The popularity of on-line trading and growth in the number of broker- dealers with on-line channels has significantly changed the way many investors trade and manage their savings and investments. Last year alone, broker-dealers handled an average of about one million on-line trades per day from individual investors. In regulating the activities of all broker- dealers, NASD and NYSE have a different role from SEC, as SEC’s general role is to maintain the integrity of the securities markets. NASD and NYSE are membership-based SROs, and their general role has been to oversee their members’ activities. Among other things, NYSE and NASD, (through NASDR) regulate market facilities, write rules governing member conduct (with SEC approval), examine members for violations of securities laws and SRO rules, and discipline members that fail to follow such laws and rules. SEC, among other things, supervises the SROs to ensure that they use their regulatory powers effectively and responsibly. SEC conducts this oversight by reviewing SRO rules, disciplinary actions, and other activities. It also inspects SROs to ensure compliance with the Securities Exchange Act of 1934 (the Exchange Act). Both SEC and the SROs conduct examinations of broker-dealers. A primary objective of the SEC’s broker- dealer examination program is to provide oversight of the SROs that are responsible for routinely examining their member firms. SEC and the SROs maintain examination procedures that provide guidelines for their respective staff in conducting examinations of broker-dealers. In our previous report, we noted that on-line trading is sometimes confused with day trading. We noted that a significant difference between on-line trading and day trading is access to the markets. On-line investors access the markets through Internet service providers and brokers’ order routing systems, a process that can take several seconds or minutes, while day traders have virtually direct access to the markets. At the time we issued our report, the differences between on-line trading and day trading were diminishing as these industries developed. For example, some on- line broker-dealers now offer their active traders services similar to those already provided to day traders, including news, price quotes, and customized software. Since we issued our previous report, NASD and NYSE have adopted rules that include definitions of day trading that are broader than the definition used in our previous report. For example, one definition describes day trading as overall trading characterized by the regular transmission by a customer of intraday orders to effect both the purchase and the sale of the same security or securities in the same day. Thus, some active on-line traders also meet the definition of a day trader. According to an SEC official, a small number of on-line account holders are likely to be responsible for the majority of trades made on-line. To assess the extent to which the on-line trading market has changed since our previous report, we gathered industry data from 1999 and 2000 on on- line trading accounts and market volume and analyzed those trends for changes in activity. We used industry data from J.P. Morgan H&Q for this purpose. We also collected data from SEC, NYSE, and NASDR on complaints related to on-line trading. We analyzed these data to identify trends in the volume and nature of complaints in 1999 to 2000. During this period, NYSE began using an on-line trading complaint category. SEC began categorizing on-line trading complaints in 1997. To better understand the data and their reliability, we determined how the data are gathered and analyzed and collected regulators’ opinions as to the limitations of the data. To understand regulators’ efforts to respond to our previous recommendations, we reviewed the rules, OCIE recommendations, and other guidance created since our May 2000 report. We examined these documents for specific criteria and determined the extent to which we believed the actions taken were consistent with both the substance and form of the recommendations in our previous report. We met with officials from SEC, NYSE, NASDR, the Securities Industry Association (SIA), and three larger firms to discuss their perspectives on the newly issued rules, guidance, and recommendations. We also reviewed the public Web sites of a limited number of small, medium, and large broker-dealers that offer on- line trading services to determine what these firms were doing in terms of providing disclosure to on-line investors. To assess the extent to which the regulators’ actions are enforceable and the likelihood that the regulators will identify instances of noncompliance, we determined the legal force behind the newly created rules, guidance, and recommendations and the other means regulators use to encourage cooperation from broker-dealers. We also determined the extent to which the regulators considered the newly created criteria in their examination procedures and modules. To make this determination, we reviewed NASDR’s, NYSE’s, and SEC’s examination modules for procedures that address the disclosure of margin risk, order routing or trade execution, privacy policies, trading concepts and risks, and risk of systems outages and actual outages, or operational capability. We met with officials from SEC, NASDR, and NYSE to discuss these issues and understand how they are considered in examinations and otherwise enforced. We conducted our work in New York, NY and Washington D.C. between November 2000 and June 2001 in accordance with generally accepted government auditing standards. According to industry data, the on-line trading industry has changed significantly during 1999 and 2000, with rapid growth in both accounts and trading activity giving way to a period of diminishing growth in the number of accounts and declining trading activity. The volume of complaints involving on-line trading generally followed a similar pattern during these 2 years, peaking in the first half of 2000 and then decreasing. The nature of these complaints has also changed, with complaints about access to accounts falling relative to complaints about margin position sellouts. In our earlier report, we reported that the number of firms offering on-line trading had grown from 37 in January 1997 to 160 in July 1999 and that many traditional brokers were planning to offer an on-line option to their customers. In its January 2001 report on on-line trading, SEC reported that over 200 broker-dealers were providing retail investors with the ability to trade on-line. During 1999 and 2000 the number of on-line brokerage accounts continued to grow, nearly doubling from 8.6 million in the first quarter of 1999 to 17.4 million in the second quarter of 2000, or more than 10 percent each quarter. Since then, the quarterly rate of increase has slowed to less than 6 percent (see fig. 1). On-line trading activity followed a somewhat different pattern, rising dramatically and then declining. The average volume of on-line trades grew from about 455,000 per day in the first quarter of 1999 to more than 1.24 million per day in the first quarter of 2000—an increase of 173 percent. However, after the first quarter of 2000 the average volume of on- line trades fell. Investors made an average of about 900,000 trades per day in the last quarter of 2000, a drop of about 28 percent. Despite the decline in 2000, on-line trading remained well above 1999 levels (see fig. 2). The growth of on-line trading activity outpaced the growth of overall retail trading activity from the first quarter of 1999 to the first quarter of 2000 but then began to decline, falling more than conventional trading through brokers. On-line retail stock trading increased from around 29 percent in the first quarter of 1999 to around 40 percent in the first quarter of 2000, and by the end of the year around 30 percent of all retail stock trades were being performed on-line. One measure of investors’ dissatisfaction with on-line broker-dealers is the number of complaints investors file with SEC and other regulatory authorities. During the past 2 years, the number of complaints SEC has received have followed a pattern somewhat similar to that of trading volume, reaching a peak in the first half of 2000 and then declining. In fact, the surge in such complaints in the first half of 2000 outpaced the increase in trading volume from the previous 6-month period. For 2000, SEC received 27,920 complaints, of which 4,271—or 15 percent—were classified as on-line complaints. While the total number of on-line complaints for 2000 increased over those of 1999, these complaints declined dramatically during the second half of the year, falling to 42 percent of their January to June levels. In the last quarter of 2000, SEC received approximately the same number of on-line complaints it received during the last quarter of 1999 (see fig. 3). Overall, the number of complaints NASDR received that involved on-line trading firms followed a similar pattern. According to NASDR, although it does not specifically track complaints as on-line issues, the number of complaints NASDR received involving on-line firms peaked in the first quarter of 2000. During that quarter, 950 complaints, or 44 percent of the total complaints it received, involved on-line trading firms. By the fourth quarter of 2000, the number of on-line complaints received had fallen to 427, or 33 percent of the 1,275 total it received. In addition to compiling complaint data, NASDR also compiles statistics on arbitration disputes between broker-dealers and customers, including disputes arising from on- line trading. The number of such disputes increased from 55 to 214 from 1999 to 2000 but it is expected to decline this year. NYSE saw the same trend in complaints. During the first quarter of 2000, NYSE member firms reported 7,625 on-line trading complaints, or 27 percent of the total complaints received. By the fourth quarter of 2000, the number of complaints had fallen to 1,737, or 11 percent of the 15,371 total it received. Some of the growth in complaints about on-line trading during the first half of 2000 may be attributed to growth in the volume of on-line trading.