Mr. Jonathan G. Katz, Secretary
U.S. Securities & Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re: Release No. 34-42418, File No. SR-NASD-00-03 and No. 34-42343,
File No. SR-NYSE-99-47; Margin Requirements for Day-trading Customers; Amendments to NASD Rule 2520 and NYSE Rule 431
Dear Mr. Katz:
Datek Online Holdings Corp. ("Datek Online") is pleased to submit these comments on the pending SRO proposals relating to margin requirements for day-trading customers. Datek Online's principal units interested in this matter are Datek Online Brokerage Services LLC ("DOBS") a leading online brokerage firm, and iClearing LLC ("iClearing"), which performs clearing and settlement services for The Island ECN, Inc., DOBS and other broker-dealers. DOBS has been at the forefront of the rapidly growing movement to empower investors by giving them greater access to investment resources, market information, the order execution process and the marketplace itself. Neither DOBS nor Datek Online have encouraged members of the general public to become day-traders. Indeed, DOBS is not in the day-trading business. It maintains no on-site day-trading facility and does not tailor the Internet tools that it makes available to the public for day-trading purposes.
While we do not advocate day-trading, we do believe, given the sweeping scope of the proposals, that the subject regulations of "day-trading" are misdirected and fundamentally flawed.1 The subject rulemakings would place a heavy burden upon the entire securities industy to identify "daytrading accounts, monitor customer activity and impose a new $25,000 minimum equity requirement for such accounts. As defined by the proposal, an account with as few as four round trip transactions in five days would be deemed a "day-trading" account. Upon discovery of such arbitrarily defined activity, the rulemakings would require securities firms of all types to operate a special disclosure and margin maintenance regime for such day-trading accounts and to exact mandated firm capital charges equal to day-trading customers' margin calls. Our assessment of the proposals may be summarized as follows:
II. THE DAY-TRADING CONTROVERSY
Policymakers cannot overlook the fact that the new face of competitive NASDAQ spreads and the liquidity in the NASDAQ market today - as compared to 1987 - are largely due to innovation spurred by day-trading and by competing markets in the form of ECNs. This innovation includes revolutionary technology such as the Watcher trading software system and The Island ECN alternative trading system pioneered at Datek in the 1990's. These emerged from the competitive crucible of day-trading in an overall NASDAQ market that was found to have maintained collusive spreads. We believe that the day-trading "debate" of the past year has often indiscriminately condemned a large segment of our financial market as having no more social utility than gambling.
In contrast, the General Accounting Office's ("GAO") thoughtful attempt in February 2000 to address day-trading made the following observations:
In short, there is no market integrity issue centered about day-trading that supports the industry-wide regulatory choices of the NASDR and NYSE with respect to the proposed amendments to NASD Rule 2520 and NYSE Rule 431. Indeed, the evidence suggests that day-trading has been a positive competitive force, a source of tremendous innovation and a spur to the reform of the old NASDAQ market.
III. ANALYSIS OF THE PROPOSALS
A. MARKET INTEGRITY
The proposals are advanced ostensibly to "protect the safety and soundness of member firms and ensure the overall financial well-being of the securities markets." There is, however, no record to suggest that the market is imperiled by day-traders. The safety and soundness of the securities industry are not financially threatened by active accounts maintaining small equity balances. The proposals are not supported by any published findings of systemic problems involving accounts with margin loans under $25,000 at true day-trading firms (as understood in the context of proposed NASD Rule 2360), electronic brokerage firms or full service firms.
The genuine market-wide issue has not been day-trading. Rather, it has been the effect of heightened volatility in segments of the NASDAQ market upon firms' exposure to customer margin loans. On this topic, online firms have responsibly and repeatedly increased house initial and maintenance margin requirements beyond the minimum levels of NASD Rule 2520. Member firms' self-interest has been proved again to be superior to any rulebook solution. In sum, the "safety and soundness of member firms" do not require these changes in the margin rules.
B. MARKET EFFICIENCY AND LIQUIDITY
As amended by NSMIA, Section 3(f) of the Securities Exchange Act of 1934 now requires the SEC when considering a rule (including those of SROs), to weigh its impact upon "efficiency, competition and capital formation." An important industry research report states that "the community of closet day-traders is enormous" and that a "small cadre of semi-pro traders have emerged as a surprisingly powerful force in the marketplace."3 These facts suggest that a larger minimum account size, as called for by proposed Rule 2520, is likely to deter some level of trading activity. This would tend to reduce market liquidity and efficiency and deter competition and capital formation. Thus, much more consideration should be given to the potential effects of the SRO proposals before the SEC acts on them.
C. COST-BENEFIT ANALYSIS
Major agency rules must be reviewed by the proposing agency for their cost-benefit impact [5 U.S.C. section 801(a)(1)(B)] and the analysis must be submitted to the Congress. The GAO is charged to review the cost-benefit analysis [section 801(a)(2)]. We submit that these proposals are a "major" regulatory initiative and cannot be justified on any cost-benefit basis. Millions of transactions at both online and traditional firms will become subject to a lengthy processing review to detect, either on a real-time or batch basis, a day-trading pattern. No effort appears to have been made to assess the industry-wide cost of creating, installing and operating such extensive processing changes, all for the purpose of identifying an unknown and uncomplaining group of active traders.
We estimate that the expense for acquisition (or internal development), testing and implementation of systems that would satisfy the proposed requirements would be substantial. Costs would be higher for firms that, unlike DOBS, do not already calculate real-time margin and portfolio values. Similarly, broker-dealers dependent upon third-party vendors or service bureaus will likely face higher cost and system integration issues. There also are continuing costs of operating the proposed procedures.
Consequently, the NYSE and NASD should assume the burden of assessing the magnitude of the industry costs and the benefits. The SROs' analysis should consider the cost-benefit of less intrusive proposals such as that of the Advisory Task Force, which would trigger day-trading account review procedures at the point that the customer requests additional intra-day margin.
D. DEPARTURE FROM METHODOLOGY OF PENDING RULE PROPOSAL
As noted at the outset, the SEC is currently considering File No. SR-NASD-99-41 which was submitted to the Commission on August 20, 1999. The proposal would create new NASD Rules 2360 and 2361. Rule 2360 would create an approval process, including an appropriateness review for non-institutional accounts at firms that promote a day-trading strategy. Proposed Rule 2361 provides the format of a "Day-Trading Risk Disclosure Statement" that must be furnished to such prospective customers.
As a result of comments requesting clarification of the scope of the usage "promoting a day-trading strategy", an amendment to proposed Rule 2360 was filed with the SEC and published on February 23, 2000. Notably the amendment adds a new Section 2360(g) which excludes certain activity from being deemed "promoting a day-trading strategy." Among the activities that will not be considered as promoting day-trading are:
(1) Promoting efficient execution services or lower execution costs based on multiple trades;
(2) Providing general investment research or advertising the high quality or prompt availability of such general research; and
(3) Having a website that provides general financial information or news or that allows the multiple entry of intra-day purchases and sales of the same securities.
Thus proposed Rules 2360 and 2361 will not be applicable to online brokerage firms such as DOBS and others merely because they make electronic tools available. In contrast, the instant margin rule amendments are applicable to all firms regardless of the fact that they neither promote day-trading nor offer special 4-to-1 intra-day margin to day-traders. Especially in light of the many reasons that we note herein that undermine the stated rationale of the newly proposed margin rules, we urge the Commission to restrict the operation of the proposed rule to firms that either promote day-trading or offer greater than 2-to-1 margin for open intra-day positions.
E. LACK OF BASIS FOR THE MINIMUM ACCOUNT SIZE
1.) An Apparent Message of Paternalism to Investors
The current $2000 minimum account equity requirement in Rule 2520 does not represent a barrier to the opening of an account. The selection of $25,000 does, however, represent a regulatory determination that accounts with equity below $25,000 should not be permitted to day-trade.
If the regulatory conclusion is simply that accounts under $25,000 should not be permitted to trade with 4-to-1 margin, then we are in agreement. Datek Online supports requiring a $25,000 minimum equity for accounts that seek to day trade with the higher, intra-day 4-to-1 margin that the amended rule would authorize. Only such accounts should be deemed "day-trading" accounts for purposes of the proposed margin changes. However, we do not support the proposals as presently framed because they would bar occasional day-trading (as arbitrarily defined) in online accounts under $25,000 in equity which presently receive only 2-to-1 margin. In this regard, the NASDR's Margin Task Force Proposal is clearly superior (see discussion below).
Is there a regulatory conclusion that accounts under $25,000 should not be permitted to day-trade either on a full cash basis or with 2-to-1 margin? The proposals do not contain such a conclusion, but they do result in such a bar. As noted above, the proposal justifies itself based upon the elusive concept of the "safety and soundness" of the market and not upon an investor protection rationale, which may have been found to be politically incorrect. The fact that, the smaller customers, including those who merely want to limit their equity commitment, would, under the proposals, be denied the trading privileges that would be available to the more affluent and venturesome margin account customer, spells out a clear case of compulsory protectionism.
Indeed, had the proposals stated that they aim to protect the investor - who seeks no advice or protection - from herself or himself, as seems to be the case, it would be truly unprecedented. That would mark this exercise as a departure from the guiding principle of our securities markets, namely, that we trust in the wisdom of the decisions of informed market participants. We see a creeping paternalism in the proposals' lack of a stated underpinning and the lingering histrionics of the preceding "debate" about "day-trading."
The online industry is premised upon empowering investors to make decisions for themselves within a communication channel that offers access to an immense array of information. The growth of our industry represents a public rejection of the view that brokers, or even regulators, should determine which investors may pursue which strategies. The Commission should reject the paternalism rationale implicit in these SRO rulemakings. Online brokers should not be forced into a conflict with their customers by telling them to stop active trading in accounts under $25,000 in equity value that are Reg. T compliant. Indeed, the enactment of these rules will only serve to dilute online brokers' message of individual responsibility and foster a mistaken message that online (execution-only) brokers engage in appropriateness reviews of unsolicited transactions. That would amount to a disguised form of the discredited "merit" regulation formerly espoused by certain state regulators.
2.) Lack of Foundation for the Minimum Account Size
a) The $25,000 equity threshold number is completely arbitrary. There is no data to suggest that there is any relationship between the size of an investor's account and investing success. Likewise, there is no data indicating any relationship between account size and the risk to a broker-dealer. Some might even argue that smaller trading lots are more manageable from a risk perspective (liquidity) both for the customer and the broker-dealer.
b) NASD's diligence procedures for opening new options accounts, Rule Interpretation IM-2860-2, do not specify a minimum equity level for trading options (although Rule 2860(b)(3) does impose some astronomical limits on total option contracts). In short, imposing a minimum equity level on equity-trading is unprecedented and unjustified by any of the relevant reports (SEC, GAO and NASAA) or NASD enforcement actions. There is much more leverage available via options and other derivative products than that currently available at online firms for equities. There is no basis articulated for such differential treatment.
c) An introducing broker-dealer that is not engaged in market making need only maintain a net capital of $5,000. Why should public investors have to maintain accounts with equity that is five times larger than required of some broker-dealers?
3.) The Minimum Account Size Requirement is Counter-Productive
The $25K minimum might encourage individual investors to commit more to a day-trading account than they might have if left alone. Many investors might find it attractive to speculate with $5 to $15 thousand. If told that they must put up $25 thousand to speculate, the psychology of being denied permission might encourage them to put up the higher amount. Given the losses generally incurred by investors in the energy, leasing and real estate limited partnerships of the 1980's, most, with hindsight, would have preferred that they not be required to make a minimum $25 thousand investment.
Further, the required disclosure notice from a brokerage firm after an investor's fourth roundtrip in 5 days that he or she is a "pattern day-trader" may prompt the customer to investigate the richer mix of service (typically free Level II quotes and possibly higher leverage) offered by the direct access dealers who promote day-trading. In fact, Bear Stearns recently observed that online brokers could be vulnerable to a migration of their best customers to the direct access firms (see footnote 3).
F. FIRM CAPITAL CHARGES ARE INAPPROPRIATE
The proposals also provide that "on the sixth business day only, members are required to deduct from Net Capital the amount of unmet maintenance margin calls pursuant to SEC Rule 15c3-1." The SRO proposals do not explain either the rationale or the proposed operation of this provision. Since the day-trading customer has no outstanding positions and must also be restricted to executing transactions on a cash available basis for ninety days or until the special day-trading margin call is met, the sole import of this provision is to punish the firm. While the drafters probably intended that the capital charge only be imposed for one day, namely the sixth day, it could also be read as requiring a capital charge on the sixth day that continued as long as the margin call remains unmet. In either case, it is inappropriate to impose punitive capital charges upon firms for such riskless unmet calls.
G. FIRM RESOURCES SHOULD BE DEVOTED ELSEWHERE
No consideration has been given to the strain that all firms will experience by diverting valuable management and technology development staff attention to the "solution" required by the rulemakings and away from clearly higher magnitude objectives. These objective include growing their businesses to accommodate new investors, increasing their firm's array of online financial services, augmenting disclosures where appropriate about the risks of many different strategies that self-directed investors may experiment with (day-trading being but one), ensuring decimalization preparedness, crafting new financial privacy compliance procedures, and planning for the implementation of T+1 in 2002.
H. BETTER ALTERNATIVES EXIST
Finally, the subject proposals should be rejected because they are clearly inferior to the suggested alternatives proposed by the NASDR's Day-Trading Margin Advisory Task Force ("NASDR Task Force") recommendations of March 15, 2000.4 Indeed, this comment letter is prompted by the unexplained rejection by the NASDR Board of the recommendations of the Task Force. It is to those that we now turn.
IV. THE PROPOSALS OF THE NASDR TASK FORCE ARE SUPERIOR
The knowledge and industry experience of the NASDR Advisory Task Force is reflected in its proposal. It eschews defining day-trading or establishing a minimum account size. Rather than require an entire industry to surveil all account activity with an arbitrary "day-trading" yardstick at the ready to stop self-directed customers, the Task Force proposed that the industry follow an approach similar to that presently followed for option accounts. Namely, those investors that wish to pursue a specialized activity should first have to apply, acknowledge they have evaluated the risks and be granted intra-day margin at 4-to-1 upon satisfying the $25,000 minimum equity requirement. A comparison follows of the subject proposals and the Task Force alternative.
Comparison of Proposed Changes to NASD Rule 2520
Task Force Recommendations
1. Identify day-trader as any customer that buys/sells or sells short/buys to cover 4 times within 5 business days.
2. Immediately restrict any day-trader that incurs a day-trading call to 2 to 1 total leverage, no time and tick privilege, and (if call is not met in 5 days) restrict to cash available basis for 90 days.
3. Require all customers that are classified as day-traders (4 times in 5 days) to have a minimum equity of $25,000.00 to continue day-trading.
4. Require funds deposited to meet minimum equity or day-trading calls to remain in the account for 2 days.
5. Prohibit use of cross-guarantees to meet day-trading requirements.
1. Customer must apply for 4 to 1 day-trading leverage and be approved.
2. Allow customer 5 days to meet call before placing any restriction on the account.
3. Only require customers that are approved for 4 to 1 leverage to have $25,000.00 minimum equity.
4. To treat all withdrawals as being done at 12:01 a.m. on the day of withdrawal and hold deposits over-night only.
5. No objection, but should be allowed for non-day-trading accounts.
6. Certain option related activities should be exempt from day-trading requirements.
7. Institutional type accounts that have $1,000,000.00 or more should be exempt from 90-day cash available restriction.
For the DOBS customers, iClearing employs conservative margin policies and does not accord extra margin for intra-day positions. DOBS' systems make real-time calculations of customers account positions, margin balance and buying power. These systems serve both to keep investors reliably informed and to protect DOBS. We believe the Task Force proposal, if implemented, would result in fewer day-trading accounts than under the current proposals. A comparison of the higher 4-to-1 day-trading margin proposals versus the current DOBS practice is best summarized in the following table:
Comparison of Customer
Day-trading Buying Power versus Regulation-T Buying Power
Day-trading (4 to 1)
Regulation-T (2 to 1)
LMV = Long Market Value
As shown in the last line of the two examples above, the effect of the SROs' proposals would be to substantially increase the buying power of individuals who generally have not indicated any desire for increased leverage. We question the wisdom of providing that additional leverage.
The Commission must first decide whether there is a day-trading margin problem. We submit there is not a threat to the "financial well-being of the securities markets" from small, active accounts, and no justification for imposing the instant screening rule upon firms that do not promote day-trading. In the margin arena, the firms' self-interest is the surest bulwark for controlling risk exposure from customer margin debt.
To the extent that there is any lingering concern about day-trading, we urge the Commission and SROs to study it more closely as the GAO recommended, to continue education efforts in conjunction with the entire industry to improve investor understanding of investing risks and to pursue the more tailored approach of imposing regulatory burdens only upon those firms that promote day-trading (as in the case of proposed NASD Rules 2360 and 2361) or at the point when investors wish to avail themselves of higher 4-to-1 intra-day margin (as proposed by the NASDR Advisory Task Force).
Very truly yours,
Edward J. Nicoll
Chairman and CEO
|1||The SEC presently has before it another NASDR proposal that is squarely aimed at firms that do actively solicit the investing public to engage in day-trading, File No. SR-NASD-99-41. Such firms would be required to make an appropriateness determination before opening a day trading account for a non-institutional customer (Rule 2360) and furnish prospective customers with a Day-Trading Risk Disclosure Statement (Rule 2361).|
|2||The Advisory Task Force, consisting of a cross-section of firms, made its report to the NASDR Board of Governors on March 15, 2000. The NASDR Board rejected the recommendations on May 18, 2000.|
|3||Amy S. Butte, Bear Stearns & Co. Inc., "Financial Technology/Day-Trading and Beyond: A New Niche Is Emerging," April 2000, p. 5.|
|4||This 15-member group tapped a wealth of industry knowledge and expertise including Darryl Wallace, Director of Operations of our iClearing business.|