Investors looking to get more mileage out of their cash and make a higher ROI might decide to purchase on margin.
By purchasing on margin, you’re essentially taking out a loan from the brokerage firm to make an investment.
Like any financial product, these loans are highly regulated. In this case, the most important legislation to be aware of is Regulation T, which governs the ways in which investors and brokers can and can’t use margin loans to purchase securities.
In this article, we’ll explore all things Regulation T. We’ll explain what it is, outline the key provisions and rules it sets out, and provide real-life examples of how the regulation impacts investors and brokers.
What is Regulation T (Reg T)?
Regulation T (Reg T) is a Federal Reserve Board regulation that governs the purchase of securities on margin.
It sets initial margin requirements, puts restrictions on credit transactions, provides enforcement mechanisms to prevent violations, and defines rules for using cash accounts.
The primary objectives of Reg T are:
- Reducing systemic risk: By limiting the amount of credit extended for securities purchases it helps prevent excessive leverage and potential financial instability.
- Protecting investors: By enforcing margin requirements, Reg T ensures investors do not overextend themselves financially.
- Maintaining fair market practices: It curbs speculative trading that could lead to market manipulation or sudden price crashes.
Key provisions and rules under Regulation T
Regulation T’s primary objective is to establish the framework for margin trading, governing how much credit brokers and dealers can extend to investors.
Beyond that, it also defines margin requirements, sets some rules for cash accounts, and outlines the consequences of violating the regulation.
Here’s what you need to know about Reg T.
Regulation T margin requirements and limitations
Reg T enforces strict margin requirements to limit leverage and prevent excessive risk-taking.
The primary rule set out by Reg T is the initial margin requirement: Investors can borrow up to 50% of the purchase price of a marginable security.
That means that if an investor wants to purchase a security to the value of $10,000, they’ll need to put up at least $5,000 in cash, with a maximum margin loan of $5,000.
There are a couple of other requirements and limitations defined by Regulation T:
- Maintenance Margin: After purchase, investors must maintain at least 25% equity in their account (regulated separately by FINRA and exchanges).
- Prohibition on Uncovered Loans: Investors cannot borrow beyond the set limits, and brokers cannot extend credit for non-marginable securities.
Types of securities covered by Regulation T
Reg T applies to a wide range of securities, but not all investments are eligible for margin trading.
Covered securities include:
- Exchange-listed stocks (e.g., NYSE, NASDAQ)
- Corporate bonds
- Certain mutual funds (only after 30 days of ownership)
- Convertible bonds and stock options (depending on broker policies)
These securities are excluded from Reg T:
- Government securities (e.g., U.S. Treasury bonds)
- Municipal bonds
- Penny stocks and IPO shares (restricted due to volatility)
- Commodities and futures (regulated separately)
Enforcement mechanisms used to prevent violations
Regulation T also sets out specific mechanisms that can help prevent violations and penalties to be applied to traders or brokers that break the rules.
These include:
- Margin Calls: If an investor’s equity falls below the required level, they must deposit additional funds or securities to increase their equity to 25% or above.
- Liquidation of Assets: If a margin call is unmet, the broker can sell securities without notice to cover the trader’s shortfall.
- Freeriding Penalties: If an investor buys and sells securities without paying for them, the brokerage may freeze the account for 90 days.
- Account Restrictions: Violations may lead to a loss of margin privileges or forced liquidation of positions.
Brokers and dealers, in particular, must follow strict Reg T compliance rules when offering margin accounts, including:
- Client Eligibility Verification: Brokers must assess whether an investor qualifies for a margin account.
- Risk Disclosure: Investors must be informed of margin trading risks, including the possibility of losing more than their initial investment.
- Collateral Requirements: Securities held in a margin account act as collateral for loans.
- Monitoring Margin Levels: Brokers must ensure that clients maintain required equity levels.
- Regulatory Reporting: Firms must report margin account activity to the SEC and FINRA.
- Record-Keeping Requirements: Detailed transaction records must be maintained to verify compliance with Reg T.
Failure to comply with the above can result in fines, penalties, or regulatory actions against brokerage firms offering margin accounts.
Special considerations under Reg T
While Regulation T does primarily govern margin trading, it also imposes some rules on cash accounts (those that don’t trade using margin loans) and introduces some additional special considerations that impact both investors and brokers.
Cash accounts and Regulation T
Investors using cash accounts must fully pay for securities by the settlement date (T+4 under Reg T, though industry standards now follow T+2).
Another key restriction in cash accounts is freeriding, which occurs when an investor:
- Buys a security in a cash account.
- Sells it before paying for the purchase.
- Uses the sale proceeds to cover the original purchase.
Since the funds from the sale are not yet settled, this creates an unsecured transaction, violating Reg T. If freeriding occurs, the brokerage firm is required to freeze the investor’s account for 90 days.
Day trading and pattern trader rules
Although Reg T does not specifically define pattern day trading, its framework interacts with FINRA rules that:
- Require $25,000 minimum equity in a margin account for pattern day traders.
- Restrict leverage beyond the standard 50% initial margin if the account falls below the required threshold.
These rules limit excessive risk-taking and prevent overleveraging in speculative trading strategies.
Short selling restrictions
Investors cannot short-sell in a cash account. Short-selling requires a margin account under Reg T.
Mutual funds, IPOs, and restricted securities
These three security types have some additional rules under Reg T:
- Mutual funds cannot be purchased on margin until held for at least 30 days.
- Initial public offerings (IPOs) often have margin restrictions, preventing excessive speculation on newly issued stocks.
- Penny stocks and other high-volatility securities may be ineligible for margin trading, depending on brokerage policies.
Example of Regulation T
Here’s a quick step-by-step example of how Regulation T operates in real-world trading.
- Opening a margin account. An investor applies for a margin account with a brokerage firm. The broker reviews the investor’s financial background, risk tolerance, and trading experience before granting approval.
- Understanding margin requirements. The broker informs the investor of Reg T’s margin requirement and explains that interest will be charged on any borrowed funds.
- Buying securities on margin. The investor decides to purchase 100 shares of XYZ stock at $50 per share, totaling $5,000. They pay $2,500 in cash, and the brokerage provides a 45% margin loan ($2,500).
- Borrowing and interest charges. The brokerage extends credit for the $2,500, and the investor starts accruing interest on the borrowed amount based on the broker’s margin rate.
- Equity maintenance and market fluctuations. If the stock price drops, the investor must maintain enough equity in the account to meet the maintenance margin (typically 25%). If the equity falls below this level, the broker issues a margin call, requiring the investor to deposit additional funds or sell securities.
- Meeting a margin call. Say the stock price drops to $30 per share, meaning the total value of the investment falls to $3,000. The investor’s equity shrinks to $.500 ($3,000 - $2,500 loan). Since this is below the 25% maintenance margin ($750 required), the broker issues a margin call for at least $250. The investor must either deposit $250 in cash or sell some shares to cover the shortfall.
- Closing the position. If the investor decides to sell the shares at $60 per share, the total value becomes $6,000. After repaying the broker’s $2,500 loan, the investor keeps the remaining $3,500 (minus interest and fees).
Calculating margin requirements
The formula for calculating your margin requirements for a given security purchase is simple:
Let’s illustrate with an example.
Say you plan to buy 200 shares at $50 each ($10,000 total).
Initial Margin Requirement = $10,000 × 50% = $5,000
This means you must deposit $5,000 in cash, and the broker can lend the remaining amount. Of course, you could also deposit more cash if you wish to limit your exposure and interest expense.
Real-life scenarios and practical applications
To help you understand how Regulation T is applied in the real world, here are three common examples of its impact in different scenarios:
- Day trader with insufficient funds. A trader attempts to make multiple trades without the required $25,000 in their account. Their broker restricts them from further trading.
- Freeriding penalty. An investor buys shares, sells them the next day, but fails to deposit funds. Their account gets frozen for 90 days.
- Margin call event. A stock price falls, and an investor's equity falls below the maintenance margin. They must deposit more cash or sell assets to meet the margin call.
Staying compliant with Regulation T
As an investor using a margin account, understanding your responsibilities under Reg T is crucial.
While your broker will help you stay compliant, it's also your responsibility to keep abreast of any changes and ensure you stay educated.
