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Regulation T, often shortened to Reg T, refers to Federal Reserve Board rules that dictate how much credit broker-dealers can extend to investors via margin accounts. Reg T also governs certain cash transactions.
Trading on margin is a high-risk strategy that allows qualified investors to borrow funds from their brokerage to place bigger trades.
In margin trading, Regulation T allows investors to borrow up to 50% of a trade, with cash or equity covering the other 50% (a.k.a., initial margin). An investor who fails to meet the initial margin requirements may be subject to a Reg T call, which is one type of margin call.
Understanding Regulation T, and Regulation T calls, is important when trading securities on margin.
Key Points
• Regulation T (Reg T) is a Federal Reserve Board rule that limits the credit brokerages can extend to investors for margin trading; it also covers certain cash transactions.
• Margin trading enables investors to borrow money from their brokerage to take bigger positions, using their account assets as collateral.
• Reg T establishes the initial margin requirement, limiting the amount an investor can borrow to a maximum of 50% of the security’s purchase price.
• The regulation functions as a risk management tool to limit potential losses for investors and ensure they contribute some of their own capital to the trade.
• A Reg T call is issued when an investor fails to meet the 50% initial margin requirement, restricting further trades until the deposit is made or securities are sold off by the brokerage.
What Is Regulation T?
Regulation T is issued by the Federal Reserve Board, pursuant to the 1934 Securities Exchange Act. The purpose of Reg T is to regulate how brokerage firms and broker dealers extend credit to investors in margin trading transactions. Specifically, Regulation T governs initial margin requirements, as well as payment rules that apply to certain types of securities transactions.
What Is Margin Trading?
Margin trading refers to the practice of borrowing money from a brokerage to make investments. This allows the investor to increase their investment without putting up any additional money out of pocket, whether they are investing online or through a traditional brokerage.
For example, when an investor is buying on margin, they may be able to put up $10,000 to purchase 100 shares of stock and borrow another $10,000 on margin from their brokerage to double their investment to $20,000.
Placing bigger bets increases an investor’s potential gains, but can also amplify losses. As such, margin trading is considered a high-risk strategy, and it’s only available to qualified investors.
Regulation T is central to understanding the inner workings of margin accounts. When someone is buying on margin, the assets in their brokerage account serve as collateral for a line of credit from the broker.
Note that the margin funds must be repaid with interest. Interest rates charged on margin accounts vary according to the brokerage and the amount borrowed.
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How Reg T Works
Regulation T works by establishing certain requirements for trading on margin. Specifically, there are three thresholds investors are required to observe when margin buying, one of which is directly determined by Regulation T.
• Minimum margin. Minimum margin represents the amount an investor must deposit with their brokerage before opening a margin account. Under FINRA rules, this amount must be $2,000 or 100% of the purchase price of the margin securities, whichever is less. Keep in mind that this is FINRA’s rule, and that some brokerages may require a higher minimum margin.
• Initial margin. Initial margin represents the amount an investor is allowed to borrow. Regulation T sets the maximum at 50% of the purchase price of margin securities. Again, brokerage firms may require investors to make a larger initial margin deposit.
• Maintenance margin. Maintenance margin represents the minimum amount of margin equity that must be held in the account at all times. If you don’t know what margin equity is, it’s the value of the securities held in your margin account less the amount you owe to the brokerage firm.
FINRA sets the minimum maintenance margin at 25% of the total market value of margin securities though brokerages can establish higher limits.
Reg T and Cash Account Rules
Regulation T’s main function is to limit the amount of credit a brokerage can extend. It’s also used to regulate prohibited activity in cash accounts, which are separate from margin accounts.
For example, an investor cannot use a cash account to buy a stock then sell it before the trade settles under Reg T rules, a violation known as freeriding. It may be beneficial to review the basics of leveraged trading to deepen your understanding, too.
Recommended: What Is Leveraged Trading?
Why Regulation T Exists
Margin trading can be risky, and Regulation T is intended to limit an investor’s potential losses. If an investor were able to borrow an unlimited amount of credit from their brokerage account to trade, they could potentially realize much larger losses over time if their investments fail to pay off.
Regulation T also ensures that investors have some skin in the game, so to speak, by requiring them to use some of their own money to invest. This can be seen as an indirect means of risk management, since an investor who’s using at least some of their own money to trade on margin may be more likely to calculate risk/reward potential and avoid reckless decision-making.
Example of Reg T
Regulation T establishes a 50% baseline for the amount an investor is required to deposit with a brokerage before trading on margin. So, for example, say you want to open a margin account. You make the minimum margin deposit of $2,000, as required by FINRA.
Next, you want to purchase 100 shares of stock valued at $100 each, which result in a total purchase price of $10,000.
Under Regulation T, the most you’d be able to borrow from your brokerage to complete the trade is $5,000. You’d have to deposit another $5,000 of your own money into your brokerage account to meet the initial margin requirement. Or, if your brokerage sets the bar higher at 60% initial margin, you’d need to put up $6,000 in order to borrow the remaining $4,000.
Why You Might Receive a Regulation T Call
Understanding the initial margin requirements is important for avoiding a Regulation T margin call. In general, a margin call happens when you fail to meet your brokerage’s requirements for trading in a margin account. Reg T calls occur when you fall short of the initial margin requirements. This can happen, for instance, if you’re trading options on margin or if you have an ACH deposit transaction that’s later reversed.
Regulation T margin calls are problematic, especially for self-directed investing, because you can’t make any additional trades in your account until you deposit money to meet the 50% initial margin requirement. If you don’t have cash on hand to deposit, then the brokerage can sell off securities in your account until the initial margin requirement is met.
Brokerages don’t always have to ask your permission to do this. They may not have to notify you first that they intend to sell your securities either. So that’s why it’s important to fully understand the Reg T requirements to ensure that your account is always in good standing with regard to initial margin limits.
Recommended: Stock Market Basics
The Takeaway
Regulation T is used to determine initial margin requirements — i.e., the amount of cash or equity an investor must keep available in their account, relative to the amount they’ve borrowed. Margin trading may be profitable for investors, though it’s important to understand the risks involved. Specifically, investors need to know what could trigger a Regulation T margin call, and what that might mean for their portfolios.
An investor who fails to meet the initial margin requirements may be subject to a Reg T call, which is problematic because they are restricted from making additional trades until they deposit the 50% initial margin requirement. If the investor doesn’t have cash on hand to deposit, then the brokerage can sell off securities in the account until the initial margin requirement is met.
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FAQ
What is the purpose of Regulation T?
Reg T governs the basics of buying on margin, as well as prohibiting a cash account violation known as freeriding, among other provisions. Fundamentally, Reg T helps limit investor’s risk exposure.
What is the difference between Reg T and FINRA?
While Regulation T provisions mainly apply to the 50% cash requirement for initial margin, FINRA rules apply to other ongoing aspects of margin trading, such as maintenance margin.
Are all margin calls the same?
No. A Reg T margin call comes into play when an investor doesn’t meet the minimum 50% cash margin requirement for an initial trade. A maintenance margin call occurs when the minimum margin in an investor’s account falls below the required amount. If the investor doesn’t bring up the account balance in a timely manner, the brokerage can sell off other securities in the account to do so.
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