NASD DAY-TRADING WITCH HUNT

On March 25, 1999, the NASD issued a press release entitled "NASD Regulation To Solicit Comment on Proposed Rules for Day Trading Activities Washington, D.C."  The proposals envision a disclosure statement advising investors to consider six points before engaging in day trading (the "Disclosure Statement")'. Additionally, the proposed rules require firms that recommend day trading to an investor to make a threshold, pre-account opening/trading determination that the strategy is appropriate for that investor (the "Suitability Determination"). In making the Suitability Determination, the firm would have to weigh essential information about the investor, including his or her financial situation, investment experience, and investment objectives. 

A Dramatic Point!
These disclosures are not addressing the trade, but the trading.  This is not an issue about recommending a specific stock, but whether or not a trading strategy, i.e., day trading, is suitable. 

Yet Another Disclosure Statement

Let us examine the NASD's proposed Disclosure Statement. When considering each of the six points, ask yourself whether the disclosure is effective and likely to deter reasonable investors.

1. Day trading can be extremely risky. Presumably traders would be warned that they could lose all funds involved in day trading and, as a result, funding should not come from inappropriate sources, e.g., retirement savings, student/mortgage loans, or funds needed to meet ongoing obligations.

Comment: This sends a dangerous message that there are some "safe" modes of investing in the stock market. The fact of the matter is that all investing carries risk. Today's rock-solid stock could be tomorrow's front -page disaster. Once we begin to categorize "risky" as variable, i.e., limited, moderate, and extremely, we lull the investing public into a false sense of security. It must always be a given that investing carries risk. If this type of disclosure were effective, then the pamphlet all new options investors receive would be dissuading many options traders, and broker-dealers would be reporting a large number of cancelled account openings by would-be investors following receipt of the document. The fact is no such phenomenon exists.

Similarly, point #1 above is not targeting a particular stock or even a group of stocks, but is attempting to target an investment mode: day trading. Consequently, the NASD seems to be implying that one cannot lose all funds invested through other modes of investing, such as, buying IPOs, dollar cost averaging, or technical analysis. This is nonsense.

2. Customers should be cautious of claims of large profits from day trading. Customers are warned to be wary of advertisements or other statements that emphasize the potential for large profits in day trading. The NASD seeks to emphasize that day trading can also lead to large and immediate financial losses.

COMMENT: Admittedly, day trading leads to large and immediate losses (and also profits). However, if one is watching a given stock position minute-by-minute versus the casual investor who checks on stocks in the evening's paper, which customer is exposed to the greater risk of large and immediate losses? And what is the conceptually significant difference between a day trader entering orders from his desk at a so-called day trading firm, or entering those orders online through his E*Trade account, or through his full service broker? In reality the NASD has not sufficiently distinguished among three separate and distinct concepts:

• day trader: an individual who tends to buy and sell stocks on an intraday basis, such that positions are normally "flat" at the market's close;

• day trading firm: a broker dealer offering trading facilities to day traders at competitive, discount commission rates and without generally recommending or soliciting purchases/sales of specific securities (such firms may permit day traders to act as registered proprietary traders or as unregistered customers).

The public should be wary of all advertising, unless and until the claims are verified. As it has done all too frequently in the past, the NASD perpetrates the myth that bigger is better, that well-known firms are inherently better than lesser-known firms. Consider the recent television ad for a major NASD member that depicted a tow truck operator as having made so much money investing that he didn't need to work and owned his own island. Is such a claim from a wirehouse less troubling? And will the NASD also warn investors against computer trading programs, technical analysis, and following CNNfn or CNBC's pundits? Should the public be informed of the divergence of numbers and whisper numbers, or the weakness in investing solely based upon fundamental analysis? Will we require all investors to read a written warning against buying on good news or selling on bad news, before accepting trades on days with reported news?

3. Day trading requires knowledge of securities markets. The NASD intends to warn day traders that such a technique requires in-depth knowledge of the securities markets and trading techniques and strategies. In attempting to profit through day trading, an investor must compete with professional, licensed traders. The NASD then concludes that an investor should have appropriate experience before engaging in day trading;

COMMENT: This is an interesting dilemma for the NASD. When its major NASDAQ market makers were engaged in price-fixing the market, as detailed in the 1996 United States Department of Justice/Antitrust Division case, the NASD seemed to lack the requisite in-depth knowledge of the securities markets, trading techniques and strategies to properly police its membership. And lest the regulator forget, the 1996 Securities and Exchange Commission 21(a) Report detailed its misconduct.

The NASD's combative approach towards the day trading issue will never build the necessary membership consensus. As in the past the powers-that-be decline to embrace dissent, make no effort to fully appreciate and integrate contrary positions, and seem intent on bullying an unpopular constituency into submission. The will of the major NASDAQ market makers holds sway. When the NASD unabashedly decided to instigate and solicit complaints against the day trading community, it declared war. Sadly, the NASD has learned little from its past mistakes and continues to be held captive by anti-consumer and anti-independent/regional broker-dealer interests. This is not to pretend that the independent/regional community is monolithic; far from it. Many outspoken critics of day trading genuinely believe their positions, and frequently operate smaller firms. Nonetheless, even among such day trading critics there remains a reservoir of distrust for the NASD's motives and conduct.

Amazingly several state securities divisions seem to have found the day trading/ECN issue to be of pressing, immediate concern. Of course, when the major NASDAQ market makers were engaged in apparent price fixing detrimental to the public, neither the NASD nor the states seemed particularly interested or concerned. So it is curious that these state policemen, who also turned their backs to the NASDAQ antitrust abuses foisted upon the public, now seek an activist role - - - right in front of the television camera - - -in the day trading inquisition. Educated consumers might examine who's up for election, where anticipated campaign contributions are coming from, and where previous financial support was derived.

Professional, registered traders aren't anymore likely to be profitable than the rest of us. Professional traders have their ups and downs, make huge sums and lose huge sums. If this were not true, then how does one explain the enormous failure of the professionals at Long-Term Capital? Why is it that for every dramatic market move, some traders predicted the direction . . . but others missed it completely (of course they insist that they didn't make an error but that the market is merely engaged in some arcane technical adjustment).

Isn't it odd that the NASD is unintentionally admitting the very fact that may have motivated day trading to begin with: the battle lines on Wall Street are not between buying and selling public investor, but between  the public investor and the industry! The exact comment in the NASD's press release on this point was:

In attempting to profit through day trading, an investor must compete with professional, licensed traders employed by securities firms.

Which is to say that the NASD is aware that its member firms' "professional, licensed traders" routinely take advantage of public investors. Why isn't that part of the proposed Disclosure Statement? Why isn't that disclosed to all investors before allowing them to open any securities account?  And ultimately isn't the industry-public competition one of the very justifications for day trading: to attempt to better the odds for the public investor?

4. Day trading requires knowledge of a firm's operations. The NASD believes that an investor should be familiar with a securities firm's business practices, including the operation of the firm's order execution systems, procedures, and should confirm that a firm has adequate systems capacity to permit customers to engage in day trading activities;

COMMENT: This is quite a stretch, even for the NASD. Why are these issues only applicable to day trading firms? We have recently read of massive meltdowns among major online brokerage firms, most notably Schwab and E*Trade. Does the NASD now consider those firms to be day trading firms? Have we all forgotten the '87 crash when many of the country's leading brokerage firms simply took their phones off the hook rather than accept any more orders? Systems capacity is not a day trading issue, but an across-the-board concern. As to knowing how orders are executed, how foolish to think that even the casual investor should routinely place market orders without verifying the time and price of execution.

QUESTION: How are day trading attributes to be defined?  Can an individual investor engage in day trading (perhaps for limited or isolated periods of time) without being deemed a "day trader"?  If day traders enter their orders at a particular firm, does that automatically define the firm as a "day trading firm"?  What percentage of a firm's overall business, once derived from day traders, qualifies it as a day trading firm?

5. Day trading may result in large commissions. The NASD opines that day trading may require an investor to trade his or her account aggressively, and pay commissions on each trade. The total daily commissions that they pay on trades may add to losses or significantly reduce earnings;

COMMENT: This seems a bit facetious. Obviously if a person is going to sit at a quote screen all day, the intention is to trade more frequently than the casual investor. That the NASD believes it necessary to disclose to the public that commissions are charged on each trade seems laughable. More foolish is the concern that investors need to be warned that the more commissions they pay, the more those amounts will be deducted from gross profits or added to gross losses. Do we similarly need to warn students that the more expensive their annual tuition, the more expensive the cost of graduation? Are there signs posted at gas stations warning drivers that the farther you intend to drive the more gas you will need, and consequently the greater the cost of your trip? Where does this all end? What is the value of such surplusage?

6. Day trading on margin or short selling may result in losses beyond the initial investment.In a token nod to the old belt-and-suspenders crowd, the NASD wants to warn day traders about the risks of margin and the dangers of short-selling.

COMMENT: Has anyone read a Margin Agreement lately? Is the NASD pretending the substantial disclosures in Margin Agreements, replete with disclaimer overkill, don't already exist? In the real world, how does one engage in short selling without a margin account?

The securities industry is effectively regulated by three distinct and often overlapping layers of authority: the United States Securities and Exchange Commission (SEC), the various states' securities divisions, and the various self-regulatory organizations (SROs) of which the NASD and the NYSE are the most prominent. At each of those three regulatory levels are rules and regulations that effectively impose a suitability obligation upon broker-dealers and registered representatives.

First off, it would seem that virtually everything proposed to be disclosed in the Disclosure Statement is already covered under 2310's references to suitability and fair dealing. Additionally, the SEC's Section 10(b) and Rule 10b-5 have ample coverage of many of these areas. Second, the Suitability Determination attempts to impose dramatically new and dangerously expansive obligations upon the securities industry.

Traditionally, suitability determinations (including 2310) have been limited to specific recommendations or solicitations by the broker-dealer. Consequently, if a transaction wasn't solicited, then suitability shouldn't be an issue. Even the concept of "fair dealing" is discussed in terms of sales efforts. However, in recent years there has been an erosion of this doctrine. In some cases we have seen the expansion of the so-called "shingle rule," i.e., when one hangs out a shingle as a broker-dealer, one is expected to engage in a certain level of professionalism and ethics. Are BDs now expected to act in loco parentis and supervise all customers as if they are children?  Is there no point at which adults must eventually be held accountable for their own decisions?

I'm struck that many of the same NASD forces that rail against runaway plaintiffs' litigation don't seem bothered by these day trading proposals. The subtlety in the NASD's approach is that it  isn't addressing solicited trades. Unless the industry wakes up, these seemingly innocuous recommendations may establish a potent beachhead on Wall Street. Conceivably, BDs and RRs will soon be liable not only for solicited/recommended transactions, but also unsolicited/customer-directed trades.  Keep in mind that we are not addressing unauthorized trading, nor churning, nor excessive trading, because all the trading by day traders is entered by the customer in accordance with his or her investment approach.

I find the general thrust of the proposals to be, at best, silly, superfluous, and paternalistic; at worst, they portend a chilling intervention of big business and government into our private lives. Further, the motivation for these so-called consumer initiatives appears prompted by the growing fear among major broker-dealers that an irreversible migration of customers and trades to non-traditional competitors is underway. And these influential firms are bringing all their influence to bear to persuade all-too-compliant regulators and all-too-accepting reporters to pound the drums of panic. With the smoke from the bonfires of discount commissions, SOES, Internet access, and real-time quotes still in the air, modern day Wall Street puritans are now seeking more witches for burning.

When regulators and politicians can't do anything effective about something, they conduct hearings, prepare position papers, draft ineffective regulations, and engage in highly-publicized prosecutions. Consequently, we live in a country where no common citizen is capable of understanding or preparing a tax return. We watch television commercials advertising automobiles and are blitzed with a two-second legal disclosure in typeface too small to read, which is presented at a rate of speed beyond the comprehension of any mortal. After nearly 70 years of federal legislation controlling public offerings, we dump miniature telephone books of disclosures upon would-be investors; yet stock fraud flourishes despite a wealth of information, an ever growing number of media delivering such knowledge, and an ever increasing number of regulators utilizing state-of-the-art monitoring tools. Regulation by autopsy continues unabated.

At some point the government must get out of our bedrooms and boardrooms . . . as must the NASD. These day trading rules smack of misguided paternalism. One simply cannot regulate away human folly. One simply cannot legislate risk out of investing. If there is any majesty within the American fabric it is our freedom to fail and the freedom to dust one's self off again and try again. Affter nearly two decades in this industry I've noted that a lot of successful professional traders seem to have an inordinate amount of stories about failures and wrong hunches in their past. In fact, I can't think of how often I've heard an older trader tell a younger one that the only way to learn how to trade is to trade, and the only way to learn how to take profits is to experience some losses. On the Street, the cost of a beginner's trading losses is often jokingly referred to as tuition.

So, what are we to do with all those people who are sitting in front of trading screens, hour upon hour, day trading? And what are we to do about those terrible businesspersons who provide the physical location for this behavior?  And what are we to make of the histrionic depictions of widows and orphans being fleeced out of their money by unscrupulous day trading firms? Well based upon my personal experience, day traders seem to consist of former Wall Street professionals who became disenchanted with their compensation, part-time traders who want to see if they can translate their home-grown strategies into full-time, profitable careers, and the usual assortment of amateurs and dreamers who have drifted through a number of unsatisfying careers and jobs . . . and, yes, may very well add day trading to their long list of mistakes.

And now, in pursuit of the witches of day trading, we are preparing for another regulatory inquisition. When the Salem witch trials were in full bloom, Giles Corey refused to plead guilty or not guilty. To force a plea, the authorities placed stones upon his chest, hoping to crush some response out of this principled victim. However, even at the end, before the last killing stone was placed upon him, Giles Corey defiantly said "More weight!" In 1999 it is finally time for public investors and independent/regional broker dealers to say to Congress, to the SEC, to the states, and to the self-regulatory organizations No More Weight! No more paperwork, no more brochures, no more booklets.