Definition and Examples of Regulation T
The risk inherent in trading on margin is that an investor stands to lose more than the cash they have in a brokerage account. For this reason, margin accounts are subject to the rules of the Federal Reserve Board, and the Financial Industry Regulatory Authority (FINRA). Regulation T (often referred to as “Reg T”) limits the number of new margin purchases to 50% of the total purchase amount.
This means if an investor has established a margin account with a brokerage and wishes to purchase $10,000 worth of a stock, that investor must have a minimum of $5,000 of their own cash in the account–50% of the total purchase.
Both cash accounts and margin accounts that are held with brokerages can hold shares of stocks, bonds, mutual funds, and other investment vehicles. A margin account allows an investor to borrow money from the brokerage, while a cash account does not.
How Regulation T Works
In determining whether or not to approve a request for a margin account, a brokerage typically reviews an applicant’s income, net worth, estimated liquid net worth, and possibly their credit history.
Because margin accounts are essentially a broker-dealer’s agreement to loan money to the account holder, brokerages may establish their own regulations for these accounts with stricter guidelines than the federal regulations.
Although Regulation T is commonly thought of as setting rules for margin accounts, it also establishes transaction rules for cash accounts created by brokerages. For example, it prohibits an investment tactic known as “freeriding,” which essentially is executing a purchase, promising to send funds necessary for the purchase, but then selling the shares and reaping a gain without ever providing the money for the purchase.
How would this play out? Say an investor who has $5,000 in a cash brokerage account purchases $10,000 worth of stock with a promise to wire the remaining $5,000 balance within two days. If those shares jump to $15,000 in value the next day and the investor sells, reaping the $5,000 gain while never actually paying the $5,000 that was due at the time of the original purchase, that is a freeriding violation.
An investor who commits a freeriding violation is subject to having their account frozen for 90 days. If an account is frozen, the investor may continue to purchase securities only as long as there is sufficient cash in the account to cover the full amount of a purchase.
A “good faith” violation happens when a buyer sells stock then buys a stock later that same day even though his or her account balance cannot fund the new stock purchase until the sale settles. Three good-faith violations in a 12-month period could result in a 90-day trading penalty.
Cash Liquidation Violations
Similarly, if an investor executes a purchase of shares of a security with no available cash in the account to cover the cost, then a day later sells shares of a different holding to pay for the first order, that is a “cash liquidation” violation.
An investor who incurs three cash liquidation violations in a 12-month period in a cash account will have that account restricted for 90 days. This is similar to freezing an account. The account holder will only be able to execute purchases that they have sufficient settled cash to cover the trade.
What It Means for Individual Investors
Investors need to remember that while margin accounts provide opportunities for significant gains, they also pose a higher risk. Investors whose portfolios fall below a certain threshold may be forced to sell shares of stock at a loss due to a margin call.
Margin balances at FINRA member firms have increased every month for more than a year between 2020 and 2021, eclipsing $800 billion in 2021.
The longer time horizon of investing for retirement can allow for a few bad decisions, but it’s important to be right as much as possible when you are investing with borrowed funds.
- Regulation T limits the amount that a brokerage or dealer can lend to a customer for investment purposes to 50% of the total purchase price.
- It is most often associated with the purchase of securities using funds borrowed from a broker, which is known as “buying on margin.”
- Many brokerages establish their own regulations for margin accounts with stricter guidelines than the federal regulations.
Frequently Asked Questions (FAQs)
When was Regulation T enacted?
Regulation T was issued by the Board of Governors of the Federal Reserve System pursuant to the Securities Exchange Act of 1934.
Do cash accounts fall under Regulation T?
Although Regulation T is most often thought of as setting rules for margin accounts, it also establishes transaction rules for cash accounts created by brokerages. For example, it prohibits freeriding, which is essentially executing a purchase, promising to send funds necessary for the purchase, but then selling the shares and reaping a gain without ever providing the money for the purchase.
Can you request an extension under Regulation T?
Regulation T gives an investor a maximum of four business days to pay for securities purchased in a cash or margin account. If the payment due exceeds $1,000 and is not received within this time period, the broker-dealer must either liquidate the position or get an extension from its designated examining authority, such as FINRA. Section 220.8(b)(2) of Regulation T provides an exemption for payment delays of up to 35 calendar days if it is caused by the mechanics of the transaction and not related to the customer’s payment ability or willingness.