Chapter 3 - Margin Flashcards
How does the Securities Exchange Act of 1934 relate to margin?
The SEA granted the power to regulate credit in the purchase of securities to the Federal Reserve Board (FRB/Fed). The SEC is charged with the responsibility of enforcing the rules that the FRB establishes.
Which FRB rules govern the extension or use of credit for securities transactions?
Reg T = governs the extension of credit by BDs
Reg U = governs the extension of credit by lenders other than BDs (when securities are used as collateral)*
Reg X = governs those who borrow to buy securities
- Regulation U applies to partners of a member firm as well as customers. Limits that apply to Reg U don’t apply to transactions by BDs that act as market makers or underwriters, therefore these dealers are only limited by their own credit quality.
Regulation T
Governs the extension of credit by BDs. Determines which securities can be purchased on credit (margin), when payment must be made, and the amount of credit that can be extended. Also establishes the minimum amount of margin that a customer must deposit when establishing a position.
Marginable securities
Securities which can be used as collateral for a margin loan. Loan values are set by the Fed.
Exchange-listed
Nasdaq
LEAPS (long-term equity anticipation securities) - options with maturities exceeding 9 months
IPO shares*
Open-end investment company shares (mutual fund)*
Unit investment trusts*
US Treasury and Municipal securities (loan values set by FINRA rather than the Fed)
Standard options are not marginable
OTC equities are not marginable
*These are also subject to SEA, which prevents extension of credit on new issues for 30 days. So, the shares must be held for 30 days before they can be used as collateral.
Payment deadlines (margin - amount of required payment, timing, consequences of non-payment)
Reg T requires payment for purchases in cash or margin be made promptly. Unlike for cash accounts (full purchase price due), for margin accounts a specified percentage of the purchase price is due.
If the required amount isn’t paid by the Reg T payment date (two business days following settlement date), the BD is required to cancel the transaction by selling out the securities and freezing the margin account for 90 days (i.e. customer pays cash in advance for 90 days). After 90 days, customer can be extended credit again. This prevents freeriding.
Freeriding
Practice of purchasing securities without paying for them in the hope of being able to profit without any outlay of funds
Prohibited under FRB rules
A firm also may not allow a customer to make a purchase and then meet the payment through a liquidation (i.e. purchasing Z stock and immediately selling Z stock to make payment). A customer may immediately sell a security, but they must not immediately withdraw proceeds and must still make payment.
Bottom line - customer must still make payment even if they sell the security
Extensions on payment are available, such as in the event of mail delay
Practically, BDs don’t let customers trade without funds in their account, eliminating the possibility of freeriding or need for extensions
COD transactions
COD = cash on delivery
Also called DVP transactions (delivery vs payment)
For a bona fide COD transaction (securities are delivered to customer’s custodian bank and are paid on delivery), the broker has 35 days to deliver and receive payment
If the broker is unable to meet 35 days, must apply for an extension with FINRA
Margin department
Responsible for compliance with regulations pertaining to credit extension
Also responsible for keeping records of all customer accounts and ensuring payment is made properly
Opening a margin account
When a new account is opened, BD must disclose:
1. Conditions under which interest charges will be imposed
2. Annual interest rate
3. Method of computing interest
4. Whether rates are subject to change without prior notice and condition under which they can be changed
5. Method of determining debit balances on which interest will be charged
Customer is required to sign a margin agreement, with terms and conditions. If T&C are changed, BD must notify at least 30 days prior to changes.
Additionally, a written statement must be sent at least quarterly to those with credit extended.
Margin risk disclosure statement/document
Provided to all retail customers who open a margin account at a BD (prior to opening the account, either paper or electronic, on a separate page from other documents)
Also required to be furnished to the customer annually
Describes the risk to a customer when trading securities on margin
Must disclose:
- Customer could lose more funds than the amount deposited in the margin account
- Firm can force sale of securities or other assets in the account
- Firm can sell the securities or other assets without contacting the customer
- Customer is not entitled to choose which securities or other assets are liquidated or sold to meet a margin call
- Firm can increase its house maintenance margin requirements at any time and is not required to provide advance notice
- Customer is not entitled to an extension of time on a margin call
Additionally, any firm permitting retail customers either to open accounts online or engage in securities transactions online must post the margin disclosure statement on its website (must be separate from new account form).
Hypothecation
Process of agreeing to pledge assets for a loan
With permission, BDs may use their customers’ securities as collateral for bank loans
Bank may not rehypothecate customers’ securities under any circumstances
Amount that may be hypothecated
Rule 15c3-3 permits BDs to use stock with a value of 140% of the customer’s debit balance as collateral for a bank loan. (But still can’t loan more than debit balance)
Note this is calculated on an individual customer basis, not in aggregate
Ex. If a customer has a margin loan of $5k to fund $10k purchase, BD can hypothecate $7k (140%) of customer’s securities to pledge as collateral for bank loan to replace the $5k
What is a margin requirement?
Percentage of marginable securities which must be paid for with the customer’s own cash
Stock loans
May only be done with explicit consent by the customer. Generally this is part of the margin agreement but requires separate signature. Customer is not required to consent.
Fully paid = customer owns (requires separate consent)
What happens to the 140% rule if customer debit balances drop?
BD is required to reduce loan balance to be back at or below customer debit balance (and reduce hypothecated amount accordingly)
Rules for BDs pledging their own stock for bank loans
If the BD then sells that stock to a customer, the BD is required to take the stock out of its account and place the stock in a segregated account within 30 minutes after the opening of banking hours on the business day following the settlement date of the trade
Hypothecation notice to the bank
A BD that intends to hypothecate its customers’ securities at a bank is required to give written notice to the bank that the securities are carried for the account of customers and that the hypothecation doesn’t violate Rule 15c2-1
Cross-liens
Using collateral value of the customers’ securities for a separate loan made to the BD. A BD can have a lien on firm securities to support customer indebtedness, but cannot have a lien on customer securities to support firm indebtedness.
Initial margin
Percentage of purchase price, including commission, that the customer must deposit with the BD (deposit can be cash or fully paid securities)
Currently and since 1974, set at 50% (initial requirement only, i.e. if value of stock drops, Reg T doesn’t require additional deposit though BDs can ask for one. Only exception is maintenance margin call. Account with insufficient equity under Reg T amount is called a restricted account)
Reg T call
Also called a fed call
Demand for initial margin (initial only, no requirements to replenish later)
Only marginable securities (or cash) can be deposited to meet a Reg T call
Loan value
Complement of the margin requirement. i.e. if margin requirement is 60%, loan value is 40%
How to meet initial margin through fully paid securities
Must deposit more fully paid stock than cash to meet the some initial margin requirement.
Calculated as margin call divided by loan value. Ex. if purchasing $10k on 50% margin, margin call ($5k) divided by loan value (50%) = $10k required in fully paid stock deposit.
Excess equity
Equity in a margin account that’s greater than Reg T multiplied by the market value.
Ex. Market value of an account (all stock) is $12k. Debit balance (outstanding margin loan) is $5k. Equity is account is therefore $7k (12-5). Reg T requirement is 50% of stock ($12k) = $6k. Excess equity is $1k (7-6).
Customer is permitted to withdraw excess equity from account. However, since there’s no cash in the account, a “withdrawal” is another loan. If customer “withdraws” $1k, debit balance is now $6k. Excess equity is now $0.
Special memorandum account (SMA)
Accounting notation that refers to amount of cash that may be withdrawn from a margin account. When excess equity is created in an account, there is an SMA notation to indicate amount that can be withdrawn as a loan. SMAs create withdrawal availability but don’t decrease when market value of account decreases.
Restricted margin account (and various rules when an account is restricted)
Equity in account is less than Reg T requirement. However, additional purchases can be made as long as customer deposits the amount required by Reg T on the new purchase (not on total account).
Similarly, additional SMA withdrawals may be taken as long as the resulting account doesn’t violate the minimum maintenance requirement.
A customer may sell stocks from a restricted account and withdraw 50% of amount sold.
Same restriction applies to short accounts. If equity in account drops below 50% of the market value, account is restricted.
Buying power
SMA balance divided by 50% Reg T requirement (i.e. SMA x 2). Means customer can purchase x amount of stock on margin without depositing additional cash.
Minimum maintenance requirement (long accounts)
Who is it established by?
What is the % requirement?
Established by FINRA not FRB.
25% minimum for a long account, i.e. equity must be at least 25% of current market value. If equity drops below, BD must call for additional margin (maintenance call/margin call) to bring equity to 25%.
Shortcut to determine trigger point: Debit balance * 4/3 = Market value at which margin call would kick in
Guarantees involving customers
Account of a customer may be guaranteed by another customer (must be in writing) , i.e. if a customer’s account becomes undermargined, other customer account equity can be used as collateral
Minimum initial equity requirement ($)
$2,000 unless purchase is less than $2,000 (then the requirement is the full purchase price)
Ex. $3,000 initial purchase = $2,000 initial deposit
$1,800 initial purchase = $1,800 initial deposit
Initial deposit requirement only, not maintenance requirement
Credit balance
Represents short sale proceeds plus required cash margin deposit
Initial margin requirement is the same 50%
Ex. Customer who sells short $10k worth of stock will be credited $10k proceeds + required to deposit $5k initial margin = $15k credit balance
Short market value
Current market price of borrowed stock (amount customer owes back to broker)
Calculating equity on short accounts
Credit balance - short market value = equity
Similar to long accounts, formula is always “assets - amount owed = equity”
Minimum maintenance requirement (short accounts)
Generally, 30% of market value of short stock
Shortcut to determine trigger point (assuming 30% requirement): credit balance * 10/13 = Market value at which maintenance would kick in
Exceptions:
1. If stock being sold short is valued <$5/share, requirement is $2.50 per share or 100% of the current market value, whichever is greater
2. If stock being sold short is valued between $5 and $16.66/share, requirement is $5.00 per share
3. If stock being sold short is valued >$16.66/share, requirement is 30% of current market value
Margin requirements for US Gov’t and Municipal securities
FRB hasn’t established any minimums, leaving it up to SROs
FINRA has set the following:
Governments: Depends on time remaining to maturity, ranging from 1% (<1 year) to 6% (20+ years)
Muni bonds: 7% initial and maintenance requirement
Pattern day trader
Customer who day trades 4+ times in a 5-business day period, and number of day trades is >6% of total trades in that period
Gets special rules for margin
If a BD knows or has reason to believe a customer opening an account will engage in pattern day trading, BD can impose special rules immediately
Day trading
Purchase and sale (or vice versa) of the same security on the same day in a margin account, except for long/short positions held overnight and sold/purchased the next day prior to any new purchase/sale of the same security
Special rules for pattern day traders
- Minimum equity requirement - $25,000 (rather than normal $2,000) must be deposited before any day-trading begins
- Margin calls - buying power is limited to 4x the maintenance margin excess, determined as of close the previous day. If day-trader exceeds buying power limit, must meet a day-trading margin call within 5 business days. While this margin call is outstanding, buying power is limited to 2x excess. If call isn’t met by 5th business day, trading is restricted to cash-available for 90 days or until call is met. Funds deposited to meet the call must remain in the account for 2 business days.
- Cross-guarantees prohibited - can’t meet day-trading margin requirements through use of cross-guarantees (either through account of other customer or another account owned by same customer)
Margin on option contracts
Option contracts, while they typically have no loan value, are subject to Reg T margin requirements and exchange maintenance requirements. Since they have no loan value, buyer of an option must deposit the full purchase price, regardless of whether the option is bought in a cash or margin account.
Must be paid for within T+4, then BDs must clear transactions and deposit margin with the OCC the next business day
A BD can require deposit from customers prior to Reg T payment date
OCC
Options Clearing Corporation
Covered call option
underlying stock/security (or escrow receipt) is on deposit with the firm
Escrow receipt
Letter from the bank saying that a stock is on deposit at the bank and will be delivered if the call is exercised
Covered put option
Aggregate exercise price (or bank guarantee letter) is on deposit with the firm
Bank guarantee letter
Letter from the bank saying that the bank holds cash equal to the aggregate exercise price and will pay against delivery on the underlying stock if the put is exercised
Writer
Grantor of an option
Margin requirement for covered call writer
None because covered = writer is long the stock or escrow receipt
Margin requirement for uncovered call writer
If call is ITM or ATM, 20% market price of the underlying stock + premium (amount ITM is irrelevant)
If call is OOTM, greater of:
1. 20% market price of the underlying stock + premium - amount OOTM
2. 10% market price of the underlying stock + premium
Remember these are to calculate total margin requirement. However, typically the premium is not typically taken into account for the “deposit amount” owed by the writer, since that is paid and deposited by the buyer.
Also pay attention to the NUMBER of calls sold x100 for each
In the money (ITM)
Exercise price lower than market price
Option premium
“purchase price” of option (remember to assume x100 for 100 share unit)
Margin requirement for covered put writer
If writer is short the underlying stock, has cash equal to the exercise price, or has a bank guarantee letter - no margin required
Margin requirement for uncovered put writer
ITM/ATM: 20% market price of underlying stock + premium
OOTM: greater of:
1. 20% market price of the underlying stock + premium - amount OOTM
2. 10% aggregate strike price of the underlying stock + premium
Remember these are to calculate total margin requirement. However, typically the premium is not typically taken into account for the “deposit amount” owed by the writer, since that is paid and deposited by the buyer.
Also pay attention to the NUMBER of puts sold x100 for each
Margin requirement for leveraged ETF
Multiply standard 25% on long positions/30% on short positions by the ETF’s portfolio leverage factor.
Ex. if ETF has 2x leverage factor, and client makes $2000 purchase, maintenance requirement is $1000 (25% x 2 x $2000). If client had sold short, it would be $1200 (30% x 2 x $2000)
Reg T extension is granted by ____
FINRA
Rule 15c2-1
Rule 15c2-1 prohibits certain practices as being fraudulent/deceptive:
- Commingling securities carried for the account of a customer with those of another customer without obtaining written consent from both
- Commingling securities of a customer with those of any person who is not a customer of the BD, including securities owned by the BD
- Hypothecating customer securities for a sum that exceeds the total indebtedness of all customers (i.e. if total margin loans are $500k, bank cannot borrow more than $500k using customer securities as collateral)
