What is 'Regulation T - Reg T'
Regulation T is a collection of provisions established by the Federal Reserve Board that govern investors' cash accounts and the amount of credit that brokerage firms and dealers may extend to customers for the purchase of securities.
According to Regulation T, an investor may borrow up to 50% of the purchase price of securities that can be bought using a loan from a broker or dealer. The remaining 50% of the price must be funded with cash.
BREAKING DOWN 'Regulation T - Reg T'
Buying securities with borrowed money is commonly referred to as buying on margin, which represents assets that an investor must deposit with a broker-dealer to obtain a loan. Additionally, Regulation T promulgates payment rules on certain securities transactions made through cash accounts.
Regulation T was issued by the Board of Governors of the Federal Reserve System to provide rules for extensions of credit by brokers and dealers and regulate cash accounts. An investor who has a cash account cannot borrow funds from a broker-dealer and must pay the purchase price of securities with cash. Margin accounts allow obtaining credit to fund a portion of the securities purchase. Because buying securities on credit can expose investors to sudden losses of a much larger magnitude compared to the same purchase using only cash, the Federal Reserve Board stepped in and promulgated a rule that limited the borrowing to be no greater than 50% of the securities purchase price. This 50% requirement is called the initial margin, because it establishes a minimum borrowing level at the time of purchase. Certain broker-dealers may have stricter requirements with levels above 50%.
Margin Account Regulation
An investor who wishes to purchase securities using broker-dealer credit must apply for a margin account that grants him borrowing privileges. When an investor borrows money at his margin account, he must pay interest based on the rate schedule established by his broker-dealer. Suppose an investor wishes to obtain a loan from his brokerage firm to purchase 10 shares of a certain company with a price per share of $100, resulting in a total purchase of $1,000. Regulation T states that the investor can borrow no more than 50% of the purchase price, or $500, from the broker, while the remaining balance must be paid in cash.
Cash Account Regulation
While the primary goal of Regulation T was to govern margin, it also introduced transactions rules for cash accounts. Because it takes up to three days for securities transaction to settle, meaning when cash is delivered to the seller of securities, a situation can arise when an investor buys and sells securities before paying for them from his cash account. This is called freeriding, which is prohibited by Regulation T. In this case, the investor's broker must freeze the cash account for 90 days, requiring the investor to fund securities purchases with cash on the date of the trade.