for payment for order flow. In these
    arrangements, the market maker pays a penny or
    more a share for the order flow created by the on-
    line firm's customers and is to provide the
    customer an execution at the best prevailing
    quoted prices.

    The distinctions between on-line firms and day
    trading firms are becoming less obvious as these
    industries develop. For example, on-line trading
    firms are beginning to provide their frequent
    traders news and price quote services similar to
    those already provided by day trading firms.
    Although market makers, institutional investors,
    and day traders have direct access to ECNs, a few
    on-line firms have decided to offer their
    customers some level of direct access to ECNs or
    funnel some of their customer order flow into
    ECNs. Additionally, some day trading firms are
    going after the active trader at on-line firms by
    promoting the advantages of direct access to the
    markets.

    Technology and Software of Day Trading Firms
    The technology and software that day trading firms
    provide enable day traders to have real-time data
    and information as well as direct access to the
    markets similar to what proprietary firms offer
    their traders. The computer facilities, high-speed
    access lines, and software packages that day
    trading firms use are specifically designed to
    support and accommodate day trading. For example,
    these firms provide day traders access to Level II
    data, which shows the best bid (buy) and ask
    (sell) prices and the number of shares available
    for every market maker and ECN. The Level II data
    are often provided by day trading firms with
    extreme speed that enables day traders to
    capitalize on momentary fluctuations in prices.
    Other software features of day trading firms
    include

    �    offering traders a broad view of the market,
    such as allowing them to open up a list of
    hundreds of stocks and watch them update in real
    time;

    �    point and click order-entry windows that
    allow traders to send out orders to different
    exchanges;
    �    real-time profit and loss windows;
    �    fundamental data on companies;
    �    ticker features; and
    �    programmable key strokes that allow traders
    to specify any function key combination for order
    entry functions;

    Figure 1 provides an example of the type of
    information and software in a mainstream
    application that day trading firms offer day
    traders.

    Figure 1: Typical Trading Screen for Day Traders

    Source: Information on the screen was provided by
    TradeCart as modified by GAO.

    Structures of Day Trading Firms Pose Different
    Risks to Day Traders
    Day trading firms are typically organized as (1)
    broker-dealers that have customers who open
    accounts with the firm and use the assets in their
    own accounts to trade; or as (2) limited liability
    companies (LLC), which sell an interest in the
    firm to individuals wishing to day trade. As
    broker-dealers, these firms must register with
    SEC, and they are subject to SEC rules and
    regulations. Broker-dealers with customers are
    also required to be members of NASD and are
    subject to NASDR rules. LLCs are also registered
    broker-dealers, but individuals who day trade at
    these firms typically are not customers; they
    become part owners of the firms and are called
    associated persons. These firms allow their
    associated persons to trade using a portion of the
    firms' capital contribution. Many LLCs are members
    of the Philadelphia Stock Exchange and are subject
    to its rules. The seven day trading firms we
    visited were all registered broker-dealers, six
    were NASD members, and one was an LLC that was a
    Philadelphia Stock Exchange member. These
    structures affect the risks faced by the day
    traders at the firms.

    The structures and operations of the firms we
    visited were very different. Three firms had
    mostly registered proprietary day traders, who
    traded on behalf of the firms and the firms'
    customers. They also had a few nonproprietary day
    traders who traded using their own capital and the
    firms' software and facilities. One of these firms
    was completely unique in that it had only four
    registered proprietary day traders trading on
    behalf of about 19 investors and had no
    nonproprietary day traders. This firm did 80
    percent of its trades automatically through
    specially designed software programs and 20
    percent by its proprietary traders, and it traded
    almost 10 million shares a day. The other four
    firms had mostly nonproprietary day traders and a
    few proprietary traders.

    Officials at five of the day trading firms we
    visited asserted that they were selective about
    whom they allowed to trade at their firms. They
    said they looked for individuals who would
    approach day trading in a professional manner and
    eventually become professional traders similar to
    the traders at market making firms. In general,
    these firms tended to already have a high
    percentage of proprietary traders and were looking
    to hire more individuals who would be proprietary
    traders. One firm said that it was moving away
    from having nonproprietary day traders towards
    having only proprietary day traders. However,
    officials at two firms said that as long as
    individuals met the initial capital requirement,
    which was at least $25,000, they would allow
    anyone to trade.

    Nonproprietary day traders trade using their own
    money and risk losing as much as, or more than,
    they have invested. Proprietary day traders who
    trade at LLCs typically are limited partners that
    have invested their own money into the firm in
    order to trade, risking the accumulated capital of
    the limited partners. In many cases, these
    proprietary traders' potential losses are limited
    to the amount of their initial investments. Rules
    designed to ensure that day traders understand
    their risks of loss and the pitfalls of trading on
    margin or with borrowed funds carry added
    significance for any day trader whose own money is
    at risk. However, we found some non-LLC day
    trading firms that hire proprietary traders to
    trade, risking the firms' money or that of
    investors in the firms. These traders can be fired
    if they continually lose the firms' money, but
    their risk of loss is different because they do
    not risk their own money. None of the investors in
    these firms had filed any complaints with
    securities regulators.

    Extent of Day Trading
    Day traders are few in number, but they account
    for a growing amount of the Nasdaq trading volume.
    SEC estimated that about 7,000 people are day
    traders at day trading firms. By comparison, about
    80 million individuals own stock, and more than 5
    million use on-line brokerage firms. As a whole,
    day traders represent less than 1/10th of 1
    percent of all individuals buying and selling
    stocks. SEC also estimated that there are about
    100 day trading firms operating, with hundreds of
    offices around the country, which is a small part
    of the nearly 8,000 registered broker-dealer
    firms. However, NASDR and SEC officials said they
    could not be sure of the total number of day
    trading firms because these firms are required to
    register only as broker-dealers, not as day
    trading firms. ETA estimated that there are 62 on-
    site day trading firms.

    Day trading firms account for an estimated 10 to
    15 percent of the total Nasdaq trading volume in
    1999, according to industry officials. Their
    trading volume has steadily increased over the
    last few years. In 1997, day trading firms as a
    whole represented an estimated 7.7 percent of the
    Nasdaq trading volume. As of year-end 1999, we
    estimated that the seven firms we visited
    represented about 9 percent of Nasdaq's trading
    volume. An industry report estimated that on-site
    day traders were responsible for 11 percent of the
    Nasdaq trading volume during the first quarter of
    1999.12 ETA has consistently said that day traders
    represent about 15 percent of the Nasdaq trading
    volume.13

    Day traders trade more often than the average
    trader placing orders through a brokerage firm or
    on-line. The firms we visited told us they
    generally executed anywhere from about 2,700
    trades a month to about 1.8 million trades a
    month. On a yearly basis, day traders at the firms
    made anywhere from 33,000 trades a year to about
    22 million trades a year.14 In contrast, one
    industry study stated that the average full-
    service brokerage customer conducts between 6 and
    12 trades a year, and the average on-line investor
    conducts between 15 to 25 trades a year.

    Profitability of Day Traders
    Whether day trading is profitable is the subject
    of much debate within the securities industry.
    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. Moreover, ETA officials stated
    that the risk of loss in day trading can be
    substantial. It estimated that the learning period
    for day trading is about 3 to 5 months, and not
    only will most people lose money in that period
    but a substantial number of day traders will never
    be successful. However, officials at six of the
    seven firms that we visited said that the most of
    their experienced traders were profitable.

    All of the firms we visited agreed with ETA's
    estimate that it takes individuals from 3 to 5
    months to be profitable. Some of the firms said
    that although they have had individuals leave
    during the 6-month period, none had experienced a
    high turnover rate because of unprofitability.
    However, two firms said that they had asked
    individuals who, in their estimation, could not be
    profitable day traders to leave.

    One of the firms that we visited published the
    profitability of its day traders on its Web site.
    The data showed that 47 percent of its traders
    made money after commissions in 1998, and 52
    percent made money in 1999.15 We estimated that of
    the 47 percent who made money, 74 percent-35
    percent of the total number of traders-beat the
    return of the Standard & Poor's index of 500 (S&P
    500) stocks in 1998.16 In 1999, 55 percent of this
    firm's traders made money. We estimated that of
    the 55 percent who made money, 78 percent-43
    percent of the total number of traders-beat the
    return of the S&P 500. In comparison, industry
    statistics show that less than 25 percent of all
    stock mutual funds have been able to beat the
    return of the S&P 500 in the last few years. The
    other six firms that we visited told us that many
    of their experienced traders were profitable.
    These firms did not, however, publish data on the
    profitability of their traders on their Web sites.
    Further, day traders have achieved these results
    during an extended bull market.

    Day trading firms we visited said they make a
    profit from day traders' activities. These firms
    charge commissions on each trade made by day
    traders as well as fees for computer and
    electronic services provided by the firms. The
    firms that we visited said that they net about $2
    or more on each trade. Using the data from 1 firm
    that had 500 traders conducting about 20 trades a
    day, we estimated that the firm nets about $20,000
    a day. Some firms netted more than that amount,
    and others netted less. Officials at one firm said
    that the firm's daily net profit was about
    $150,000.

    Effects of Day Trading
    The effects of day trading in its current form are
    unknown. When day traders primarily traded through
    SOES, several studies analyzed the effects of SOES
    trading on spreads, liquidity, and volatility. Our
    previous review of these studies found that they
    could not isolate the effect of SOES trading from
    that of other changes in the market.17 The effects
    of day traders in the more recent environment,
    which depends less on SOES and more on ECNs, have
    not been similarly assessed.

    Industry officials have said that day traders have
    provided some benefits to the markets. For
    example, as evidenced by their growing share of
    the Nasdaq volume, day traders bring substantial
    liquidity to the markets. These officials also
    said that the increased use of limit orders by day
    traders has helped to improve price efficiency for
    all traders. For example, when day traders enter a
    limit order that is between the best bid and ask
    spread, they improve prices for all retail orders.
    Additionally, day trading firms have also been an
    impetus behind the development and use of some
    ECNs, which has enabled individuals, for the first
    time, to have direct access to the securities
    markets.

    On the other hand, as we reported in 1998, market
    participants have said that day trading through
    SOES caused increased volatility in the market.18
    They stated that the trading strategies of SOES
    day traders, such as the momentum-based strategy
    of buying in "up trending" markets and selling in
    "down trending" markets, have led to increased
    volatility. The studies that examined volatility
    and trading through SOES showed that they were
    related. However, the studies did not clearly
    establish whether SOES trading caused volatility
    or whether other market forces caused volatility,
    which then attracted SOES trading. Market and
    regulatory officials have been concerned that the
    effects of day trading through ECNs are similar to
    those they attributed to SOES trading. However,
    they have not yet attempted to evaluate these
    effects. They have been primarily concerned about
    the practices of day trading firms because some
    day trading firms have violated securities rules
    and regulations and misled customers.

    Securities Regulators' Oversight of Day Trading
    Firms Found No Widespread Fraud
    Over the last 2 years, securities regulators have
    focused their oversight efforts on day trading
    firms through both targeted examinations and
    proposed rule changes. NASDR and SEC performed 67
    examinations of day trading firms and their
    branches during this period.19 Although they found
    no widespread fraud among the day trading firms,
    they found a number of violations and are
    concerned about compliance with some rules. The
    most frequently occurring violations involved
    rules relating to written supervisory procedures,
    net capital computations, short sales, and
    advertisements. The examinations also found
    violations relating to margin and customer
    lending. During the same time period, NASDR and
    NYSE have also proposed rules that would address
    some of the risks of day trading. SEC is reviewing
    the rule proposals.

    SEC and NASDR Targeted Examination Resources at
    Day Trading Firms
    NASDR, NYSE, and SEC examine all securities broker-
    dealers on a cyclical basis based on the risks
    they pose to their customers and the securities
    markets. NASDR and NYSE examine all their member
    firms on a regular schedule, and SEC examines a
    sample of broker-dealers each year to assess the
    effectiveness of NASDR and NYSE examinations and
    to ensure compliance with securities laws. These
    routine examinations review various aspects of
    broker-dealer operations, including sales
    practices, advertising, and financial integrity,
    among others. NASDR, NYSE, and SEC also do "cause"
    examinations to address particular problem areas
    identified through various means, such as customer
    complaints. They also target high-priority areas
    for annual on-site inspections. During 1997 and
    1998, NASDR and SEC targeted day trading firms
    because they were concerned that the firms were
    marketing unrealistic expectations and
    unsubstantiated representations about the
    profitability of day trading, but not adequately
    describing the risks.

    SEC and NASD officials told us that the violations
    found at the day trading firms were generally
    similar to violations they find at most securities
    firms. They said that when they find violations,
    they notify the firms and give them 30 days to
    respond in writing, stating the steps that they
    are taking to correct the violations. SEC
    officials said that if firms do not agree to take
    necessary corrective actions, SEC examiners would
    either refer the matter to SEC's Enforcement
    Division for review or take other action. As of
    January 2000, neither SEC nor NASDR had reexamined
    any of the firms or branches they targeted in 1997
    and 1998.

    SEC and NASDR examiners may also refer firm
    conduct or violations that they consider warrant
    investigation to SEC's Enforcement Division for
    further review. Their examiners referred 15 day
    trading firms to the Enforcement Division. SEC
    officials said that the Enforcement Division's
    investigations of these firms relate to margin
    lending, net capital, broker-dealer registration
    issues, short sales, supervision, and advertising.
    The investigations were ongoing as of February 16,
    2000.

    Written Supervisory Procedure Violations
    NASDR rules require each broker dealer to
    establish, maintain, and enforce written
    procedures that enable it to supervise its
    registered representatives and associated persons
    and that are designed to ensure the member
    complies with applicable securities laws.
    Examiners are to review a firm's procedures and
    its books and records to determine if the firm is
    enforcing and complying with the procedures.

    During their day trading examinations, NASDR and
    SEC found 29 instances in which day trading firms
    failed to enforce their own written supervisory
    procedures. Of the seven firms that we visited,
    two had such violations. SEC and NASDR examiners
    found that firms violated rules or failed to
    enforce internal supervisory procedures that

    �    forbade a registered representative or any
    person associated with the firm from recommending
    securities or trading strategies,

    �    directed supervisory personnel to evaluate
    prospective clients by reviewing a client's income
    and type of employment,
    �    prevented employees from arranging for credit
    to a customer on terms more favorable than
    available through other means, and
    �    required an annual review of branch offices.
    In some cases, violations resulted from a firm's
    failure to have appropriate written supervisory
    procedures. For example, some firms

    �    failed to have procedures that addressed the
    lending of funds between customers;

    �    failed to have procedures that addressed the
    types of business in which it engaged;
    �    failed to have procedures that specifically
    supervised the type of business in which it
    engaged (one firm advertised itself as a broker-
    dealer that specialized in on-line day trading,
    but it did not have procedures that specifically
    supervised this type of business);
    �    failed to have procedures pertaining to short
    sale transactions; and
    �    failed to have procedures that addressed the
    disclosure of credit terms between customers.
    Short Sale Violations
    SEC and NASDR's short sales rules prohibit
    investors from selling an exchange-listed stock
    short unless the stock's last trade or bid was at
    the same price as or higher than the previous
    trade or bid.20 The purpose of these rules is to
    keep firms and investors from exacerbating price
    movements when markets are declining. NASDR also
    requires that securities firms mark all sales as
    either "long" or "short" and that the firms
    determine if they can obtain shares of the
    security sold short to deliver to the buyer.21 SEC
    and NASDR examiners found 14 violations of short
    sales rules. Of the seven firms that we visited,
    the regulators found two firms that had violated
    the short sale rules.

    The regulators also found that some day trading
    firms lacked the surveillance systems needed to
    prevent and detect short sale violations by day
    traders. They found that this was particularly
    true of day trading firms that were organized as
    LLCs.22

    Net Capital Violations
    Day trading firms, like all other broker-dealer
    firms, are required to comply with the net capital
    rule.  The net capital rule is a liquidity-based
    capital standard that requires broker-dealers to
    (1) maintain a minimum level of liquid capital
    sufficient to promptly satisfy all of its
    obligations to customers and other market
    participants and (2) provide a cushion of liquid
    assets to cover potential market, credit and other
    risks.23 Examiners usually evaluate a firm's net
    capital as of a given date. They are to check to
    see whether the firm has computed its net capital
    and whether the calculations were done according
    to the rules. Inaccurate computations result in
    firms either overstating or understating their net
    capital or having net capital deficiencies.

    SEC and NASDR examiners found 16 examples of day
    trading firms either not maintaining the required
    minimum net capital amount or not preparing their
    net capital computations in accordance with the
    rules. Of the seven firms we visited, one firm had
    violated the net capital rules.

    Advertising Violations
    NASDR reported that 80 percent of the day trading
    firms that it examined had potentially problematic
    advertisements that had been referred to its
    Advertising Regulation Department for review. The
    problem areas ranged from exaggerated statements
    of profits that can be generated from day trading
    to day trading Web sites and other communications
    with the public that have indicated that losses
    can be controlled or minimized through the use of
    certain strategies or techniques. SEC has also
    stated that it is concerned about Web sites that,
    although not operated by day trading firms, are
    trying to capitalize on day trading. Many of these
    sites appear to advertise the potential rewards of
    day trading by use of the sites' recommendation.
    SEC said it is looking into whether these sites
    are violating the federal securities laws.

    SEC and NASDR examiners found over 20 advertising-
    type violations. One of the seven firms that we
    visited had advertising violations. The types of
    advertising violations found at day trading firms
    included

    �    failure to maintain and evidence written
    approval by a registered principal on one piece of
    sales literature utilized during the day trading
    seminar sponsored by a branch office of the firms;

    �    failure of an affiliate of a day trading firm
    to file a pamphlet, which appeared to contain
    misleading or exaggerated statements, with NASDR's
    advertising department;
    �    failure to refrain from making
    recommendations in advertisements;
    �    exaggerated or unbalanced statements
    advertising a trader's profit; and
    �    failure to file initial advertisements with
    NASDR.
    Fewer Violations Relating to Margin and Customer
    Lending
    SEC and NASDR found fewer violations relating to
    margin and lending issues. Although these
    violations tended to be isolated, margin and
    related customer lending are two issues that
    regulators believe are potential problems with day
    trading firms because of the nature of day trading
    and the way it is conducted.

    Margin
    Day trading generally occurs in margin accounts.24
    Generally, a customer that trades in a margin
    account is subject to the initial margin
    requirements of Regulation T and the maintenance
    margin requirements imposed by the SROs.  The
    initial margin requirements under Regulation T
    permit a firm to lend its customers up to 50
    percent of the initial purchase of stock.25 To
    comply with Regulation T, the customer would have
    to deposit funds or margin securities equal to 50
    percent of the purchase price of the stock bought
    during the day and held in the account at the end
    of the day.  For instance, a customer who wants to
    buy $150,000 worth of stock can put up $75,000 and
    then finance the other $75,000 with a loan from
    the broker-dealer. Once stocks have been
    purchased, NASDR and NYSE maintenance margin rules
    require a customer to maintain equity in his or
    her account equal to at least 25 percent of the
    value of the stock held in the account. For
    instance, a customer who bought $150,000 of stock
    on margin would have to have equity in a margin
    account of at least $37,500. If a customer does
    not satisfy these requirements, the broker-dealer
    must ask the customer to deposit additional cash
    or margin securities to satisfy the margin
    deficiency, known as a margin call. Thus, there
    are two separate margin requirements for each
    account: one for the initial purchase of stock and
    the other for the amount that has to be maintained
    on margin once stock has been purchased. Both
    calculations are made at the end of the day, and
    if a customer has not met the appropriate margin
    requirements, a margin call is issued. Regulation
    T margin calls must be satisfied within one
    payment period after the margin deficiency was
    created or increased, which is generally 5
    business days.  NASDR and NYSE maintenance margin
    calls must be satisfied as promptly as possible,
    and in any event within 15 business days from the
    date the margin deficiency occurred.

    Because initial and maintenance margin
    calculations are made at the end of the day, the
    above requirements are generally not applicable to
    day traders because their stocks are sold by the
    end of the day before the margin calculations are
    made.  Accordingly, NYSE and NASDR have also
    established separate margin rules for day traders
    in order to addres this and other concerns.  Under
    NYSE and NASDR rules, when day trading occurs in a
    day trader's account, the margin requirement is
    calculated at the end of the day based on the
    total cost of all the day trades made during that
    day. 26

    Regulators have found that some day trading firms
    that are structured as LLCs allow their day
    traders to be highly leveraged. Under an LLC, a
    day trader contributes to the firm's capital and,
    as a result, is permitted to trade using the
    firm's capital. Accordingly, the day trader is not
    subject to the margin requirements outlined above;
    rather, the day trader's leverage is limited by
    the firm's overall net capital requirement.  This
    enables a day trader who is a member of an LLC to
    be leveraged far higher than the 2-to-1 leverage
    allowed day traders under initial margin and
    maintenance margin rules. Regulators implemented
    margin requirements not only to protect the
    financial integrity of broker-dealers that provide
    credit, but also to protect customers from taking
    on too much leverage. The leverage afforded
    through LLCs enables their day trading members to
    have much more capital with which to trade, and
    their exposure to loss is much higher than would
    be afforded to day traders of a broker-dealer firm
    that has a more traditional structure and treats
    day traders as customers. As a result, some day
    traders can be leveraged to a greater extent than
    was intended by margin rules.

    NASDR and SEC examiners found five margin
    violations. Of the seven firms that we visited,
    one firm had margin violations. Margin violations
    included the following:

    �    An account was allowed to trade when
    Regulation T margin requirements had not been met.
    �    One firm's customers did not make the
    required deposits of additional margin into their
    accounts.
    �    An associated person of the day trading firm
    extended credit to day traders of the firm in
    amounts that exceeded the amount the firm is
    allowed under under Regulation T.

     Lending
    SEC and NASDR found that some day trading firms
    allow the use of customer-to-customer lending,
    where one customer lends money to another who
    requires funds to meet margin calls.27 NASDR found
    that half the firms that were examined allowed
    customer-to-customer lending. Combined, SEC and
    NASDR examiners found 23 day trading firms that
    allowed customer-to-customer lending. Of the seven
    firms that we visited, three allowed customer-to-
    customer lending.

    Although customer-to-customer lending is not
    illegal, regulators are concerned about the
    practice, especially when such lending is used to
    satisfy day traders' margin requirements.
    Regulators believed that some day traders would be
    unable to continue to trade without the infusion
    of capital from the loans. NASDR expressed concern
    about customer-to-customer loans that were
    arranged by the day trading firm or one of its
    employees for the purpose of meeting margin calls.
    NASDR's concern was with the role of the day
    trading firm and what type of information was
    conveyed to the borrower about the risks.

    The lending violations that the regulators found
    related to disclosure of credit terms in margin
    transactions and disclosure and other requirements
    when extending or arranging credit in certain
    transactions. For instance, Regulation T was
    promulgated to regulate the extension of credit by
    broker-dealers; it defines a creditor to include
    any person associated with the broker or dealer as
    defined in the Securities Exchange Act. Examiners
    found that some day trading firms were extending
    credit to day traders at the firm in violation of
    the rules. Examiners also found instances where
    associated persons of the day trading firms
    extended credit to customers without establishing
    procedures to ensure that day traders were given
    disclosures related to the terms of the loan. Of
    the seven firms that we visited, examiners found
    two firms had violations relating to lending.

    Proposed Rules Address Some Regulatory Concerns
    NASDR and NYSE have proposed rules that would
    require day trading firms to tighten margin
    requirements.  NASDR has also proposed rules that
    would require day trading firms to assess the
    appropriateness of day trading for each potential
    customer and fully disclose the risks of day
    trading. Although NASDR's Board had approved the
    rules, as of February 16, 2000, SEC had not
    approved them. SEC has issued the NYSE rules for
    public comment.

    Proposed Rules on Margin
    Both NASDR and NYSE have proposed tightening the
    conditions under which active day traders may
    trade stocks on margin. The NASDR proposal would
    require that a pattern day trader-a day trader who
    trades four or more times within 5 days-maintain a
    minimum equity of $25,000 at all times. If the
    account falls below $25,000, the day trader would
    be barred from further day trades until the
    account is restored. In addition, the proposed
    rules would require a special maintenance margin
    requirement of 25 percent of the cost of the
    highest open position during the day.  The
    proposed rules would also reduce the time frame
    for day traders to meet a margin call from 7 days
    to 5 days.  Under the proposed rules, if a day
    trader received a margin call, until the call is
    met, the trader's buying power would go to 50
    percent and would be calculated based on the
    trader's cumulative positions, not the single
    highest position as is currently permitted under
    NYSE interpretation.  Moreover, if the margin call
    is not met within the required 5 business days, no
    trades on margin would be allowed for 90 days or
    until the margin call is met.  Furthermore, the
    funds that day traders deposit to meet their
    margin requirements would have to stay in the
    account for at least 2 business days in order to
    provide greater financial stability to day trading
    accounts.

    Proposed Rule on Appropriateness and Disclosure
    NASDR's proposed rule to require day trading firms
    to assess the appropriateness of day trading for
    each new customer is similar to the suitability
    rules NASDR imposes on broker dealers. Suitability
    rules require broker-dealers that recommend
    securities products to investors to make sure that
    the products are suitable for the investors, given
    the broker-dealers' knowledge of the investors'
    objectives, finances, risk tolerances, and so on.28
    Because day trading firms do not generally
    recommend particular products, they likely are not
    subject to the suitability rules.29 However, the
    proposed appropriateness rule would require NASD
    firms that promote a day trading strategy to (1)
    assess whether such trading would be appropriate
    for each customer before opening an account for
    the customer or (2) get a signed document
    indicating that the customer is not going to use
    the account for day trading.30 The proposed rule
    does not expressly define what promoting a day
    trading strategy would be. However, it does state
    that a firm would be promoting a day trading
    strategy if the firm promoted day trading through
    advertising, training seminars, or direct outreach
    programs. In essence, to approve a potential day
    trader for trading, the day trading firm would be
    required to determine whether day trading is
    appropriate for the individual by reviewing such
    things as the day trader's financial situation,
    investment and trading experience, and investment
    objectives. Day trading firms would be required to
    prepare a written record setting forth the basis
    on which the firm had approved the account for day
    trading.

    Risk Disclosure Statement
    The proposed account approval procedures would
    also require a day trading firm to provide a
    potential day trading customer with a disclosure
    statement on the risks of day trading. A day
    trading firm's risk disclosure statement would be
    required to point out that day traders should be
    prepared to lose all of their funds and that
    trading on margin may result in losses beyond the
    traders' initial investment. Specifically,
    information that should be disclosed could include
    the following statements:

    �    Day trading is extremely risky.

    �    Be cautious of claims of large profits from
    day trading.
    �    Day trading requires knowledge of securities
    markets.
    �    Day trading requires knowledge of a firm's
    operations.
    �    Day trading may result in paying large
    commissions.
    �    Day trading on margin or short selling may
    result in losses beyond the initial investment.
         Ensuring that day trading firms provide their
    potential traders an appropriate risk disclosure
    statement does not address what firms tell the
    traders orally. This presents a difficult
    challenge to regulators because they generally do
    not directly observe the interactions between
    firms and traders or potential traders. Also,
    unless they have a criminal investigative
    function, the regulators are precluded from posing
    as potential traders to test the oral disclosures
    firms provide.

    Day Trading Firms Have Taken Steps to Mitigate
    Regulatory Concerns
    Officials at some of the largest day trading firms
    have recognized regulatory concerns and said that
    they have taken steps to mitigate those concerns.
    For example, these officials said that they
    already screen prospective traders; have improved
    the disclosure they provide; and have restricted
    certain activities, such as customer-to-customer
    lending. Although day trading firm officials
    generally agreed with regulators that some day
    trading firms need enhanced oversight, they said
    they did not believe that the abuses at those
    firms warranted the new rule proposals. Most of
    these officials said that the proposed rules would
    not have much effect on their operations because
    they were already complying with much of what was
    being proposed.

    Day Trading Firms Actions Regarding
    Appropriateness
    Officials at six firms said that they screened
    potential customers to determine if an individual
    was the type they wanted trading at their firms.
    Although the criteria that each firm used were
    very subjective, all but one of the firms'
    officials said that they would not take just
    anybody off the street who wanted to day trade.
    These officials said that potential traders had to
    meet their firms' initial capital requirements.
    Additionally, they said that they would not allow
    the capital that individuals used to start trading
    to be money that they would need to meet a
    mortgage or other important expenses.

    Some day trading firm officials expressed concern
    about the part of the proposed appropriateness
    rule that dealt with promoting a day trading
    strategy. They said their concern was that if they
    used the term day trading in advertising, training
    seminars, or direct outreach programs and received
    customers from such efforts, they could be subject
    to being sued by any individual who lost money day
    trading. They also stated that regulators were
    holding day trading firms to a higher standard
    than the rest of the industry in that the
    suitability requirement that applies to the
    securities industry applies only when a broker
    recommends a product. The appropriateness rule,
    they contend, seems to apply more broadly than the
    specific recommendation of a product required
    before the suitability rule applies.

    Another concern expressed by officials from these
    firms was that because of the nature of day
    trading, it would be very difficult for them to
    determine beforehand whether or not day trading
    was appropriate for someone. They claimed that an
    individual would have to actually engage in day
    trading before a determination could be made about
    whether day trading was appropriate for the
    individual.

    Officials from some of the firms we visited said
    that the appropriateness rule would have very
    little impact on their firms.  They said this was
    because very few obtained day traders through
    advertisements or training seminars, which are two
    ways the appropriateness rule indicates that a
    firm would be promoting a day trading strategy.
    For instance, only two of the firms offered
    training seminars. Most of the firms said that
    their traders came to them through referrals.
    Furthermore, most of the firms said that they did
    not promote day trading strategies. Instead, they
    educated traders about how to limit their losses
    when trading. For example, some firms said that
    they would start individuals trading by allowing
    them to trade in increments of 100 shares. Once
    the traders learned how to limit their losses, the
    firm would then allow them to trade increasing
    numbers of shares.

    Day Trading Firm's Actions Regarding Disclosure
    According to officials at the seven firms we
    visited, they were already implementing NASDR's
    proposal that day trading firms be required to
    give potential customers a risk disclosure
    statement, even though SEC had not approved the
    risk disclosure proposal. Moreover, some of the
    firms had some type of risk disclosure form before
    the rule proposal. For instance, officials of one
    firm said they have had a disclosure statement
    since 1995, and officials at another firm said
    they have had one since 1997. Officials from both
    firms said that they had revised the form
    periodically. Five of the firms had started
    requiring customers to sign disclosure statements
    in 1999.

    In February 1999, before NASDR had issued its
    disclosure proposal, ETA had proposed that its
    member firms adopt a risk disclosure statement.
    This statement not only reflected the risk
    disclosures proposed by NASDR, it also pointed out
    additional risks, such as the inability to
    liquidate positions because of market conditions
    and the possibility of loss through systems
    failures. As a result, one of the firms began to
    require its potential customers to sign disclosure
    statements. When NASDR issued its proposed
    appropriateness and disclosure forms in April of
    1999 for comment, three of the firms implemented
    risk disclosure forms similar to what NASDR had
    proposed.

    The disclosure forms of the seven firms that we
    visited generally appeared to be in line with
    NASDR's proposed risk disclosure. Those firms that
    had not exactly copied the NASD proposal had
    covered risks that NASDR's proposal had not
    included. For instance, one firm had a statement
    that persons who are new to electronic day trading
    should strictly limit both the number of trades
    they do and the size of their trades to reduce the
    risk of large dollar losses during the learning
    process. Another firm had a statement that said
    the firm would neither make recommendations about
    general market conditions nor recommend any
    particular transactions to the day trader. It also
    said that all day trading decisions pertaining to
    the trading of a stock or the timing of a
    transaction would be the individual's own
    decisions. However, none of the firms that had
    their own distinct risk disclosure statement had
    mentioned that day trading through short selling
    could result in losses beyond the trader's initial
    investment. NASDR's recommended disclosure
    statement includes such a warning.

    Officials at the seven firms we visited agreed
    that disclosing the risks of day trading was very
    important. The general consensus was that if firms
    disclosed the risks up front, they were limiting
    their liability in the long run. Some of them
    clearly supported informing individuals about the
    risks of day trading, and others said that when
    considered appropriate, they tried to talk people
    out of day trading. A few of the firms said that
    disclosure of the risk was not enough, and
    education about how the securities markets worked
    was also important.

    Day Trading Firm's Actions Regarding Customer to
    Customer Lending
    Three years ago the Federal Reserve amended
    Regulation T in a way that permits firms to
    arrange loans from one customer to another or find
    third parties who would lend to their customers.
    We found that day trading firms and their traders
    have been fully utilizing the change in the
    regulation. However, this type of lending at day
    trading firms has raised concerns among
    regulators. At issue is whether some day traders
    are allowed to continue to trade when they no
    longer have sufficient capital and whether the
    traders understand the potential risks of these
    loans. Margin rules generally limit how much
    customers could borrow to buy stocks, but lending
    to cover margin calls enables traders to continue
    trading when they otherwise might not be able to
    do so. The customer-to-customer loans are
    generally made on an overnight basis to traders
    who would otherwise face a margin call. The day
    traders who lend typically receive interest
    payments equal to one-tenth of 1 percent daily,
    which amounts to 36.5 percent on an annual basis.

    Due to the increased regulatory interest regarding
    these loans, four of the firms we visited had
    stopped allowing customers to lend to each other.
    Of the firms that discontinued the practice, two
    did so because their clearing firms would no
    longer allow the lending to continue. The three
    firms that did allow customer-to-customer lending
    did not have a problem with the practice. One
    official said that customer-to-customer loans
    allowed individuals who accumulated wealth through
    day trading to move their earnings into long-term
    growth investments such as mutual funds instead of
    keeping the money at the firm.

    Conclusions
    Since it began in 1985, electronic day trading has
    been evolving in response to various regulatory
    and market changes.  At the time of our review, it
    accounted for a growing segment of securities
    trading. Day traders provide competition for
    market makers and institutional investors that may
    benefit themselves and other individual investors.
    However, day traders may also cause adverse market
    effects, such as greater volatility in stock
    prices. Gaining a better understanding of the
    effects of day trading on the individuals who
    engage in it as well as on the markets could help
    regulators ensure that controls are in place to
    protect both.

    The purpose of SEC's and NASDR's targeted
    examinations of the day trading firms was to
    ensure that day trading firms adequately informed
    day traders of the risks of their activities and
    had appropriate controls for their ongoing
    operations. Although they did not find widespread
    fraud and abuse in the industry, they found a
    number of problems, some of which they referred to
    enforcement officials for further investigation.
    Day trading is a particularly risky activity for
    individuals because they are competing with
    professional traders and can potentially lose
    considerable money. Further, the way day trading
    is done has changed rapidly and may continue to
    evolve. The new rules proposed by NASDR address
    some of the problems found during the reviews of
    day trading firm activities. However, because day
    trading has become a growing part of the Nasdaq
    market and because of the uncertain effects of
    such trading on investors and the markets,
    continuing to target day trading firms for annual
    examination could benefit both the traders and the
    market.

    The actions taken by the seven largest day trading
    firms to improve disclosure about the risks of day
    trading should help ensure that appropriate
    information is available to a large percentage of
    prospective traders. In addition, if the firms
    take the actions they plan to improve their
    operations, including better screening of
    prospective traders; restricting customer-to-
    customer lending; and enhancing compliance systems
    for short selling, margin, and net capital, these
    actions should address a number of the problems
    regulators have found. Ongoing implementation of
    such controls by firms and oversight by regulators
    are important to ensure that potential day traders
    understand that they are directly competing with
    professional market makers and institutional
    traders and can lose as much or more than they
    have invested.

    Recommendations
    Because the effects of day trading in an
    environment that depends less on SOES and more on
    ECNs are uncertain, we recommend that the
    Chairman, SEC, in conjunction with NASD, evaluate
    the implications of the growing use of ECNs by day
    traders on the integrity of the markets. We
    recognize that major changes are occurring in the
    structure of securities markets, especially the
    change to decimal trading, and recommend that the
    evaluation of day trading begin after decimal
    trading is implemented.

    Also, day trading is risky for individual
    investors, represents a large and growing portion
    of the Nasdaq trading volume, and is an evolving
    part of the securities industry. Therefore, we
    recommend that the Chairman, SEC, do at least one
    more cycle of targeted examinations of day trading
    firms to ensure that the firms take the corrective
    actions they propose in response to previous
    examination findings.

    Agency Comments and Our Evaluation
    In commenting on a draft of this report, SEC
    concurred with our conclusions and agreed to
    implement our recommendations. NASD said that this
    report provided insight into the public policy
    issues related to day trading. It also pointed out
    that our report covers a complex and changing area
    where there may be different approaches on how
    best to protect investors and ensure marketplace
    integrity. NASD also stated that it had one
    substantive observation, that we had not addressed
    the impact of margin lending practices on the
    profitability of day trading firms, which it
    suggested merits further scrutiny. Although
    determining the impact of margin lending on firms'
    profitability may provide useful information not
    only for day trading, but also for the securities
    industry as a whole, it was not in the scope of
    our review. Both SEC and NASD provided technical
    comments that we incorporated as appropriate.

    We will provide copies of this report to
    Representative Tom Bliley, Chairman, House
    Commerce Committee; and Senator Susan M. Collins,
    Chairwoman, Senate Permanent Subcommittee on
    Investigations.  We are also sending copies to the
    Honorable Arthur Levitt, Chairman, SEC; and Frank
    Zarb, President and Chief Executive Officer, NASD.
    Copies will be made available to others on
    request.

    Major contributors to this report are listed in
    appendix III. Please call me on (202) 512-8678 if
    you or your staff have any questions about the
    report.

    Richard Hillman
    Associate Director, Financial Institutions
     and Markets Issues

    _______________________________
    1 SEC and NASDR are responsible for ensuring
    investor protection and market integrity in the
    securities markets.
    2 Margin is the amount of cash or securities a
    customer must maintain with a firm in order to
    obtain a loan.
    3 SOES allows small orders placed through it to be
    automatically executed against Nasdaq market
    makers at the best bid (buy) or ask (sell) prices
    displayed on the Nasdaq system. It allows
    customers to access and trade with market makers
    without having to call them on the phone.
    4 The requirement was a direct result of the
    market makers' poor performance during the 1987
    crash. At that time, market makers failed to
    answer their phones to honor their quoted prices,
    and customers could not get orders executed at any
    price. In response, Nasdaq implemented an
    automatic electronic execution system for
    customers through SOES.
    5 The trading strategy used by SOES day traders
    was one of looking for the beginning and end of a
    trend-specifically the trends of market makers-and
    trying to buy and sell a stock using SOES and
    SelectNet while the stock was moving in price.
    Because of the automatic execution feature of
    SOES, day traders had a trading advantage over
    market makers and their customers in that they
    could execute trades faster than the market makers
    could update their quotes. This ability allowed
    SOES day traders to profit at market makers'
    expense from short-term price movements in stocks.
    6 SEC intended these rules to make the Nasdaq
    market a more competitive, customer order-driven
    market and thus reduce bid-ask spreads. As a
    result of the order handling rules, market makers
    have to fill or display any customer's limit order
    that improves on the inside price. This gives the
    customer's limit order protection in the market,
    as opposed to just having the market maker execute
    the order when conditions were favorable to the
    firm.
    7 Limit order is a customer order to buy and sell
    a security at a specific price.
    8 One ECN, Instinet, already existed, but it could
    be accessed only by institutions.
    9 One reason ECNs are popular is that as spreads
    narrow on volatile stocks, market makers are more
    inclined to step aside and post trades into ECNs,
    where investors can trade directly with one
    another. Another reason is that investors can save
    money because fees are low and because they can
    effectively negotiate prices with limit orders.
    ECNs match up potential stock buyers and sellers
    directly while allowing customers to maintain
    anonymity.
    10 When Nasdaq was first developed, it attracted
    illiquid stocks that did not meet the New York
    Stock Exchange's or the American Stock Exchange's
    listing requirements. Nasdaq market makers
    typically quoted wide spreads (the difference
    between the bid and the ask price), reflecting the
    nature of illiquid stocks. In addition to the wide
    spreads, Nasdaq ensured that market makers were
    able to earn the spread on every transaction. A
    market maker was always on the other side of every
    trade. This meant that customers were rarely
    allowed to trade with each other. They were forced
    to buy and sell stocks from a market maker who
    would benefit from wide spreads.
    11 The open limit order display system gives orders
    greater market representation, which increases the
    possibility of matches. Orders that are not
    immediately matched are typically displayed for
    all subscribers to see.
    12 See Gregory W. Smith, "The Electronic Brokerage
    Industry," Hambrecht & Quest, October 5, 1999.
    13 Ibid.
    14 Our figures are based on the average number of
    daily trades done by all the traders at each firm,
    assuming 20 working days in a month.
    15 This particular firm required $75,000 initial
    capital contribution. Our estimate was based on
    the individual having $100,000 in capital. The
    1998 return of the S&P 500 was 19.3, and the 1999
    return was 19.5. We did not assess the reliability
    of these numbers from the firm.
    16 The firm provided more specific data to us on
    individual traders. We did not assess the
    reliability of these data.
    17 See Securities Market Operations: The Effects of
    SOES on the Nasdaq Market (GAO/GGD-98-194, Aug.
    31, 1998).
    18GAO/GGD-98-194.
    19 SEC did 47 examinations of 41 separate firms and
    their branches. NASDR did 20 examinations, 15 of
    which were of different firms than SEC examined.
    In total, SEC and NASDR examined 56 separate day
    trading firms.
    20 A short sale refers to any sale of a security
    that the seller does not own or any sale that is
    consummated by the delivery of a security borrowed
    by, or for the account of, the seller.
    21 NASD rule 3370 also requires that broker-dealers
    keep written records of short sale affirmative
    determinations that include, among other things,
    the identity of the individual and firm that
    offered the assurance and the number of shares
    needed to cover the short sale.
    22 A firm is supposed to have procedures that are
    designed to prevent a trader from selling on a
    downtick when the firm's aggregate position in the
    stock is short. However, when the firm does not
    aggregate all of the positions of the traders at
    LLCs-known as associated persons-then the firm
    does not know whether it is holding long or short
    positions in an individual security and could end
    up marking short sales as long sales and vice
    versa.
    23 Generally, a firm's net capital is computed by
    deducting illiquid assets from its "net worth," as
    determined under Generally Accepted Accounting
    Principles, adding to that amount properly
    subordinated debt under Appendix D of the net
    capital rule, and further deducting certain
    prescribed percentages, known as haircuts, from
    securities held in the firm's proprietary
    accounts.
    24 A customer may purchase and sell a security on
    the same day in a cash account if the customer has
    the money in the account. However, if the customer
    does not have the money in the account, a day
    trade may amount to free riding-purchasing a stock
    and then selling it without having paid for the
    purchase.
    25 Regulation T is a Federal Reserve rule that
    specifies margin requirements. For example, it
    requires an initial margin of 50 percent for new
    purchases of stocks in margin accounts.
    26 However, under a NYSE rule interpretation, if
    the broker-dealer keeps a record showing the "time
    and tick" of each trade as evidence of the
    sequence of the day trades, the day trader may
    maintain margin based on the largest aggregate
    open position during that day. In effect, this
    requires day traders to demonstrate that they have
    the ability to meet the initial margin
    requirements of Regulation T for at least their
    largest open positions during the day.  For
    example, a day trader who makes 20 buy and sell
    trades during the day and ends the day flat would
    receive a margin call based on 50 percent of the
    largest open position held during the day,
    assuming that there was a margin deficiency in the
    account. NASDR margin rules are substantially the
    same as NYSE's rules.  However, NASDR has not
    adopted the "time and tick" interpretation
    regarding day trading margin.
    27 Regulators have also found that customer-to-
    customer lending may be facilitated by a day
    trading firm that would work with its clearing
    firm to identify day traders with credit balances
    who would be in a position to lend money to other
    customers.
    28 Suitability Rules refer to NASD Rule 2310
    Recommendations to Customers.
    29 Suitability applies only when a broker makes a
    recommendation. There can be no claim against the
    broker for unsuitable investments when the broker
    does not make a recommendation.
    30 According to NASDR, a day trading strategy is an
    overall trading strategy characterized by the
    regular transmission by a customer of intraday
    orders to effect both purchase and sale
    transactions in the same security or securities.

    Appendix I
    Comments From SEC
    Page 37                  GAO/GGD-00-61 Day Trading

    Appendix II
    Comments From NASD
    Page 39                  GAO/GGD-00-61 Day Trading

    Appendix III
    GAO Contacts and Staff Acknowledgments
    Page 39                  GAO/GGD-00-61 Day Trading
    GAO Contacts
    Richard J. Hillman (202) 512-8678

    Michael A. Burnett, (202) 512-8678

    Acknowledgments
         In addition to the persons named above,
    Tamara Cross, Edwin J. Lane, Bob Pollard, and
    Gregory True made key contributions to this
    report.

    *** End of Document ***