Other Voices

September 1999
BARRON'S
By Robert A. Kanter

THROUGOUT THE HISTORY OF U.S. markets, exchange specialists, Nasdaq dealers, futures traders and options market-makers have all been "day traders." Although some may object to the characterization, they'd be hard pressed to disagree that day-trading means nothing more than purchasing and selling the same security on the same day. To a professional, the term has none of its current and widespread negative connotation. In fact, professionals have perceived day-trading as a reduction of risk for those who provide liquidity to the markets. The key word is professional; to a professional, day-trading is a routine, matter-of-fact occurrence, as old as the Buttonwood Tree.

Many day-trading firms may have violated the spirit of the securities laws, and even the laws themselves, covering customer suitability, margin regulations and registration requirements. But the media need to differentiate between firms that exploit customers and honest, well-capitalized, professionally managed proprietary trading firms.

Technology has eliminated the need for a physically centralized marketplace. The advent of computerized trading, including the Internet and electronic communication networks, along with the Securities and Exchange Commission's Firm Quote and Display Rules, have equalized the opportunities for market participation. Individual investors now have access to information and trading systems that allow them to employ trading strategies and techniques that were previously available only to market-making firms. Theoretically, anyone can become a market-maker.

So far, the regulators have maintained a watchful and cautious stance. But as in every field of business, there will be those who find ways to abuse the system. Abuses should be dealt with vigorously and risks should be addressed with thoughtful adaptation of rules and procedures to maintain order and confidence in the market. Abuses of a few, however, should not cast a shadow over the entire day-trading industry or force back the tide of technology that is transforming the market and providing vital new sources of liquidity, price transparency and efficiency.

After all, not all day traders or firms that day trade are alike. Exchange specialists, over-the-counter dealers, options market-makers and block positioners serve an important function, providing liquidity to the market. In return for providing this service, they enjoy special privileges under the securities regulations.

Customer-based day-trading firms that have evolved from the use of Nasdaq's Small Order Execution System are currently the focus of regulators, politicians and the press. Customers of these firms and Internet online brokerage firms will become important additional sources of liquidity. Regulators will need to devise guidelines to rid those firms of abuses without inhibiting competition and opportunity.

Specifically, day-trading and online firms catering to individuals should make a trader-training program available to any customer engaging in short-term trading. The firms should continuously monitor and critique the short-term trading of their customers through computer analysis. They should provide periodic statements of commission expenses, including hidden trading expenses, so that customers can accurately evaluate their after-cost trading. Maximum trading losses over a specific time span should be determined in advance based on each customer's finances.

The proprietary trading firms that facilitate trading for trained professional traders and have adequate capital can serve as models. There are, however, some proprietary firms that are closer in organization to customer-based trading firms. Such improperly structured proprietary firms should be candidates for regulation to protect customers. In contrast, firms that do not ask for a capital contribution as an entry requirement, but rather risk firm capital and are responsible for their traders' cumulative losses, should be recognized and regulated as providers of market liquidity. The National Association of Securities Dealers has recently required the proprietary traders of their member firms who deal in Nasdaq stocks to register as equity traders and to pass, in addition to standard industry tests, a special test that addresses proprietary trading.

Regulators have generally allowed technology to drive market change. But there have been recent signs that, to address a perceived day-trading "crisis", regulators may in haste adopt rules that address the stereotype of day-trading rather than addressing actual problems that harm the customer.

The practice of payment for order flows is a striking example. The ability of an online brokerage firm to substantially increase its commission on a customer's order by selling that order makes a mockery of a competitive marketplace mandated by the Securities Exchange Act Amendments of 1975. It is doubtful that Congress intended competition to be the purchase price of an order rather than the best bid or offer in the marketplace.

Nasdaq market-makers and firms that internalize their orders are benefiting from order flow and time advantages. Regulators can solve these inequities technologically. All bids/offers that are above or below the national best bid or offer should be displayed, and an electronic link between all electronic communications networks should be designed. This would add price protection to the Nasdaq market. Market-makers would be required to post their own orders electronically on the Nasdaq platform, which would act as their exclusive ECN. It would be required that all orders be fed through the system achieving best execution through electronic means. Price protection would encourage all market participants to enter bids and offers into the system where they would be rewarded for bettering the market. Depth and liquidity would be increased, and intra-day volatility decreased. The sell side of a transaction could give its preferred market-maker the coveted right of first refusal on the unexecuted portion of an order after it has been fed through the electronically linked integrated system, thus creating an incentive for proprietary firms to deal competitively. Price protection would encourage competition, and payment for order flow would be vastly reduced if not eliminated. The mandate of the Securities Act Amendments of '75 would be fulfilled.

Rapid technological advances of recent years have created enormous opportunities for development and expansion of the capital markets, allowing for unprecedented equality of market participants. Day trading is a routine, necessary component in the electronic market, adding fuel and liquidity, while offering opportunities for profit and risk reduction. Let's make the right regulatory decisions to keep such opportunities alive.

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