The nation's two biggest stock markets today proposed new rules to govern how much day traders can borrow, in a move designed to curb widespread practices that have given small investors access to massive amounts of money and disproportionate power over the markets.
The rare joint proposal by the New York Stock Exchange and the National Association of Securities Dealers, which runs the Nasdaq Stock Market, would require day traders to keep higher balances in their brokerage accounts--but also allow them to legitimately borrow more during the day. Ultimately, it could scale back the astronomical number of trades that have tossed around technology stocks and seesawed the markets to record highs.
The plan also lays out an official definition of the term day trader, possibly extending the label to plenty of investors who like to describe themselves as "active." The rule must be adopted by the Securities and Exchange Commission and is expected to be tweaked, incorporating a flood of comments expected from the industry and the public.
"Basically, the proposal is attempting to draw a ring around people who are day traders, as opposed to people who have one trade that is a day trade," said Elisse B. Walter, chief operating officer of NASD Regulations Inc. "There is still a lot of discussion about whether these are [the] right parameters."
Under the proposal, a day trade is defined as buying and selling the same stock in the same day with borrowed money. A "pattern day trader" is anybody who makes more than four day trades in five business days.
People who fit this description will be required to keep in their accounts, at all times, $25,000 in equity--the value of their stocks and cash. Generally, investors are required to have $2,000 on hand to trade.
But they will also be allowed to borrow for the day three times their equity--able to trade with a total of four times what they have in cash and stock. At the end of the day, they must meet federal standards that require loans to be no more than twice the amount of equity.
"The idea here is that 4 to 1 and $25,000 is more reflective of what happens in the day trading world than 2 to 1 and $2,000," Walter said. "It's like I'm taking away the speed limit, but I'm giving you a moped."
Owners of online firms welcomed the change. "It's a very good thing to require day traders to demonstrate that they have the capital," said Jim Lee, president of Momentum Securities.
Major online firms said that their customers would be little affected by this change. At Charles Schwab & Co., the average customer has more than $25,000 on balance and trades 12 to 15 times a year, a spokesman said.
But others said they were concerned about the technical requirements of keeping track day by day of possible day traders. "Each firm is going to have to reprogram their computers and every single day rejigger the roster of day traders and the parameters that guide them," said a spokesman for Ameritrade, whose average customer has $45,000 on balance. "It will be very cumbersome to manage."
The increased use of borrowed money for stock trading has fueled online brokerages, making them a major profit center.
At Ameritrade, for example, interest from so-called "margin loans" has grown 300 percent in the past year. Such interest now accounts for nearly half of revenue.
Currently, borrowing during the day is supposed to fall under that 2 to 1 ratio. Brokerage firms have imposed tighter margin rules for hundreds of volatile stocks--mainly Internet stocks--in some cases lending no money to buy them. So the proposal may appear to be a liberalization, but routinely day trading firms have extended mounds of credit--8 to 1 is not uncommon--according to several day traders and owners of day trading firms. They simply cut private loans with company money. And federal requirements monitor how much is on balance at the end of the day, when most day traders are out of the market, not what goes on during the day.
Customers who lose too much to meet the federal requirement at the end of the day routinely borrow money from one another and shift it back the next day. In extreme cases, these practices have allowed people to start off with very little down--$2,000 if they are following the rules--and trade millions of dollars worth of stocks, according to several sources, including regulators, day traders and owners of firms.
Customers of day trading firms could continue to borrow money from friends and relatives, but they would be banned from covering for one another to meet margin requirements--a practice known as "cross-guaranteeing." The proposal would require day traders to meet margin calls within five days, instead of the current seven. The money they pay back would then have to stay in the account for two days before they are allowed to use it for trading again.
Nobody has solid figures on how many people would fall into this new description of day trader, but many said it is well above the 4,000 to 5,000 people who walk into day trading shops to trade.