Oral Testimony of Peter C. Hildreth
Director of Securities Regulation, New Hampshire Bureau of Securities and NASAA President
Before the Senate Governmental Affairs Committee, Permanent Subcommittee on Investigations
September 16, 1999
Chairman Collins, Senator Levin and members of the Subcommittee:
I’m Peter Hildreth, Director of Securities Regulation for the State of New Hampshire and president of the North American Securities Administrators Association (“NASAA”). Thank you for the opportunity to appear before you once again and to present the views of NASAA as you look into issues and problems surrounding day trading. We recognize and appreciate your leadership in focusing attention on the problems in this area.
Last December, in part because of enforcement actions taken by Texas and Massachusetts, the NASAA Board of Directors formed a Project Group to research the industry, prepare a report of its findings and make recommendations.
The Project Group, chaired by David Shellenberger, gathered information, analyzed issues, and studied trading records. The NASAA Day Trading Project Group Report, released in August, was the result of that effort.
We believe there are problems associated with the day trading industry, not the least of which is the hype about how average people can get rich quickly, with no experience necessary.
We hope our report, the first of its kind, will help Congress and the public, as well as our fellow regulators, better understand the issues and problems. We believe it will also help in framing appropriate responses from Congress and regulators.
Electronic day trading has become part of our culture. It has captured the national imagination in part because it combines two major developments that characterize America in the late Nineties – the bull market on Wall Street and the technology revolution brought about by the personal computer and the Internet.
Unfortunately, much of the early media coverage tended to glamorize day trading. The fact is day trading is anything but glamorous. As our report makes clear, day trading is very risky and most people who day trade will lose all of the funds they put into it.
We have not examined all day trading firms and their hundreds of offices we believe exist. However, at the firms and branch offices we have examined, we’ve found problems with marketing, suitability, loan arrangements, supervision and customers trading other people’s money without regard to licensing requirements.
There are several issues you asked us to address in our testimony:
First, A general discussion of day trading
Chairman Levitt has already described how day trading is distinguished from other investment strategies. My written testimony provides NASAA’s perspective on this issue. In the interest of time, I’ll move on to other issues you asked us to address.
The more common and conventional day trading firms, those registered with the NASD, provide the means for customers to trade their own accounts. They promote and facilitate a particular type of trading. The firms provide computer terminals, sophisticated software to track stock prices in real time and direct, dedicated line access to the market, access that only a few years ago was limited to brokerage firms alone. The firms’ customers, the day traders, attempt to make profits on small changes in the prices of stocks. They are known as day traders because they make intra-day trades – closing out positions by the end of each day.
Day trading firms often market and provide courses in day trading basics, strategies and techniques. Day trading firms charge commissions that are higher than those of discount brokers or on-line brokerage firms. Because day traders trade so frequently, their commissions add up quickly.
“On-line trading” and “day trading” have been confused and sometimes referred to interchangeably. There are big differences. “On-line trading” simply describes the ability to access a brokerage account and effect transactions over the Internet. Reportedly, there are millions of on-line brokerage accounts.
Day trading firms promote a particular type of investment or strategy. Discount brokers tend to passively accept orders from customers, eschewing the making of recommendations.
Next, The risks of day trading;
Trading is, by definition, a form of speculating, as distinguished from investing. Day trading is trading on an extremely short-term basis, and is highly speculative.
When firms promote their services with claims as to the potential for success and profitability, they have an obligation to tell their customers the truth about the risks. We also believe they have an obligation to determine whether day trading is suitable, or appropriate for a particular customer. That means not accepting just anyone who comes through the door with a check and wants to sit down at the computer and trade.
We commissioned an outside expert, Ronald L. Johnson, who analyzed customer account records from a day trading firm in Massachusetts that was the subject of an enforcement action. His analysis suggests the majority of day traders – more than 70 percent – lose money. Only about 12 percent showed the potential to be profitable.
Mr. Johnson also found that day traders would have to generate annual returns of 56 percent just to cover commissions and margin interest, never mind capital gains taxes. These are long odds indeed just to break even.
This was the first such analysis of retail day trading account data. It was a limited sample, but the results are consistent with what we have found in other investigations, such as evidence from a Block Trading branch office where 67 of 68 accounts lost money.
We urge others – especially academics – to conduct further research on the profitability of day trading by retail customers. However, the burden of proof remains on the day trading firms. They must justify their claims of customer profitability and their marketing that suggests that average people can make a career of day trading.
Third, What are the findings of state regulators’ exams;
Some of the abuses and problems that the Project Group has observed include:
- Deceptive marketing, including inadequate risk disclosure. For instance, as you can see from our poster, one firm, On-line Investment Services, Inc., maintained a web site claiming that 85 percent of its customers were profitable. They deleted the claim when Massachusetts asked for proof.
- Violation of suitability requirements. In a case against Landmark Securities, Inc., the Complaint alleged that the manager falsified information on a new account form to create the impression day trading might be appropriate for the customer. The customer, a recent college graduate, was a part-time bartender with an annual income of $15,000, a net worth of less than $15,000, and no prior investing experience.
Other abuses we noted are:
- Questionable loan arrangements, including promotion of loans among firms’ customers and loans to customers by brokers.
- Failure to supervise.
Next, our position on the NASD’s proposed rule;
In a comment letter to the NASD, the NASAA Project Group endorsed the draft rules on appropriateness and risk disclosure and made suggestions for enhancing the rules. We recommend that the SEC approve the rules.
Finally, other legislative or regulatory initiatives.
We believe the NASD should also adopt a rule prohibiting the abusive loans I have discussed. We also recommend enhanced regulatory attention to day trading firms. First, the proposed NASD rules on appropriateness and disclosure. The Project Group believes that the existing rules on suitability apply to day trading. The failure by some day trading firms to adhere to the existing suitability rules, however, suggests that specific day trading rules are warranted. Day trading is a particularly risky program of trading that warrants heightened suitability and disclosure requirements.
The NASD already has special suitability requirements for opening options accounts and the like.
Second, the matter of a ban on the loan programs. Day trading firms’ promotion and arrangement of lending among customers to meet margin calls is problematic. Firms have promoted the loans in order to keep accounts open that would otherwise be closed or restricted for failure to meet margin calls. These loans serve to undermine margin requirements and encourage customers to trade beyond their means.
Some of these loans come with interest rates that it some states may exceed legal limits. A typical rate is .1 percent for an overnight loan, or 36.5 percent on an annualized basis. In addition, the loan programs have invited severe compliance problems, including forgeries and the unauthorized transfer of customers’ funds.
We believe that the loan programs are highly questionable under existing law. Nonetheless, we believe the NASD should adopt an explicit rule prohibiting the programs.
Finally, enhanced focus on day trading firms. Too many day trading firms continue to engage in highly questionable conduct. More enforcement actions should be brought.
Let me be clear, state regulators don’t have a problem with day trading per se. It has been around a long time, long before the personal computer. We believe investors should have available to them all the latest technologies. Technology and information have revolutionized investing; they have leveled the playing field between Wall Street and Main Street.
Our concerns are with day trading firms that aren’t being honest with their customers about the risks.
Firms that essentially say, “Hey, come on down…we’ll sell you a training course, you can sit in front of our computers and you’ll get rich.” This is hucksterism. The odds are you won’t get rich; the odds are you will lose all money with which you trade.
The fact is day trading isn’t investing, it’s gambling. There’s no other word for it.
Day traders can lose a lot of money in a hurry. People should not be gambling with money they can’t afford to lose. The poster taken from All Tech’s recent web site illustrates that some firms have held out day trading as an option for retirees, people laid off from their jobs, even college graduates just starting out. This sort of marketing is irresponsible, reckless and predatory.
Day trading firms need to play by the same rules that the rest of the brokerage industry has to follow.
Frankly, in the exams we’ve conducted of day trading firms, we have found a cavalier attitude toward regulatory compliance. Too many firms either don’t know the rules or are flouting them because they think the rules don’t apply to them.
Well, the rules do apply. We expect that more enforcement actions will be brought, and that these will send a message to the firms that appear to believe they are above the law.
Chairman Collins, I greatly appreciate the opportunity to share the NASAA Project Group’s findings with the Subcommittee today. NASAA and its members stand ready to assist you as you continue your investigation into the practices and operations of the day trading industry.
September 16, 1999