Chapter 5
Understanding Regulations
IN THIS CHAPTER
Looking at a history of day trading and regulations
Wondering who all these regulators are, anyway
Considering some basic brokerage requirements
Handling hot tips
Trading with other people
The financial markets are wild and woolly playgrounds for capitalism at its best. Every moment of the trading day, buyers and sellers get together to figure out what the price of a stock, commodity, or currency should be at that moment given the supply, the demand, and the information out there. It’s beautiful.
One reason why the markets work so well is that they are regulated. That may seem like an oxymoron: Isn’t capitalism all about free trade, unfettered by any rules from nannying bureaucrats? Ah, but for capitalism to work, people on both sides of a trade need to know that the terms will be enforced. They need to know that the money is in their account and safe from theft. And they need to know that no one has an unfair advantage. Regulation creates the trust that makes markets function.
Day traders may not be managing money for other investors, and they may not answer to an employer, but that doesn’t mean they don’t have rules to follow. They have to comply with applicable securities laws and exchange regulations, some of which specifically address those who make lots of short-term trades. Likewise, brokers and advisers who deal with day traders have regulations that they need to follow, and understanding them can help day traders make better decisions about whom to deal with. In this chapter, you find out who does the regulating, what they look at, and how it all affects you.
How Regulations Created Day Trading
Canada’s regulatory system is very different from that in the U.S., though it all stems from the same place. The American system came first, and so we borrowed many rules from our southern neighbours. Things have developed significantly since then, and although many similarities exist you’ll also find a lot of differences. But first, a quick course in American history is in order so you can see how regulation in fact helped create trading.
With the advent of the telegraph, traders could receive daily price quotes. Many cities had bucket shops, which were storefront businesses where traders could bet on changes in stock and commodity prices. They weren’t buying the security itself, even for a few minutes, but were instead placing bets against others. These schemes were highly prone to manipulation and fraud, and they were wiped out after the stock market crash of 1929.
After the 1929 crash, small investors could trade off the ticker tape, which was a printout of price changes sent by telegraph, or wire. In most cases, they would do this by going down to their brokerage firm’s office, sitting in a conference room, and placing orders based on the changes they saw come across the tape. Really serious traders could get a wire installed in their own office, but the costs were prohibitive for most individual investors. In any event, traders still had to place their orders through a broker rather than having direct access to the market, so they could not count on timely execution.
Another reason why so little day trading happened back then is that until 1975, all American brokerage firms charged the same commissions. That year, the U.S. Securities and Exchange Commission (SEC) ruled that this amounted to price fixing, so brokers could then compete on their commissions. Some brokerage firms, such as Charles Schwab, began to allow customers to trade stock at discount commission rates, which made active trading more profitable.
Today, Canadian fees are all over the map and getting cheaper, so compare commission prices before you settle on a broker.
The system of trading off the ticker tape more or less persisted until the stock market crash of 1987. Brokerage firms and market makers were flooded with orders, so they took care of their biggest customers first and pushed the smallest trades to the bottom of the pile. After the crash, the exchanges and the SEC called for several changes that would reduce the chances of another crash and improve execution if one were to happen. One of those changes was the Small Order Entry System, often known as SOES, which gave orders of 1,000 shares or fewer priority over larger orders.
Similar regulation was developed in Canada at about the same time. The Order Exposure Rule was created to make sure smaller orders were given the same priority as larger ones. Here, 50 standard trading units or fewer (about 5,000 shares) have to be immediately entered on a market place. Brokers can’t fill their larger orders first.
In the 1990s, when Internet access became widely available, this became less of a problem because traders could place orders in real time. But the rule still applies. Brokers could, theoretically, wait to execute Internet orders so they could deal with their 100,000-share trades first. Of course, that would be terrible for business — and with so much competition, fast execution is a selling point. Still, this rule, plus the speed of the Internet, put traders on the same footing as brokers and made day trading look like a pretty good way to make a living.
Who Regulates What?
In Canada, financial markets get regulatory oversight from various bodies, but most of the rules come from the provincial security commissions (such as the Ontario Securities Commission, or OSC) and the Investment Industry Regulatory Organization of Canada (IIROC). Both have similar goals: to ensure that investors and traders have adequate information to make decisions, and to prevent fraud and abuse.
Unlike in the United States, which has the Securities and Exchange Commission, Canada has no national regulator. IIROC governs dealers (the institutions whose trading software you’re using) across the country, and the securities commissions enforce the provincial Securities Act and Commodity Futures Act. The commissions’ mandate, says the OSC’s website, is to protect investors from “unfair, improper or fraudulent practices and to foster fair and efficient capital markets and confidence in capital markets.”
Both IIROC and Canada’s other self-regulatory organization, the Mutual Fund Dealers Association (MFDA), which oversees dealers who sell only mutual funds, police their own members, but the former self-regulatory organization (SRO) does a lot more. IIROC regulates the Toronto Stock Exchange (TSX), the Canadian Securities Exchange (formerly the Canadian National Stock Exchange), and various alternative trading systems such as Bloomberg Tradebook and Omega ATS.
When it comes to equity exchanges, IIROC’s main job is to make sure nothing fishy is happening. The organization monitors trading activity and can place halts or delays if market integrity is compromised. It also enforces Universal Market Integrity Rules — the rules in Canada that govern trading.
IIROC also monitors how securities are traded in order to look for patterns that might point to market manipulation or insider trading. It works with brokerage firms to make sure they know who their customers are and that they have systems in place to make certain these customers play by the rules.
Because the stock and corporate bond markets are the most popular markets and have a relatively large number of relatively small issuers, regulators are active and visible. Not just one government is issuing currency — a whole bunch of companies issue shares of stock. When it turns out that one of these companies has fraudulent numbers the headlines erupt, and suddenly everyone cares about what the regulators are up to. That’s just the first layer in regulating this market.
Serious talk has happened in the hallowed halls of the Legislature about creating a single national securities regulator in Canada, much like the SEC in the United States. Governments have been debating the question of whether Canada needs one for decades, so the chances of it happening soon are slim. However, if you’re reading this book a few years after its publication date, be aware that some of what is written here may be obsolete.
Provincial securities commissions
Each province has its own agency to ensure the markets work efficiently. Although rules may vary, they all share a common goal: to keep capital markets safe from fraud. Each commission governs its own jurisdiction, but they do work together. The commissions also work with the SEC or other governing bodies when fraud crosses country borders.
The provincial securities commissions have various functions, including the following:
- Regulating provincial capital markets by enforcing the provincial Securities Act and, depending on where, the Commodity Futures Act. The commissions ensure that any companies that have securities listed on exchanges in their jurisdiction report their financial information accurately and on time, so that investors can determine whether investing in the company makes sense for them.
- Working with various stakeholders — retail investors, pensions funds, dealers, advisers, stock exchanges, alternative trading systems, SROs, and more — in ensuring compliance, investor protection, and keeping fair and efficient markets.
- Prosecuting firms and individuals who violate securities law. Although the commissions spend a lot of time investigating allegations of misconduct, they hold hearings over takeover bids and other regulatory issues, too.
Investment Industry Regulatory Organization of Canada (IIROC)
IIROC (www.iiroc.ca) was created in 2008 when the Investment Dealers Association and Market Regulation Services merged. The IDA was an SRO that oversaw Canadian dealers, and MRS provided regulation services for Canadian markets. The union has brought better oversight to the industry, making it more difficult for nefarious crooks to take advantage of investors.
The combined SRO oversees investment dealers in Canada that trade stocks, bonds, mutual funds, options, forex, and other securities. It also looks after trading activity on debt and equity markets. It has hundreds of member firms, with thousands of people who are registered to sell securities. IIROC administers background checks and licensing exams, regulates securities trading and monitors how firms comply, and provides information for investors so that they are better informed about the investing process.
IIROC also requires advisers to know as much as they can about their clients, via Know Your Client (KYC) forms. This includes determining whether an investment strategy is suitable for them. Find out more about suitability in the later section “Are you suitable for day trading?” — for now, just know that it’s an IIROC function.
The first thing a day trader should do is check IIROC and MFDA’s media release pages and the security commissions’ registration sites. Every time a disciplinary hearing against a firm or adviser takes place, the progress of the proceedings is posted on the site. Find out whether the firm you want to trade with has violated any regulations. The security commissions’ registrations sites allow you to type in the name of a person or firm and see whether they are in fact registered, what category they’re registered in, and if any conditions were attached to that registration. These tools help ensure you’re not dealing with a criminal.
Mutual Fund Dealers Association of Canada (MFDA)
Unlike IIROC, which oversees dealers who trade stocks and bonds, the MFDA (www.mfda.ca) represents members who work only with mutual funds. Despite operating under its own set of rules, it shares many of the same goals as IIROC. It regulates operations, standards, and business conduct of its members and tries to improve investor protection. It can fine members for violating rules, and works with authorities when criminal charges are laid.
The MFDA represents nearly 100 firms, or over 78,000 mutual fund sales persons, with about $550 billion in assets under administration. It’s highly unlikely the brokerage firm you use will be an MFDA member. Because you’re trading more than just mutual funds, you’ll be working in an IIROC environment.
The exchanges
It wasn’t long ago that each major city had its own exchange. But through mergers and an agreement that Toronto would host a central stock exchange, the TSX became the main exchange in the country. However, depending on what you trade, the TSX is not the only game in town — you’ll also find the TSX Venture Exchange (TSXV), the Montreal Exchange (MX), and other exchanges and alternative trading systems.
Canada’s main exchanges are owned by the TMX Group (www.tmx.com/). It oversees the TSX, the TSXV, the MX, and a few others. The group has outsourced its regulation duties of the TSX and TSXV to IIROC, and the others regulate trading activity in-house.
Brokerage Basics for Firm and Customer
No matter how they are regulated, brokers and futures commission merchants have to know who their customers are and what they are up to. That leads to some basic regulations about suitability and money laundering — and extra paperwork for you. Don’t be too annoyed by all the paperwork you have to fill out to open an account, though — your brokerage firm has even more.
Are you suitable for day trading?
Brokerage firms have to make sure the activity surrounding their customers is appropriate. The firms need to know their customers and be sure that any recommendations are suitable. When it comes to day trading, firms want to be sure their customers are dealing with risk capital — money they can afford to lose. They also want to be sure that their customers understand the risks they are taking. Depending on the firm, and what you’re trying to do, you might have to submit financial statements, sign a stack of disclosures, and verify that you have had previous trading experience.
It’s no one’s business but your own, of course, except that the regulators want to make sure that firm employees aren’t talking customers into taking on risks they should not be taking. Sure, you can lie about it. You can tell the broker you don’t need the $25,000 you’re putting in your account, even if that’s the money paying for your kidney dialysis. But when it’s gone, you can’t say you didn’t know about the risks involved.
Staying out of the money laundromat
Money laundering is a way to receive money acquired from illegal activities. Your average drug dealer, Mafia hit man, or corrupt politician doesn’t accept credit cards, but he really doesn’t want to keep lots of cash in his house. How can he collect interest on his money if it’s locked in a safe in his closet? And besides, his friends are an unsavory sort. Can he trust them to stay away from his cache? If this criminal fellow takes all that cash to the bank, those pesky bankers will start asking a lot of questions, because they know that most people pursuing legitimate business activities get paid through cheques or electronic direct deposit.
Hence, the felon with funds will look for a way to make it appear that the money is legitimate. It happens in all sorts of ways, ranging from making lots of small cash deposits to engaging in complicated series of financial trades and money transfers, especially between countries, that become difficult for investigators to trace. Sometimes these transactions look a lot like day trading, and that means that legitimate brokerage firms opening day trade accounts should be paying attention to who their customers are.
Fighting money laundering took on urgency after the September 11, 2001 attacks, because it was clear that someone somewhere had given some bad people a lot of cash to fund the preparation and execution of their deadly mission. Several nations increased their oversight of financial activities during the aftermath of the strikes on the World Trade Center and Pentagon. That’s why one piece of paperwork from your broker will be the anti–money laundering disclosure. The Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) is the government body that looks after money laundering activities, but brokers track this as well. If they suspect a trader is laundering money they’ll report it to FINTRAC, which will then investigate.
In order for your brokerage firm to verify that it knows who its customers are and where their money came from, you’ll probably have to provide the following when you open a brokerage account:
- Your name
- Date of birth
- Street address
- Place of business
- Social Insurance Number
- Driver’s licence and passport
- Copies of financial statements
Rules for day traders
Here’s the problem for regulators: Many day traders lose money, and those losses can be magnified by the use of leverage strategies (trading with borrowed money, meaning that you can lose more money than you have in the quest for large profits). If the customer who lost the money can’t pay up, then the broker is on the hook. If too many customers lose money beyond what the broker can absorb, then the losses ripple through the financial system, and that’s not good.
IIROC has a long list of rules that its member firms have to meet in order to stay in business. The organization sets margin requirements and, depending on the type of account, the requirements are stricter to reflect the greater risk. You can get more information on industry compliance at www.iiroc.ca/industry/industrycompliance/Pages/default.aspx.
The rules set by IIROC are minimum requirements. Brokerage firms are free to set higher limits for account size and borrowing in order to manage their own risks better.
Tax reporting
If you’re a long-term investor receiving dividends, your online broker will send you a slip at the end of the year detailing how much income you’ve made. Traders will also receive tax forms if they received dividends or interest income — this mostly applies to people who hold overnight positions. Brokers may also send out a summary of trades to help track capital gains and losses.
Hot Tips and Insider Trading
The regulations are very clear for things about suitability and money laundering. You get a bunch of forms, you read them, you sign them, you present documentation, and everyone is happy. The rules that keep the markets functioning are clear and easy to follow.
Another set of rules also keeps markets functioning — namely, that no one has an unfair information advantage. If you knew about big merger announcements, interest rate decisions by the Bank of Canada, or a new sugar substitute that would eliminate demand for corn syrup, you could make a lot of money in the stock market, trading options on interest rate futures, or playing in the grain futures market.
Insider trading is a broad term. Any non-public information that a reasonable person would consider when deciding whether to buy or sell a security could apply, and that’s a pretty vague standard — especially because the whole purpose of research is to combine bits of immaterial information together to make investment decisions.
Day traders can be susceptible to hot tips, because they are buying and selling so quickly. If these hot tips are actually inside information, though, the trader can become liable. If you get great information from someone who is in a position to know — an officer, a director, a lawyer, an investment banker — you may be looking at stiff penalties. According to the Canada Business Corporations Act, courts can assess civil penalties of “any measure of damages it considers relevant in the circumstances.” A criminal conviction can land someone in jail for up to ten years.
Insider trading is difficult to prove, so federal regulators use other tools to punish those it suspects of making improper profits. In the United States, Martha Stewart wasn’t sent to prison on insider trading charges; she was charged with obstructing justice by lying to investigators about what happened.
Whenever a big announcement is made, such as a merger, the exchanges go back and review trading for several days before to see whether any unusual activities occurred in relevant securities and derivatives. Then they start tracing them back to the traders involved through the brokerage firms to see whether it was coincidence or part of a pattern.
The bottom line is this: You may never come across inside information. But if a tip seems too good to be true, it probably is — so be careful.
Taking on Partners
After your day trading proves to be wildly successful, you might want to take on partners to give you more trading capital and a slightly more regular income from the management fees. You can do it, but it’s a lot of work.
If you start trading as a business a good chance exists you’ll have to register with your provincial securities commission as a dealer, an investment fund manager, or perhaps something else depending on what you’re doing. What triggers registration is complicated. If you’re thinking about bringing people on board, it’s best to call your securities commission or a lawyer and ask them what you need to do. You may also want to read part 25.1 of the Ontario Securities Act (www.ontario.ca/laws/statute/90s05) to find out which category you’d fall under.
Registration is not a do-it-yourself project. An error or omission may have tremendous repercussions down the line, from fines to jail time. If you want to take on partners for your trading business, spend the money for qualified legal advice. It will protect you and show prospective customers that you’re serious about your business.