In October 1929, you could buy $10,000 worth of stock with just $1,000 cash. Brokers happily lent the other 90%. When the market crashed, those loans came due. Investors who couldn't meet their margin calls were forced to sell—at any price—which pushed stocks lower, triggering more margin calls, forcing more sales. The cascade turned a market correction into the Great Depression.
That's why the Federal Reserve now sets the rules for borrowing to buy securities. The current answer to "how much can you borrow?" has been the same since 1974: 50%.
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Introduction to Margin Accounts
Customers can open different types of accounts at a broker-dealer. In a cash account, a customer must deposit 100% of the purchase price of a security. A margin account allows a customer to borrow either money or securities from a broker-dealer.
The rules for both cash and margin accounts are governed by the Federal Reserve under Regulation T (Reg T). There are also additional Financial Industry Regulatory Authority (FINRA) requirements for the opening and maintenance of margin accounts.
A customer opens a margin account in order to borrow cash or securities from a broker-dealer. By borrowing, the investor is using leverage. Leverage can provide greater returns but can also result in greater losses. Risks and returns are lower in a cash account, where the customer does not borrow money.
| Account Type | Borrowing | Risk/Return |
|---|---|---|
| Cash Account | No borrowing; pay 100% | Lower risk, lower potential returns |
| Margin Account | Can borrow up to 50% | Higher risk, higher potential returns |
Regulation T: Buying on Margin
Regulation T (Reg T) is a Federal Reserve Board regulation that covers lending from broker-dealers to customers. It sets initial margin requirements (the percentage of the security's purchase price that the customer must pay for with cash) for marginable securities.
Before the Securities Exchange Act of 1934, margin requirements were set by individual exchanges—and they were shockingly low. In the 1920s, investors routinely bought stocks with 10% down. When the crash came, those undercapitalized positions collapsed like dominoes. Congress gave the Federal Reserve authority over margin requirements specifically to prevent another leverage-fueled catastrophe. The Fed experimented with different rates over the decades—it was 100% briefly in 1946—before settling on 50% in 1974, where it's remained ever since.
Under Reg T, a broker-dealer may lend a customer up to 50% of the purchase price of a marginable security.
| Item | Long Position | Short Position |
|---|---|---|
| Stocks and convertibles | 50% | 50% |
A customer buys 200 shares of ABC (a New York Stock Exchange-listed stock) at $50 per share. Under Reg T, the initial margin requirement is 50% of $10,000 = $5,000.
To purchase the stock in a margin account, the customer would be required to provide $5,000 and the broker-dealer would lend the customer the additional $5,000.
Exempt Securities
Exempt securities are not covered under Reg T. The major exempt securities are:
- U.S. government securities
- Agency issues
- Municipal issues
- Commercial paper
The Federal Reserve has no power to set initial margins for these securities. However, these securities are marginable subject to minimum maintenance requirements set by FINRA.
Marginable vs. Non-Marginable Securities
Not all securities can be purchased on margin. Nasdaq and all exchange-listed securities are marginable, as are U.S. government and municipal bonds. Over-the-counter (OTC) securities are allowed only if they are listed on the Federal Reserve marginable securities list.
Newly issued securities cannot be purchased on margin until they have been publicly traded at least 30 days. Because mutual fund shares are always considered new shares, they cannot be purchased on margin. But once mutual fund shares have been held for 30 days, they can be used as collateral for a margin loan.
| Category | Securities |
|---|---|
| Marginable |
|
| Non-marginable |
|
| Margin securities (collateral) |
|
Minimum Deposit Requirement
Margin accounts have a minimum equity requirement of $2,000:
| Purchase Amount | Deposit Required |
|---|---|
| Less than $2,000 | 100% of the purchase price |
| $2,000 - $4,000 | $2,000 |
| Over $4,000 | 50% (Reg T requirement) |
Regulation T: Selling Short on Margin
Short selling is when an investor borrows securities from a broker-dealer, and then sells them. This can only be done in a margin account.
Short selling has been controversial since the Dutch East India Company in the 1600s. During every market panic, someone blames the short sellers. After the 1929 crash, Congress considered banning the practice entirely. Instead, they opted for regulation. The logic for requiring margin on short sales is straightforward: when you short a stock, your potential loss is theoretically unlimited (the stock could rise forever), so the broker needs collateral to protect against that risk.
A customer will use a short-selling strategy when they are bearish and believe that the price of the borrowed securities will fall. Their strategy is to sell the securities at the current high price, then buy the securities back at a cheaper price in the future. After they buy the shares at the hopefully lower price, they return them to the broker-dealer (covering their short position).
In summary:
- Bullish investors hope to buy low and sell high.
- Bearish investors hope to sell high and buy low.
The Reg T initial margin requirement is the same for buyers and short-sellers—50%.
A customer shorts 1,000 shares of XYZ stock. XYZ is currently trading at $10 per share. Reg T requires that the customer deposit 50% of the value of the trade, or $5,000.
Regulation T for Cash Accounts
Regulation T (Reg T) also applies to cash accounts. In a cash account, Reg T requires that the broker-dealer collect payment from the customer promptly, which means no later than two business days after the settlement date.
In a stock trade, regular way settlement is one business day. So, Reg T requires payment by the customer within three business days after the trade (T+3), which is two business days after settlement (S+2: Settlement + 2 business days).
Reg T Extension
If payment is not collected by S+2, under exceptional circumstances, the firm may ask FINRA for a Reg T extension. If granted, this gives the customer another two business days (or longer if a special request is made) to pay.
If the customer does not pay on either "S+2" or the extension date, if one is granted, the firm is obligated to sell out that position and freeze the account for 90 days.
When an account is frozen, the customer can still trade in the account. However, they can no longer borrow and must have 100% of the required cash to pay for the transaction. After 90 days, given that the customer complies, the freeze is removed.
Free-Riding
Free-riding is the prohibited practice of buying securities without intending to pay for them, and then selling them on or before the settlement date to generate the cash needed to pay for the original purchase.
XYZ will be announcing quarterly earnings in two days. A customer believes the news will be positive and decides to buy 1,000 shares of XYZ at $50 per share. The customer does not have the $50,000 to pay for the stock but plans to sell the stock when the price rises.
The customer is trying to take a "free ride" by using the broker-dealer to buy the stock for them. Relying on money from the sale of stock to pay for the purchase of the same stock is a violation. The customer's account will be frozen for 90 days.
Restricted Margin Accounts and Minimum Maintenance
A restricted margin account is where the equity in the customer's account has fallen below 50%. This happens when the value of the securities declines after purchase.
Calculating Equity
Equity Value = Market Value of Security − Amount Owed Broker
Equity Percentage = Equity Value ÷ Market Value of the Security
A customer buys $80,000 worth of stock in a margin account and deposits the required $40,000 initial margin requirement and borrows $40,000 from the broker-dealer. The next day, the stock's value declines to $60,000. How much equity does the customer now have?
The market value is $60,000. The customer owes the broker-dealer $40,000.
$60,000 − $40,000 = $20,000 of equity
Equity percentage: $20,000 ÷ $60,000 = 33.33%
Since the equity percentage has fallen below 50%, the account is now restricted. But this restriction has little impact on the customer. They are not required to deposit any more money, the account is not frozen, and they can still buy more stock by depositing only 50% of the purchase price.
Minimum Maintenance Requirements
However, there are limits to how far the equity percentage can fall. These limits are the minimum maintenance requirements set by FINRA.
| Position Type | Long Position | Short Position |
|---|---|---|
| Stocks and convertibles | 25% | 30% |
A customer has 200 shares of ABC stock at $50 in a long account. The minimum maintenance margin requirement is 25% of $10,000 = $2,500. The customer will be called for additional margin if the equity in the account drops below $2,500.
A customer has sold 200 shares of ABC stock at $50 in a short account. The minimum maintenance margin requirement is 30% of $10,000 = $3,000. The customer will be called for additional margin if the equity in the account drops below $3,000.
Broker-dealers can, and usually do, establish more stringent (meaning higher) maintenance margin requirements than the 25% set by FINRA.
Test-Taking Tip: For the purpose of the test, you will not be required to do any elaborate margin calculations. You will need to understand the basic requirements:
| Requirement | Long Stock | Short Stock |
|---|---|---|
| Regulation T initial margin | 50% | 50% |
| FINRA minimum maintenance | 25% | 30% |
Special Memorandum Account (SMA)
When a security that has been bought on margin increases in value, the equity in the account also increases. When the equity in a margin account rises over 50% of the market value, the amount over 50% is referred to as excess equity. Excess equity is put into a special memorandum account (SMA).
Excess equity creates buying power of 2 × SMA (since the initial margin requirement is 50%). This means the customer could use their $5,000 of excess equity to buy $10,000 of stock (meeting the 50% margin requirement). In addition, the SMA amount could be withdrawn from the account in cash. But note that this withdrawal would be considered a loan and added to the amount that the customer owes the broker-dealer.
Opening a Margin Account
To open a "cash" account, only the new account form is required. In a cash account, the customer agrees that they will pay in full for all purchases. To open a margin account, additional documentation is required.
The Margin Agreement
Prior to opening a margin account, the customer must sign a margin agreement. The margin agreement sets the terms and conditions between the customer and broker-dealer.
The agreement has three parts:
| Component | Purpose | Required? |
|---|---|---|
| Hypothecation Agreement | Customer pledges (hypothecates) securities to the brokerage firm as collateral. Firm holds securities in street name. Allows broker-dealer to sell securities if account falls below minimum maintenance. | Yes |
| Credit Agreement | Sets terms and conditions of the loan. States that interest will be based on the broker loan rate (e.g., call loan rate + 2%). | Yes |
| Loan Consent Agreement | Allows broker-dealers to lend out a customer's margined securities to other customers for short-selling purposes. | No (but typically included) |
The firm also has the right to repledge (rehypothecate) the securities to a bank to raise funds. The Federal Reserve controls lending by banks to broker-dealers under Regulation U (Reg U). Funds are borrowed from the bank by the brokerage firm at the broker's call (or call loan rate).
Test-Taking Tip: Borrowing between banks and brokers is covered under Reg U. Borrowing between brokers and their customers is covered under Reg T.
Disclosure Requirements
Alongside the margin agreement, noninstitutional customers opening a margin account must be given a credit disclosure statement as well as a margin risk disclosure statement explaining the risks of margin trading. This disclosure must be redelivered to margin customers annually.
Unlike opening a standard cash account (where a signature is NOT required), the margin agreement must be signed by the customer at or prior to settlement of the first trade in the account.
Summary & Key Points
Margin accounts allow customers to leverage their investments by borrowing from broker-dealers. While this can amplify returns, it also amplifies losses—and creates obligations that can force sales at the worst possible times.
The regulatory framework—Reg T for initial requirements, FINRA rules for maintenance—exists because of hard lessons learned in 1929 and since. Every percentage requirement you memorize for the exam represents a guardrail against the kind of cascading failures that can turn individual losses into systemic crises.
Margin Requirements
- Cash account: Customer pays 100% of purchase price
- Margin account: Customer can borrow up to 50% under Reg T
- Initial margin (Reg T): 50% for both long and short positions
- Minimum maintenance (FINRA): 25% long, 30% short
- Minimum deposit: $2,000 for margin accounts
Cash Account Rules
- Reg T payment deadline: S+2 (settlement + 2 business days)
- Frozen account: 90 days, must pay 100% cash for trades
- Free-riding: Buying without intent to pay, using sale proceeds to cover purchase
Margin Account Setup
- Margin agreement: Hypothecation (required), credit (required), loan consent (optional)
- Customer signature: Required for margin accounts (unlike cash accounts)
- Reg T: Broker-to-customer lending
- Reg U: Bank-to-broker lending
Key Terms
- Regulation T: Federal Reserve rule governing broker-dealer lending to customers
- Initial Margin: Percentage customer must deposit to purchase securities (50% for stocks)
- Maintenance Margin: Minimum equity required to maintain a position (25% long, 30% short)
- Street Name: Securities registered in the broker-dealer's name, not the customer's
- Hypothecation: Pledging securities as collateral for a margin loan
- Rehypothecation: Broker repledging customer securities to a bank
- Short Selling: Selling borrowed securities, hoping to buy back at lower price
- Covering: Buying securities to return borrowed shares and close short position
- SMA: Special Memorandum Account holding excess equity
- Call Loan Rate: Rate banks charge broker-dealers for margin funding