Regulation T

Regulation T refers to a series of rules put forth by the Federal Reserve Board for investors who borrow money on margin to invest. Buying on margin lets investors and traders invest with borrowed money, but such transactions involve high risk. Regulation T limits that risk.

The utility of regulation T restricts how and under which conditions an investor can trade through cash accounts or when an investor trades on margin using funds borrowed from a broker and shares collateral. It allows margin investors to borrow only up to 50% of the shares' price on a margin purchase.

• Regulation T is a set of rules that deals with loans borrowed from a brokerage to buy securities.
• Any investor seeking a loan from their broker must have a margin account and shall only receive 50% of the entire purchase price, while the rest is paid in cash by them.
• The broker charges an interest rate on the amount they lend to the investor.
• Although there are many provisions in regulation T that allow investors with time and easement, it has its risk related to leverage and margin.

Regulation T is a set of rules that governs margin accounts and regulates the amount of funds that a broker and an investor can extend while borrowing money to purchase securities. It was established to mitigate and reduce credit risks and balance the potential loss that an investor may make while trading on securities they bought on borrowed funds.

Regulation T Federal Reserve requires an investor to open a margin account to borrow funds from their broker or firm to buy securities. Still, certain limits and restrictions are introduced to ensure the investor is in check and does not commit violations or bring heavy losses. With a margin account, the investor can borrow 50% of the entire share purchase price, and they have to pay the rest in cash. A margin regulation T call is issued when the investor does not meet the 50% cash after making a transaction in a margin account.

There is also the threat of receiving a potential regulation T call in scenarios where there is a delay in payment as the broker charges interest on the fund that they have lent to the investor. Although many investors use margin accounts, they are not risk-free, and many associated charges and risks come with them. There is always a leverage and margin call risk, and if not catered properly, the interest can become a debt, ultimately causing a violation and freezing of accounts.

Suppose Markus, who has always been an investor, is seeking a loan from his brokerage firm. He has been pursuing a company whose shares are trading for $99 per share. Markus wants to buy 100 shares of the company. Therefore, the total purchase amount equals $9900.

Now, Regulation T states that if Markus wants to borrow money from his broker, there are certain limitations: he can only borrow up to 50% of the entire purchase and shall pay the remaining amount in cash.

Hence, he receives $4950 from his brokerage firm and another $4950 Markus pays through cash. It is a simple regulation T example; this way, the entire risk of borrowing money is reduced, but Markus first needs to apply for a margin account that allows him borrowing privileges, and at the same time, he has to pay interest on the borrowed funds at a well-agreed rate between the broker-dealer arrangement.

As per regulation T settlement and paying back rules, it adamantly restricts the freeriding tactic, which, in simple words, means that an investor executes the purchase, makes a promise to transfer the required funds for the buying execution, but then sells the securities and makes profit with no money offered to the broker. There is a 90-day restriction to prevent this, through which the investor's margin account gets frozen for 90 days. With a frozen account, the investor can continue buying shares until sufficient funds are available to cover the total purchase price. It is a part of freeriding violations.

On the contrary, in a scenario where an investor purchases securities with no cash available in the margin account and a day later sells the shares of a different holding to pay from the purchase price they bought yesterday, it is a cash liquidation violation. If an investor repeatedly does so three times in 12 months, again, their account will be frozen for 90 days, and they will only be able to execute any trade for which they have total funds available.

Here is a comparison between the two:

• In regulation T, a maintenance margin equals 50% of marginal securities. In contrast, portfolio margins do not differ between initial and maintenance margins.
• Regulation T deals with risk mitigation and aversion. On the other hand, portfolio margin takes a risk-based approach.
• The Financial Industry Regulatory Authority (FINRA) manages the regulation of T margin requirements and extension guidelines. On the contrary, portfolio margin follows the Theoretical Intermarket Margining System (TIMS) margin methodology.

This has been a guide to what is Regulation T. Here, we explain its example, differences with portfolio margin, and 90-day restriction. You can learn more about it from the following articles –

• Price Cap Regulation
• Regulation A
• Regulation D