What is Regulation T?
This is a collection of protocols formulated by the Federal Reserve Board that governs investors’ margin and cash accounts. When investors purchase securities on borrowed money, it’s referred to as buying on margin.
Buying stock on credit exposes investors to huge losses compared to purchasing the same securities with cash. To govern buying on margin, the Board of Governors for the Federal Reserve System stepped in and came up with rules that limit borrowing.
The new rules were known as initial margin and so they limited borrowing to be no greater than 50% of the stock buying price.
How Reg T governs margin accounts
For traders who want to purchase securities using broker-dealer credit, they are required to apply for a margin account. This account grants an investor borrowing privileges. As a result, the investor will have a chance of borrowing money on their margin account. An interest based scheduled rate provided by the broker-dealer will have to be remitted.
Here is an example for better understanding.
Let’s assume an investor wants to obtain a loan from a brokerage firm to buy stock for a particular company. The price for each share is set at $50 and the investor is willing to purchase 100 shares.
This will result in the final amount totaling to $ 5,000. According to Reg T rules, the investor cannot borrow more than 50% of the buying price from the broker. This translates to $2,500 which means the remaining balance has to be remitted in cash.
Downside of using margin account
As said earlier, investors can make huge losses when using margin accounts. This happens as a result of a decrease in stock prices. When it comes to volatile markets, investors usually place an initial margin payment for stock.
They are also required to place an additional amount in cash if the price of the security falls. There are brokers who may end up selling the investors securities without notifying them.
This results in losses for the investor. If the broker sells the securities when the prices have dropped, as the investor, you will lose the chance of recouping your losses even when the market bounces back.
How to recognize risks for margin accounts
To avoid huge losses, it is wise to fully understand the risks associated with margin accounts. They include:
a. The probability of losing more money than you invested
b. Investors may be forced to sell a few or all securities on short notice. This is done to cover market losses
c. Additional cash or stock may be deposited on short notice to cover market losses
d. Your securities may be sold by your brokerage firm without your consultation. This is done to pay off the money you borrowed.
What is a cash account?
This is a type of brokerage account where the investor pays the full amount for the purchased stock before selling it. In this case, the investor does not borrow funds from the broker-dealer to complete the purchase.
When the investor buys and sells stock before paying then the investor is free-riding. This practice is not permitted under Regulation T. It may result in the freezing of the investor’s cash account for a period of 90 days by the broker.
There is some good news. The investor can buy stock with the frozen cash account but purchases must be completed in full on the date of trade.
While Reg T was initially developed to govern the margin account, the rules were extended to govern transactions for cash accounts too. This was done to minimize freeriding and freezing of accounts. Furthermore, it helps to minimize losses that investors may incur as a result of market changes.