The term “day trading” has various definitions. In 1999, day trading was commonly described as a trading strategy that involved making multiple purchases and sales of the same securities throughout the day in an attempt to profit from short-term price movements. Since that time, the definition has evolved. For example, NASDR and NYSE use two definitions of day trading in the recent amendments to their margin rules. First, NYSE Rule 431(f)(8)(B)(I) and NASDR Rule 2520(f)(8)(b) generally define day trading as “the purchasing and selling or the selling and purchasing of the same security in the same day in a margin account.” Second, both NYSE and NASD define a “pattern” day trader as a customer who executes four or more day trades within 5 business days, unless the number of day trades does not exceed 6 percent of their total trading activity for that period. Additionally, NASDR’s rule on approval procedures for day trading accounts defines a day trading strategy as “an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to affect both purchase and sale transactions in the same security or securities.” In this report, we define day trading as consistently both buying and selling the same securities intraday via direct access technology to take advantage of short-term price movements. Day trading firms use sophisticated order routing and execution systems technology that allows traders to monitor and access the market on a real- time basis. This technology allows traders direct access to stock markets through Nasdaq Level II screens that display real-time best bid (buy) and ask (sell) quotes for any Nasdaq or over-the-counter security, including quotes between market makers trading for their own inventories. Day traders also conduct transactions through electronic communications networks (ECNs), which allow customers’ orders to be displayed to other customers and allow customers’ orders to be paired. As a result of this technology, day traders have the tools to trade from their own accounts without an intermediary such as a stock broker and can employ techniques that were previously available only to market makers and professional traders. Both rules define day trading as the purchasing and the selling or the selling and purchasing of the same security on the same day in a margin account. There are two exceptions to this definition: first, a long security position held overnight and sold the next day prior to any new purchase of the same security; and second, a short security position held overnight and purchased the next day prior to any new sale of the same security. Day trading firms register with SEC and become members of one of the SROs, such as NASD or the Philadelphia Stock Exchange; they are therefore subject to regulation by SEC and an SRO. As registered broker- dealers, day trading firms are required to comply with all pertinent federal securities laws and SRO rules. SROs generally examine every broker- dealer anywhere from annually to up to every four years, depending on the type of firm. Day trading firms are also subject to the securities laws and oversight of the states in which they are registered. In 1999, state and federal regulators began to identify concerns about certain day trading firms’ activities. In 1999, state regulators examined and initiated disciplinary action against several day trading firms and identified several areas of concern. SEC completed an examination sweep of 47 day trading firms in 1999 and subsequently issued a report. According to SEC’s report, the examinations did not reveal widespread fraud, but examiners found indications of serious violations of securities laws related to net capital, margin, and customer lending. However, most of the examinations revealed less serious violations and concluded that many firms needed to take steps to improve their compliance with net capital, short sale, and supervision rules. NASDR also initiated a series of focused examinations of day-trading firms that focused on the firms’ advertising and risk disclosures, among other areas. SEC and NASDR also initiated several enforcement actions against day trading firms and individuals in early 2000. In our 2000 report, we found that day trading among less-experienced traders was an evolving segment of the securities industry. Day traders represented less than one-tenth of 1 percent, or about 1 out of 1,000, of all individuals who bought or sold securities. However, day trading was estimated by some to account for about 15 percent of Nasdaq’s trading volume. Although no firm estimates exist for the number of active day traders, many regulatory and industry officials we spoke with generally thought 5,000 was a reasonable estimate and believed the number was stable or had gone down slightly. However, the number of open accounts at day trading firms is likely much higher. We also noted in our 2000 report that before 1997, day traders submitted most of their orders through the Small Order Execution System (SOES). We concluded that the effects of day trading in an environment that depends less on SOES and more on ECNs are uncertain. Because of these findings and our work in this area, we recommended that after decimal trading is implemented, SEC should evaluate the implications of day traders’ growing use of ECNs on the integrity of the markets. We also recommended that SEC do an additional cycle of targeted examinations of day trading firms to ensure that the firms take the necessary corrective actions proposed in response to previous examination findings. Concerns about day trading culminated in hearings before the Permanent Subcommittee on February 24 and 25, 2000, and the ultimate issuance of a report by the Permanent Subcommittee in July 2000. The Permanent Subcommittee expressed its concerns about certain industry practices at the hearing and made several recommendations in its subsequent report. In general, the recommendations suggested changes to NASDR’s disclosure rules and margin rule amendments and summarized comments Permanent Subcommittee Members had submitted to SEC when those rules were published for comment in the Federal Register. In addition, the Permanent Subcommittee recommended that NASDR prohibit firms from arranging loans between customers to meet margin requirements and that firms be required to develop policies to ensure that individual day traders acting as investment advisors are properly registered. Since 1999, day traders as a group and firms that offer day trading capability have continued to evolve. Most regulators and industry officials we spoke with said that day traders are generally more experienced and that fewer customers are quitting their jobs to become day traders. We also found that many day trading firms now market to institutional customers, such as hedge funds and money market managers, rather than focusing on retail customers. In addition, more day trading firms are likely to engage in proprietary trading through professional traders who trade the firms’ capital rather than their own and earn a percent of the profits. Finally, we found that traditional and on-line brokers and other entities that want to offer their customers direct access to securities markets are acquiring day trading firms. A concern raised in 1999 was that day trading firms were marketing to inexperienced traders who did not fully understand the risks of day trading and therefore lost substantial amounts of money. Some industry and regulatory officials said the combination of intense regulatory scrutiny and adverse market conditions in late 2000 and into 2001 have driven many unsophisticated traders out of day trading. Traders currently engaged in day trading are more likely to be experienced and to have a greater knowledge of the risks involved than traders in 1999. Industry officials said that many traders gained their experience by day trading for several years, while others were professional traders who became day traders. During our first review, regulatory and government officials were particularly concerned that day trading firms were attracting customers who were ill-suited for day trading because they lacked either the capital or the knowledge to engage in such a risky activity. Since 1999, day trading firms have begun to focus on institutional as well as retail customers, including hedge funds and small investment management companies. According to press reports, All-Tech Direct, Inc., a day trading firm, announced in August 2001 that it planned to get out of the retail business completely and was severing its relationship with all of its retail branches. Overall, institutional investors are increasingly interested in the kind of high-speed order execution that day traders get from direct access systems and the relatively low fees day traders pay to execute trades. In addition, some day trading firms that focused solely on retail customers in 1999 have since hired professional traders who trade the firms’ capital (proprietary traders). For some, this move reflects a departure from their retail customer focus. A few officials said many of their retail customers started as proprietary traders and learned to trade by using the firm’s capital rather than their own. Another change involves the growth in the number of day trading firms being acquired by other brokerages and in market participants that want the direct access technology. For example, since 1999 on-line brokers Charles Schwab and Ameritrade have purchased CyberCorp. (former CyberTrader) and Tradecast, respectively. Likewise, in August 2001 T.D. Waterhouse Group Inc. announced plans to purchase one of the smaller day trading firms, R.J. Thompson Holdings. In addition, Instinet, an ECN, purchased ProTrader as a way to offer direct access technology to its customers. Moreover, financial conglomerates are also moving toward offering fully integrated services, which include all aspects of a securities purchase, from direct access to securities markets to clearing capabilities. In September 2000, Goldman Sachs announced its planned acquisition of Spear Leeds & Kellogg, which offers such fully integrated services. Other firms with fully integrated capabilities include on-line brokerages such as Ameritrade and Datek, as well as an ECN, Instinet. Some regulatory and industry officials said that they expect traditional and discount brokerages to continue to acquire day trading firms, as these brokerages face increased pressure to provide direct market access to their more active traders (estimated at between 50,000 and 75,000).