Regulation T: Definition, Purpose & Example

Instructor: LeRoy Rands

Bill has taught college undergraduate and MBA classes in finance, economics & management, 40 years of finance experience and has a MBA degree.

One of the options for an investor buying securities through a broker-dealer is to set up a margin account and borrow money to pay for part of the securities. Margin accounts or using broker-dealer credit for purchases is regulated by Regulation T.

Definition of Regulation T

Can an investor purchase securities if he doesn't have all the cash needed? Where does he get credit?

There are two types of accounts set up by broker-dealers for investors who want to purchase securities. They are:

  • cash accounts, where the investor/customer pays in cash for the full transactions
  • margin accounts, where the investor can borrow part of the funds needed from the broker-dealer

The Board of Governors of the Federal Reserve established Regulation T to regulate credit transactions between investors and brokers and dealers. The regulation prevents investors from getting too exposed to losses by being overly in debt and prevents brokers and dealers from taking advantage of eager investors.

Margin Accounts

A margin account is an investment account set up for an investor who needs to use credit extended by the broker-dealer in order to finance the purchase of securities. It is a separate account from a cash account, because a cash account requires the investor to provide all the cash to complete a securities purchase.

However, Regulation T sets limits on how much an investor can borrow from the dealer-broker. Under Regulation T, the investor can borrow the lesser of $500 or 50% of the equity amount.

James is looking to buy 100 shares of XYZ common shares at $10 a share. He sets up a margin account at Prudent Financial. He puts $500 into the account and borrows the other $500 for the purchase of the XYZ shares from Prudent under the margin agreement.

The transaction by James fits within Regulation T because the amount borrowed from Prudent is $500 or less and is 50% or less of the total value of the securities held in the account. The Federal Reserve Regulation T is specific on the limits that can be borrowed because of the risk to the investor if the value of the securities change.

Margin Calls

The securities held in a margin account can change in value as the market price of the securities change due to the trading activity in the stock. The securities could increase or decrease in value. If the price of a security decreases, the amount of money borrowed in the margin account could increase above 50% of the value of securities. This could result in a margin call. A margin call is a notice to the investor to make up the deficiency in the account before the next payment cycle.

James now owns 100 shares of XYZ stock that he purchased at $10 a share. Two weeks after the transaction, the price of the stock falls to $9 on the New York Stock Exchange. Prudent Financial notifies James that he is now deficient in his margin account by the amount of $50.

  • $9 × 100 shares = $900
  • $900 × 50% = $450 the new maximum credit
  • $500 owed - $450 = $50 deficiency

James is given notice of how much time he has to deposit $50 into his margin account in order to be in compliance.

The risk to an investor in a margin account is that any change in the value of the investment directly impacts the equity or cash value of the account. In James' situation, a 10% drop in the price of the stock resulted in a 20% drop in James' equity in the stock.

Margin Deficiency

The investor only has a limited amount of time to deposit the funds into a margin account to make up a margin deficiency. The broker-dealer, however, has a couple of options. He can give the investor more time to make up the deficiency, which probably depends on the customer/broker relationship and how long they have been doing business.

The other option is that the broker-dealer can liquidate and close the margin account. The broker-dealer would sell the securities in the account, recover the funds loaned to the investor and pay the remainder to the investor less any costs associated with liquidating the account.

Special Maintenance Accounts

One of the other accounts allowed under Regulation T is called a special maintenance account. The special maintenance account for an investor is associated with a cash or margin account to make transfers of:

  • dividend and/or interest payments on the securities in the cash or margin account
  • transfer of cash to meet a margin call
  • cash not required in the margin or cash account
  • proceeds from the sale of a security

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