PDT Rule & Prop Firms

Prop trader LLC members of BDs and non-BDs are lower class members and they rarely receive much financial reporting from management (Class A owners). They usually just receive reporting for gains and losses in their sub-trading account. Most prop traders don't care much about overall firm finances anyway; they are happy to get all the leverage they can get.

This gets to the heart of the problem with Tuco, a sub-LLC prop trading firm, not organized as a BD.

Securities traders need $25,000 on deposit in a retail broker dealer to be classified as a "pattern day trader" (PDT) account; which affords them leverage of 4/1 versus the default 2/1. Prop traders in BDs also need $25,000 to join these firms.

Traders who lack $25,000 capital are enticed with offerings from sub-LLC prop trading firms (non-BDs); many of whom ask for deposits of $2,000 or $5,000. Notice the wording about this concept in the SEC enforcement action against Tuco below.

SEC excerpt: "The defendants enticed traders with services unavailable at a registered broker-dealer. As alleged in the complaint, they allowed traders to day-trade without meeting the $25,000 minimum equity requirement under NASD regulations for such trading. The SEC's complaint also alleges that for each $1 in the trader's sub-account, Tuco and Frederick allowed the traders at Tuco to use up to $20 of Tuco's equity, which has been invested by other traders, to purchase securities (20:1 buying power). NASD and NYSE regulations, however, only allow a day-trader to have 4:1 buying power. "

We have been pointing out for years that we felt that prop trading firms were trying to violate the 4/1 and 2/1 leverage rules of Reg T. See below.

SEC excerpt: "Tuco's unregistered operations posed a substantial risk to both investors and the securities markets, and we will act to stop these operations."

Doesn’t this imply that every sub-LLC prop trading firm not organized as a broker-dealer is highly-vulnerable to this same level of enforcement by the SEC? The SEC seems to want traders to either be treated as “retail or customer accounts” with 4/1 (PDT) or 2/1 leverage, or LLC members of compliant-BD prop trading firms (which require $25,000 to join).

SEC excerpt: “The SEC's complaint also alleges that Tuco received transaction-based compensation for its members' trading, and Tuco's traders conducted substantial day-trading through Tuco's brokerage accounts both in dollar amounts and number of trades. As a result, Frederick earned substantial commissions on the trading as the registered representative for the Tuco principal accounts at the registered broker-dealer. The SEC alleges that Frederick then used substantial amounts of his commissions to pay Tuco's operating expenses.”

We know that many owner/managers of non-BD sub-LLC prop trading firms are themselves licensed brokers at the broker dealers their sub-LLC prop trading firms trade through. Many of the sub-LLC entrepreneurs (licensed brokers) build their business models around collecting high levels of commissions on trading recruits (cannon fodder). Sometimes these entrepreneurs disclose receiving these commissions from their traders and sometimes they don’t. As in Tuco, they may use these commissions to fund their sub-LLCs and/or pay the firm’s expenses. It seems that the SEC is rightfully upset about these often non-disclosed conflicts of interest.

This is where otherwise-compliant BD prop trading firms face some questions in this connection. Those BDs cooperate closely with their brokers to build out the sub-LLCs; to recruit more cannon fodder for the commission model.

SEC excerpt: “The SEC's complaint also details the defendants' inaccurate reporting of the traders' equity balances. As of Dec. 31, 2007, Tuco and Frederick used about $3.62 million of the traders' approximately $10.2 million total equity to pay Tuco's expenses and to cover trader losses. Approximately a $1.35 million shortfall remained as of Jan. 31, 2008. Tuco and Frederick failed to disclose those details or that Tuco and Frederick's recovery of the shortfall in the traders' equity is dependent on Frederick's recovering the funds from third parties.”

 

Don’t you think that many sub-LLC firms, which lack BD compliance and regulatory oversight, have engaged in this same type of “robbing Peter to pay Paul” accounting? Especially, when you factor in the severe market losses of recent months?

Even independent contractor prop traders (receiving a 1099-Misc rather than joining as an LLC member) who make deposits to sub-LLC prop trading firms should be concerned here. Their deposits and market access are also at risk if the SEC shuts down their firm over night.

Most prop trader recruits are led to believe by management that the firm has loads of firm capital available for traders. It’s never construed those traders' deposits and commissions are recycled for firm capital. Wouldn’t that be a version of a Ponzi-type scheme; where new recruits are financing older recruits and not really the firm or true profits?

How many prop trading firms (BD or not) are ready to prove out their true firm capital to traders? I mean capital that is not pledged or encumbered in anyway; free of swap or other derivative risk too?

The SEC emergency order against Tuco is a bombshell to the prop trading firm industry and its awakened many prop trading firm owner/managers to contact our firm for our opinion on the subject and/or help.

It's probably a good idea to speak with your firm's management ASAP and (as we have always advised) withdraw as much capital as possible.

It’s also wise to consult with an attorney ASAP. We can refer you to some attorneys who are knowledgeable in the prop trading firm industry and our ongoing warnings in this regard.

We have other new concerns about the financial health of prop trading firms and together with this SEC enforcement action we believe risks are growing geometrically. We are concerned about the spreading credit crunch and recent unprecedented fights between banks and hedge funds over margin calls, lending, and derivative and swap contracts.

Banks are sending margin calls to hedge funds and withdrawing lines of credit. This can put a hedge fund out of business in quick order. Banks often also take the other side of trades on derivatives and swap contracts with their hedge fund clients. The media has reported that banks are not allowing funds to sell these contracts and we understand from attorneys in the know that many derivative contracts are unsigned. Talk about shifting money and risk around; it doesn’t get any bigger than the 45-trillion dollar swap market.

We are concerned because some prop trading firms have commingled prop trading firm models with the hedge fund business model. This is how WorldCo was busted and put out of business by the regulators a few years back; at great loss to their prop traders. Refco had similar problems too.

Some well-known prop trading firm BDs have mentioned adding hedge fund models to their prop trading firms. This troubles me. We have always told them, when they told us in advance, to skip it as it was trouble.

All prop traders in BD and non-BD firms need to ask “what's behind the (prop trading firm) curtain” when it comes to true net capital, leverage and accounting.

All sub-LLC non-BD prop trading firms appear to be very vulnerable to the Tuco precedent and they should significantly change over night; or just close and return their trader’s monies. Tuco seems very broad in its reasoning against these firms.

All BD prop trading firms should stop allowing sub-LLC firms to carry-on these inappropriate (and illegal) business practices. They should disclosure the ultimate receiver of commissions to all traders who pay those commissions; so there are no undisclosed conflicts of interest. Better yet, don’t allow conflicts of interest in the first place.

Are BD prop trading firms also vulnerable to the spreading credit crunch and potential disagreements with their own lenders (if any)?

The SEC and other regulators are obviously very concerned with current shock waves in financial markets; and particularly with the impact of leverage; especially undue leverage which violates Reg T (leverage) rules.

The SEC and other regulators may now feel compelled to take enforcement action to protect investors and traders (from themselves). Reigning in these sub-LLCs seems entirely appropriate. The problem is how to find them, as they often fly below the radar. The best way to find them may be on the books of the BD prop trading firms that utilize sub-LLCs in their model.

Unfortunately, like all other good intentioned efforts to correct excesses and problems, this current effort and warnings can contribute to a “run on the (prop trading firm) bank."

It certainly is appropriate, fair and wise to address all these concerns with your prop trading firm and an attorney (and us too if you like). If you feel uncomfortable, then there is nothing wrong with asking for your money back and stopping prop trading. You can open a retail trading account (with less leverage) instead or just cool it for a while.

Why is it that so many day trading prop trading firms have been shopped around (to corporate buyers) over the years; and often shunned or closed down by those buyers after they acquire these firms and realize all the trouble behind the curtain?

Not many prop trading firm names have survived in tact? There are a few independent firms with powerful (in the media) CEOs; who constantly harp on how safe their model is versus others. Will they too be safe from the current regulatory, credit crunch and severe loss environment? If they don’t have sub-LLC prop trading firm clients, they may be okay. I can think of a few that should be fine in this context.

It's still hard to know at this point whether the SEC went after Tuco because they were committing a variety of violations, or whether it signals an attack on the non-BD prop trader model in general.

When the regulators attacked several prop trading firms a year ago (see below alert), they picked on some firms that appeared to be cleaner than Tuco; perhaps to make an example of them. If the SEC or FINRA or other regulators go after other non-BD prop trading firms that have kept their noses clean that would be a sign of a general attack on this structure.

 

So let's see here - it sounds like both the sub llc and regular bd series 7 firms may all be under attack (eventually). I guess the only option then is regular retail...

Would it still be wise to get a series 7 or is it just a waste of time and money?

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Whether you are licensed or not and you put up a despoist. The relationship is going to be looked at as a customer account(Retail). As it was said before, the SEC wants employees not independent contractors.


This is the bottom line.

 

isn't it funny... every time the SEC looks out for my best interest, it ends up costing me more money.

 

not seeing a conflict of interest here at all. what else is the sub supposed to do with the commissions, give it to charity?

re: high level commissions, um, ever heard of competition? free-markets are the only thing required to regulate this type of thing. and if you're paying too much for commissions, then the burden of responsibility falls on you. the moment we start thinking that the trader should take responisbility for themselves, the better off our industry will be.

perpetuating this type of socialist/pro-government intervention propaganda, especially by industry respected accountants, is counter-productive to the interests of the trader and free markets in general and should be forcefully shunned by traders and pro-competition capitalists. also, we should keep in mind that this propaganda is definitely not counter-productive to the interests of green... counted more than a few plugs in there.

edit:
anyone catch his emotionally descriptive term for new traders who negotiate bad deals ("cannon fodder"). implying, new traders are innocent victims who need protecting against the evil capitalist "entrepreneurs". wether it was intentional or not, this is big-brother socialist propaganda at its best.

 

All these non-registered Prop firms are doing business illegally by providing traders with a leverage rate greater than 4:1. I would hope the SEC gives these firms a change to register as B/D, if they do not they must shut down. If a firm like Tuco would be given a chance to register maybe it could survive. But TUCO’s main problem was the co-mingling of traders deposits with Tuco operating expenses. A Rules violation for sure.

Mr. nyxtrader point indicates both Licensed or Non-Licensed trader are independent contractors. However, the Licensed or Professional trader is a member of an exchange such as say NYSE and is allowed to obtain leverage greater than 4:1 as Bright and other Licensed firms have been doing business for many, many year. Not sure if the SEC can change or modify the Professional Traders Business Model since it falls under NYSE rules and not the SEC.

If the SEC shut down all these Prop firms what would that to the NYSE trading volume, a lot of revenue lost for NYSE and NASD. Let's hope those in charge will work out some way we can all trade and traders money is secure.

 

Ok I have made some calls and this is coming from the horses mouth and it has taken some time to get a direct answer as the SEC will only give you generally info and will not give advise.

All of these firms are acting as broker dealers by ingaging in securities trading/activity. All trader must be licensed and LLC's must be registered as a BD. There is a kicker. Just because one is licensed there are still minimum equity requirements. The SEC told me, there are different requirements for licensed traders and is getting back with me today, to give me the correct amount. However he is sure that it is more than 5 or even 10k.

 

well.. here is the complaint:

http://www.sec.gov/litigation/complaints/2008/comp20480.pdf