Regulation T

Regulation T is the Federal Reserve Board rule that covers the credit broker-dealers may extend to customers who are purchasing securities. Currently for margin accounts both long and short, Regulation T (Reg T) requires customers to deposit at least 50 percent of the current market value of the securities purchased on margin, and the balance is borrowed from the broker-dealer.

Regulation T is currently set at 50 percent; however, firms not willing to take as much risk may increase the house margin requirement to 55 percent, 60 percent, 65 percent, and so on. When you’re taking the Series 7 exam, you should assume 50 percent unless the question states a different percentage.

Regulation T applies not only to margin accounts but also to cash accounts (see Chapter 16). When customers are purchasing securities in cash accounts, they have a certain number of business days to pay for the trade (one, three, or five). This delay is an extension of credit; therefore, it falls under Regulation T.

Reg T also identifies which securities can be purchased on margin and which ones can’t. Securities that may be purchased on margin include

• Exchange-listed securities
• Most NASDAQ stocks
• Non-NASDAQ over-the-counter (OTC) securities approved by the Federal Reserve Board

Securities that cannot be purchased on margin and cannot be used as collateral include

• Most option positions
• Rights
• Non-NASDAQ over-the-counter (OTC) securities not approved by the Federal Reserve Board

Securities that cannot be purchased on margin but can be used as collateral after being held for 30 days include

• Mutual funds
• Certain new issues

New securities cannot be purchased on margin for at least 30 days. Since mutual funds are always new issues, they cannot be purchased on margin. However, after holding them for 30 days or more, they can be placed in a margin account and used as collateral.

Note: Treasury securities and municipal bonds are exempt from Regulation T. However, they may be purchased on margin. The margin and maintenance requirement on treasury securities typically ranges somewhere between 1 percent and 6 percent of the market value depending on the number of years until maturity. Municipal bonds can be purchased on margin and the margin and maintenance requirements are set by the brokerage firms based on the risk.

Margin call

A margin call (also known as a Fed call, federal call, or Reg T call) is the broker-dealer’s demand for a customer to deposit money in a margin account when purchasing or shorting (selling short) securities. When customers initiate a margin transaction, they'll receive a margin call for the Regulation T amount (usually 50 percent of the purchase or short sale). This amount must be paid by the customer within 4 business days. However, if the amount owed is $1,000 or less, the brokerage firm may choose to just add it to the debit balance. If a customer is buying securities on margin, the customer may deposit fully paid marginable securities in lieu of cash to meet the margin call.

For both long and short margin accounts, the margin call is the dollar amount of securities purchased (or shorted) multiplied by Regulation T (50 percent). So, for example, if an investor purchases $50,000 worth of securities on margin, the margin call would be $25,000. Here’s how you figure that:

Starting long accounts

To open a long margin account, the customer is required to deposit Regulation T or $2,000, whichever is greater. The exception to this rule occurs when a customer is purchasing less than $2,000 worth of securities on margin. In this case, the customer pays for the transaction in full. It certainly wouldn’t make sense for a customer to purchase $1,000 of securities on margin and pay $2,000 when he could pay $1,000 if it were purchased in a cash account. Even if the customer pays in full, the account is still considered a margin account because the customer can make future purchases on margin as soon as he has over $2,000 in equity.

Table 9-1 shows you how Regulation T and the FINRA/NYSE requirements affect how much customers have to deposit when opening long margin accounts.

In short, here’s how much an investor has to deposit:

Opening short accounts

The minimum deposit for short accounts is fairly easy to remember. The $2,000 minimum required by FINRA and the NYSE applies to short margin accounts. Because of the additional risk investors take when selling short securities, the $2,000 minimum always applies, even if the customer is selling short only $300 worth of securities. In this case, the customer must deposit 50 percent of the current market value of the securities or $2,000, whichever is greater. Here’s the breakdown:

Long market value …

The long market value (LMV) is the current market value of the securities purchased in a margin account. The LMV does not remain fixed; it changes as the market value of the securities changes. Certainly, if an investor is long (owns) the securities, he wants the LMV to increase.

When a customer purchases securities on margin, the margin call (the amount the customer has to come up with) is based on the LMV of the securities. With Regulation T set at 50 percent, an investor has to deposit 50 percent of the value of the securities purchased on margin.

… Minus debit balance …

DR is the debit balance (also called the debit record or debit register); it’s the amount of money that a customer owes a brokerage firm after purchasing securities on margin. The debit balance remains the same unless the customer pays back a portion of the amount borrowed by either selling securities in the account or by adding money to the account through dividends or payments.

Note: Although you aren’t as likely to see a question about it on the Series 7 exam, the debit balance may be increased by interest charges imposed by the broker-dealer.

So, for example, if an investor purchases $20,000 worth of securities on margin, the debit balance would be $10,000. First you have to determine the margin call:

Then use the margin call and the following formula to determine the debit balance:

… Equals equity

The equity (EQ) is the investor’s portion of the account. When an investor initially opens a margin account, the equity is equal to the margin call. However, the equity changes as the market value of the securities in the account increases or decreases. When an investor has more equity than the Regulation T requirement, he has excess equity; if an investor has less equity than the Regulation T requirement, his account is restricted (see the later section “Checking out restricted accounts”).

Note: When an investor has excess equity, he develops a line of credit known as a special memorandum account (SMA) (see “Let the Good Times Roll: Handling Excess Equity,” later in the chapter). Remember that the SMA is built into the equity, not an addition to it. When a customer uses or removes the SMA, the equity decreases and the debit balance increases.

Putting it all together

The following question tests your ability to determine the debit balance in a long margin account.

Mr. Downey buys 1,000 shares of DEF common stock at $40 in a margin account. After Mr. Downey meets the margin call, what is the debit balance?

(A) $16,000

(B) $20,000

(C) $24,000

(D) $30,000

The correct answer is Choice (B). I know what you’re thinking: “This is too easy.” If the Series 7 gods are smiling down on you, you may actually get a question this straightforward. However, even if you don’t, you still need a starting point, and this is a good one. First, set up the equation:

Mr. Downey purchased $40,000 worth of stock (1,000 shares × $40 per share), so you need to enter $40,000 under the LMV (long market value). Next, figure out how much he needs to pay. Multiply the $40,000 × 50 percent (Regulation T), and you know that Mr. Downey has to come up with $20,000, which goes under the EQ (the investor’s portion of the account). If the LMV is $40,000 and the EQ is $20,000, the DR (debit balance) has to be $20,000:

Short market value …

The short market value (SMV) is the current market value of the securities sold short in a margin account. Just as the LMV in a long account varies (see the earlier “Long market value …” section), so does the SMV. The SMV changes as the market value of the securities changes. If an investor is short the securities (selling borrowed securities), he wants the SMV to decrease so the investor can repurchase the securities at a lower price.

When a customer sells short securities on margin, the margin call (the amount the customer has to come up with) is based on the SMV of the securities. With Regulation T set at 50 percent, an investor has to deposit 50 percent of the value of the securities purchased on margin.

… Plus equity …

The equity (EQ) is the investor’s part of the account. When an investor initially opens a short margin account, the equity is equal to $2,000 or Reg T (50 percent of the market value of the security), whichever is greater.

In a short margin account, the equity increases when the SMV of the securities decreases; when the SMV of the securities increases, the equity decreases.

When an investor has more equity than the Regulation T requirement, he has excess equity and develops an SMA (see the upcoming section titled “Let the Good Times Roll: Handling Excess Equity”); if an investor has less equity than the Reg T requirement, the account is restricted (see “Checking out restricted accounts,” later in this chapter).

… Equals the credit balance

There’s no debit balance (DR) in a short margin account because investors aren’t borrowing money; they’re borrowing securities. Instead, short margin accounts have a credit balance (also called a credit record, credit register, or CR for short). The credit balance is initially made up of the amount of money the investor received for selling the stock short (the short market value) and the amount that the investor had to deposit into the margin account to pay for the trade (the equity). The credit balance remains fixed unless the investor removes excess equity, more securities are shorted, or the investor covers some of his short positions.

For example, say that in an initial transaction in a margin account, an investor sells short $50,000 worth of securities with Reg T at 50 percent. First you determine the margin call:

Then you use the margin call and the following formula to determine the credit balance:

Putting the equation together

The following question tests your ability to determine the credit balance in a short margin account.

In an existing short margin account, Melissa Rice sold short 1,000 shares of HIJ common stock at $30. Prior to this transaction, the short market value of securities in the account was $52,000 and the equity was $25,000. What is Melissa’s credit balance after the transaction?

(A) $15,000

(B) $45,000

(C) $77,000

(D) $122,000

The answer you want is Choice (D). This question is a little more difficult because the transaction happened in an existing margin account. Prior to this transaction, Melissa had a short market value (SMV) of $52,000 and an equity of $25,000, which means that the CR was $77,000:

Because you know the existing CR, you only need to determine what happened to it as a result of the new transaction. Melissa shorted another $30,000 worth of stock (1,000 shares × $30 per share), so you need to enter $30,000 under the SMV (short market value). Next, figure out how much she needs to pay. Multiply the $30,000 × 50 percent (Regulation T), and you know that Melissa has to come up with $15,000, which goes under the EQ (the investor’s portion of the account). If the SMV increases by $30,000 and the EQ increases by $15,000, the CR (credit balance) has to increase by $45,000:

Because the initial credit balance was $77,000 and it increased by $45,000, the credit balance after the transaction is $122,000.

Not all margin customers have only a short margin account or only a long margin account. If you are one of the unlucky ones who gets a question asking for the combined equity of a customer's long and short margin accounts, you can either work out the equations separately, as if they're two different accounts and add the equity together, or use the following equation:

SMAs for long margin accounts

When an investor purchases on margin, that customer has a leveraged position, so he has an interest in a larger amount of securities than he would’ve had if he had paid in full. When a customer has a long margin account, excess equity is created when the value of the securities in the account increases and the equity in the account increases above the margin requirement.

The following question tests your ability to answer a question on excess equity.

Mrs. Glorious purchased 1,000 shares of DUD Corp. on margin at $50 per share. If DUD is currently trading at $70 per share, what is Mrs. Glorious’s excess equity?

(A) $5,000

(B) $7,500

(C) $10,000

(D) $20,000

The answer you’re looking for is Choice (C). This question throws you a little curveball because you have to set up a new equation when the market price changes. You first need to find the debit balance. Mrs. Glorious purchased $50,000 worth of securities (1,000 shares × $50 per share), so enter $50,000 under the LMV (long market value). Then Mrs. Glorious had to deposit the Regulation T amount (50 percent) of the purchase, so enter $25,000 (50% × $50,000) under the EQ (the investor’s portion of the account). This means she borrowed $25,000 (the DR) from the broker-dealer:

Now the curveball: The LMV changes to $70,000 ($70 × 1,000 shares). Because the DR (the amount borrowed from the broker-dealer) doesn’t change, you bring the $25,000 to your new equation. You find that the EQ has increased to $45,000:

Now multiply the LMV by Regulation T to get the margin requirement, the amount that Mrs. Glorious should have in EQ to be at 50 percent. Take the $35,000 ($70,000 × 50%) and compare it to the EQ. Because Mrs. Glorious has $45,000 in equity, she has $10,000 in excess equity ($10,000 more than she needs):

The R in DR should help you remember that the debit balance remains the same as the market price changes.

Some of the margin questions on the Series 7 exam will be related to what happens to SMA during certain events. Remember that when the SMA increases, so does the buying power. Table 9-2 makes it a little easier to see.

If an investor intends to use or withdraw her SMA, it can only be used to the extent that it won't drop the account below minimum maintenance. (See “Keeping up with minimum maintenance” later in the chapter.)

Loan value

Loan value is the compliment of Regulation T. So, with regulation T set at 50 percent, the loan value is also 50 percent (100% – 50% Regulation T = 50% loan value). Basically, this represents the maximum amount the brokerage firm will lend to a customer based on securities purchased in a margin account. As the value increases (or decreases in a short account), the loan value would increase.

Let's say the customer initially purchased $20,000 of securities on margin; the loan value would be $10,000 (50 percent of $20,000). If the value of the securities increased to $26,000, the loan value would increase to $13,000 (50 percent of $26,000).

Note: As stated earlier in this chapter, you can deposit fully paid marginable securities to meet a margin call. So if you have a margin call of $5,000, you have to deposit fully paid marginable securities with a loan value of $5,000 to meet the margin call. With Regulation T set at 50 percent, the customer would have to deposit $10,000 of fully paid marginable securities to meet the margin call. Because Regulation T is set at 50 percent, 50 percent of the $10,000 in securities would be used to meet the margin call.

SMAs for short margin accounts

Unlike in a long account, an investor with a short margin account earns excess equity when the price of the securities in the margin account decreases. An SMA is a credit line that investors can withdraw as cash or use to help purchase or sell short more securities on margin.

Excess equity is the amount of equity that a customer has in a margin account that’s above the Regulation T requirement.

The following question tests your knowledge on determining excess equity for a short account.

Mrs. Rice sold short 1,000 shares of HIJ Corp. on margin at $60 per share. If HIJ is currently trading at $50 per share, what is Mrs. Rice’s excess equity?

(A) $5,000

(B) $7,500

(C) $10,000

(D) $15,000

The correct answer is Choice (D). This question has a twist because you have to use a new equation when the market price changes. Start by setting up the equation to find the credit balance. Mrs. Rice sold short $60,000 worth of securities (1,000 shares × $60 per share), so enter $60,000 under the SMV (short market value). Then Mrs. Rice had to deposit the Regulation T amount (50 percent) of the purchase, so enter $30,000 (50% × $60,000) under the EQ (the investor’s portion of the account). The credit balance (CR) is $90,000:

Next, the SMV changes to $50,000 ($50 × 1,000 shares), so you need to calculate the investor’s current equity. Put that value under the SMV. In a short account, the CR remains the same as the market price changes, so you need to bring the $90,000 straight down from the previous equation. This means that the EQ has increased to $40,000 (the difference between $50,000 and $90,000):

Now multiply the SMV by Regulation T to get the amount that Mrs. Rice should have in equity to be at 50 percent. Compare the margin requirement of $25,000 ($50,000 × 50%) to the current equity. Because Mrs. Rice has $40,000 in equity, she has $15,000 in excess equity ($15,000 more than she needs):

The R in CR should help you remember that the credit balance remains the same as the market price changes.

Playing it SMA/RT: Using buying and shorting power for good

Buying power (for long accounts) and shorting power (for short accounts) are the dollar amounts of securities a customer can purchase on margin using his excess equity (SMA). You calculate both by dividing the SMA by Reg T:

To help you calculate the buying or shorting power in a margin account, remember the phrase People who are SMA/RT use their buying (or shorting) power. This phrase can help you remember that to determine the buying or shorting power, you need to divide the SMA by Regulation T. As long as Regulation T is at 50 percent, you probably don’t need this tip because the power will always be double the SMA (for example, $1,000 SMA can purchase $2,000 worth of securities on margin). However, if Regulation T (or house requirements) is anything other than 50 percent, this formula becomes very important.

Try your hand at the following question.

Mr. Smith has a long margin account with a market value of $20,000, a debit balance of $5,000, an equity of $15,000, and an SMA of $3,000. If Regulation T is set at 60 percent, what is the buying power?

(A) $3,000

(B) $5,000

(C) $6,000

(D) No buying power

The right answer is Choice (B). Because the question is nice enough to supply you with the SMA, you don’t have to figure it on your own. The buying power of a margin account is how much in securities an investor can buy (or sell short) without depositing additional funds. All you need to do is divide the SMA by Regulation T:

Buying power for pattern day trading accounts

With pattern day trading accounts, the minimum maintenance is 25 percent, just like regular customers. However, the buying power is treated a little differently. For pattern day traders, the buying power is four times the maintenance margin excess (equity in the account above the 25 percent minimum requirement). For regular margin accounts, the buying power is two times the SMA.

Note: Pattern day traders are prohibited from using cross guarantees and must meet the margin or maintenance requirements of the account independently. In other words, another investor's account (even with a written agreement) or even another account owned by the pattern day trader cannot be used to meet margin requirements.

Checking out restricted accounts

In the previous sections, everything is coming up roses; but what if the market price of the securities held in a long margin account decreases instead of increases? What if the securities in a short margin account show wild success? If this happens, the account becomes restricted. Restricted accounts show up when the equity in the account is below the margin requirement. However, a restricted account doesn’t mean that investors can’t buy (or short) securities in the margin account; investors may still do so by coming up with the margin requirement of the new purchase.

Restricted long margin accounts

A restricted account is calculated the same way as the excess equity (see the earlier section “Let the Good Times Roll: Handling Excess Equity”), only the investor has less than 50 percent of the long market value (LMV) in equity instead of more than 50 percent. Check out the following example.

Macy Bullhorn purchased 500 shares of LMN common stock on margin when LMN was trading at $30 per share. If LMN is currently trading at $25 per share, by how much is Macy’s margin account restricted?

(A) $1,250

(B) $2,500

(C) $5,000

(D) $6,250

The correct answer is Choice (A). You may notice the similarities between figuring out excess equity and determining whether an account is restricted. If an account is restricted, the account contains less equity than needed to be at 50 percent of the LMV. First, figure out Macy’s debit balance. Macy purchased $15,000 worth of securities (500 shares × $30 per share), so enter $15,000 under the LMV (long market value). Then Macy had to deposit the Reg T amount (50 percent) of the purchase, so enter $7,500 (50% × $15,000) under the EQ (the investor’s portion of the account). She borrowed $7,500 (the DR) from the broker-dealer:

Next, find the investor’s current equity. The LMV changes to $12,500 ($25 × 500 shares), so enter that under the LMV. Because the DR (the amount borrowed from the broker-dealer) doesn’t change, bring the $7,500 straight down from the preceding equation. You find that the EQ has decreased to $5,000 ($12,500 – $7,500):

Now multiply the LMV by Reg T to get the margin requirement, the amount Macy should have in equity to be at 50 percent. Take the $6,250 ($12,500 × 50%) and compare it to the current equity. Because Macy has only $5,000 in equity, her account is restricted by $1,250:

You can calculate the excess equity (SMA) or determine whether an account is restricted in pretty much the same way. If the investor has more equity than needed, it’s an SMA; if the investor has less than needed, the account is restricted.

Restricted short margin accounts

If the market price of the securities held in a short margin account increases instead of decreasing, the situation isn’t so great. When this happens, the account becomes restricted. You can figure out whether the account is restricted the same way you figure out the excess equity, only the investor has less than 50 percent of the SMV in equity instead of more than 50 percent.

The following question tests your knowledge of restricted short accounts.

Mr. Willing sold short 400 shares of RST common stock on margin at $40 per share. If RST is currently trading at $44 per share, how much is the account restricted?

(A) $2,400

(B) $6,400

(C) $8,800

(D) $16,000

The answer you want is Choice (A). First, figure out the credit balance. Mr. Willing sold short $16,000 worth of securities (400 shares × $40 per share), so enter $16,000 under the SMV (short market value). Then Mr. Willing had to deposit the Reg T amount (50 percent) of the purchase, so enter $8,000 (50% × $16,000) under the EQ (the investor’s portion of the account). You find that the credit balance (CR) is $24,000:

Next, find Mr. Willing’s current equity. The SMV changes to $17,600 ($44 × 400 shares), so you need to put that under the SMV in a new equation. In a short account, the CR remains the same as the market price changes, so you need to bring the $24,000 straight down from the preceding equation. You can see that the EQ has decreased to $6,400 (the difference between $17,600 and $24,000):

Now multiply the SMV by Regulation T to get the amount Mr. Willing should have in equity to be at 50 percent. Take the $8,800 ($17,600 × 50%) and compare it to the EQ. Because Mr. Willing has only $6,400 in equity ($2,400 less than the Reg T requirement), his account is restricted by $2,400:

Keeping up with minimum maintenance

A margin account can be left restricted, but if a margin account falls below minimum maintenance, the situation is much more serious. Customers then have to deal with a maintenance call (or maintenance margin call or Fed call), which requires investors to deposit money into the margin account immediately, or in stockbroker lingo, promptly.

Minimum maintenance on a long account

Minimum maintenance on a long margin account is 25 percent of the long market value. I’m sure that you’ll be happy to know that the calculations are the same as for restricted accounts (see the preceding sections) until you get to the last step. Try the following question.

Mark Smithers III purchased 1,000 shares of UVW common stock on margin when UVW was trading at $55 per share. If UVW is currently trading at $35 per share, what is the maintenance call?

(A) $1,250

(B) $7,500

(C) $8,750

(D) $10,000

The right answer is Choice (A). You may notice that the equation looks almost exactly the same as the previous two examples except for the last step. An account may be left restricted, but if it falls below minimum maintenance, the customer must come up with enough money, deposit enough fully paid securities, or sell enough margined securities to bring the account above minimum maintenance right away.

First, use the market value at the time of purchase to determine the debit balance. Mark purchased $55,000 worth of securities (1,000 shares × $55 per share), so enter $55,000 under the LMV (long market value). Then Mark had to deposit the Reg T amount (50 percent) of the purchase, so enter $27,500 (50% × $55,000) under the EQ (the customer’s portion of the account). You find that he borrowed $27,500 (the DR) from the broker-dealer:

Then find Mark’s current equity. The LMV changed to $35,000 ($35 × 1,000 shares), so you need to put that value under the LMV. Because the DR (the amount borrowed from the broker-dealer) doesn’t change, you bring the $27,500 straight down. Therefore, the EQ has decreased to $7,500:

Now multiply the LMV by the 25 percent minimum maintenance requirement to get the amount Mark should have in equity to be at minimum maintenance. Take the $8,750 ($35,000 × 25%) and compare it to the current equity. Because Mark has only $7,500 in equity, he’ll receive a maintenance call of $1,250:

Minimum maintenance on a short account

As with long margin accounts, short margin accounts can be left restricted, but if a margin account falls below minimum maintenance, the customer gets hit with a maintenance call. Minimum maintenance on a short margin account is 30 percent of the current market value. The rest of the calculations are similar to figuring out the SMA or how much the account is restricted (see “Checking out restricted accounts,” earlier in this chapter) until you get to the last step.

Minimum maintenance for a long account is 25 percent of the current market value, and minimum maintenance on a short account is 30 percent of the current market value.

The following question tests your knowledge in determining the maintenance call for short accounts.

Mrs. Martinez sold short 1,000 shares of XYZ common stock on margin at $50 per share. If XYZ is currently trading at $60 per share, what is the maintenance call?

(A) $0

(B) $2,000

(C) $3,000

(D) $8,000

The correct answer is Choice (C). First, find Mrs. Martinez’s credit balance. Mrs. Martinez sold short $50,000 worth of securities (1,000 shares × $50 per share), so enter $50,000 under the SMV (short market value). Then Mrs. Martinez had to deposit the Reg T amount (50 percent) of the purchase, so enter $25,000 (50% × $50,000) under the EQ (the investor’s portion of the account). The credit balance (CR) is $75,000:

Next, find Mrs. Martinez’s current equity. The SMV changed to $60,000 ($60 × 1,000 shares), so you need to put that value under the SMV. In a short account, the CR remains the same as the market price changes, so the CR is $75,000. Therefore, the equity has decreased to $15,000:

Now multiply the SMV by 30 percent to get the amount Mrs. Martinez should have in equity to be at minimum maintenance. Take the $18,000 ($60,000 × 30%) and compare it to the equity. Because Mrs. Martinez has only $15,000 in equity, she’ll receive a maintenance call of $3,000: