Cash & margin accounts

This chapter is long and dense with material that is typically lightly tested. Although all the information in this chapter could end up on your actual exam, it is rare to encounter more than one margin-related question. We recommend you approach this chapter accordingly and avoid putting too much effort into memorizing these concepts.

At brokerage firms, there are two main types of accounts: cash and margin accounts. Cash accounts require investors to pay 100% for each security transaction and prohibit strategies that involve unlimited loss potential like short-selling securities. Margin accounts allow investors to borrow money for investment purposes and allow risky strategies. In fact, margin accounts are required for short sales and any other strategy involving unlimited risk (like short calls).

When an investor borrows money for investment purposes, they leverage themselves. Leverage involves amplified gains and losses. Investors utilizing margin accounts are able to make more money when they make the right investments, but also are subject to more losses when the market moves against them.

Imagine you have $5,000 of your own money and borrow another $5,000 from a friend. Then, you take all $10,000 to the casino and bet it all on one game. If you win, you double your money to $20,000, which would make you more money than if you only had your $5,000. If you lose, you lose not only your $5,000, but also your friend’s $5,000 that you owe back to them.

Borrowing money for gambling works the same way as investing. Investors make more money if they make the right investment, but could lose more if they’re wrong. There’s a fair amount of risk involved with margin accounts, which is why they’re only suitable for risk-tolerant investors that can withstand losing significant amounts of money.

In this chapter, we’ll discuss how margin accounts work, the regulations that govern them, and how investors utilize them.

Opening margin accounts

Margin accounts require more than just a basic new account form. Customers opening margin accounts must fill out and sign the margin agreement, which contains three subsections: the hypothecation agreement, credit agreement, and loan consent form.

The hypothecation agreement is a bizarre-sounding form, but it involves the customer pledging their securities as collateral for their margin loans. Just like a home is collateral for a mortgage, securities held in a brokerage account serve as collateral for margin loans. If a customer borrows money from their broker-dealer and is unable to repay the loan, the broker-dealer can liquidate (sell) the securities in their account to pay off the loan.

Broker-dealers are not banks and do not have significant amounts of cash available to lend. Therefore, they rehypothecate (re-pledge) their customers’ securities to banks in return for a loan. The relationship between the bank and the broker-dealer is governed by Regulation U, which allows the broker-dealer to rehypothecate securities up to 140% of the amount of the customer’s loan to the bank. For example, if a customer borrows $10,000 through a margin loan, the broker-dealer may rehypothecate $14,000 of the customer’s securities to the bank as collateral for the loan.

Broker-dealers then take the borrowed money from the bank and re-loan it out to their customers with a slightly higher interest rate. The difference between the interest rate paid by the broker-dealer to the bank (known as the broker loan rate) and the interest rate charged to the broker-dealer’s customers is how broker-dealers make money off margin accounts.

The credit agreement is where the details of the margin loan exist. The way the broker-dealer calculates their margin interest, repayment schedule, and general terms of the loan are included in this part of the margin agreement.

The last part of the margin agreement is the loan consent form. If a customer signs this part of the margin agreement, they agree to allow the broker-dealer to lend out their securities to other customers for short sales. If you recall, short sales of securities involve borrowing securities from a broker-dealer, selling them, and hopefully buying the security back after the price drops. Borrowed securities come from other customers of the broker-dealer that own margin accounts. This occurs behind the scenes; margin customers won’t know when their securities are being borrowed.

When a customer has a loan consent form on file, their securities will be commingled with other customers’ securities. This means that their stocks, bonds, and other investments may be held in other customer accounts. This cannot be done with cash accounts, as fully paid-for securities held in cash accounts must be segregated and held in safekeeping for each investor.

The loan consent form is the only part of the margin agreement the customer is not required to sign. By law, the hypothecation agreement and credit agreement must be signed in order for a margin account to be opened.

Deposit requirements

Deposit requirements represent the amount of money required to execute an investment strategy in a margin account. Investors are subject to Regulation T or FINRA requirements when borrowing money from their broker-dealer.

Regulation T is a rule within the Securities Exchange Act of 1934 that requires investors to make a 50% deposit when borrowing money or securities for investment purposes. The Federal Reserve has control over this rule. Investors utilizing margin typically are required to deposit 50% of the overall transaction.

Sometimes investors must deposit more than 50% of their transaction. FINRA requires a margin equity (ownership) level of $2,000 in order to make use of margin loans. Applicable margin regulations require a deposit of the greater of their Regulation T and FINRA requirements.

Sidenote

FINRA

The Financial Industry Regulatory Authority, better known as FINRA, is an industry-funded non-governmental regulator. While organizations like the Securities and Exchange Commission (SEC) and state administrator are considered extensions of the government, FINRA is considered a self-regulatory organization (SRO). In basic terms, SROs are granted power by the industries they regulate. You might wonder - why would an industry voluntarily elect to regulate itself? To be clear, regulation involves costly measures. to ensure compliance, penalties for those that break rules, and hefty membership fees. The answer is quite simple - if they didn’t impose fair and balanced regulations through an organization they funded themselves, the government would do it for them.

FINRA very much acts like internal affairs within police departments. While the individuals and firms they go after surely may have some negative sentiments, the industry as a whole appreciates the job FINRA does. They maintain investor faith in the industry while staving off strict government-led regulations.

You don’t need to know much about FINRA, as the SEC and the state administrators (discussed later) are the most likely regulators to be covered on the exam. However, you may see them mentioned infrequently.

Let’s go through an example to better understand this concept.

An investor opens a new margin account and subsequently executes a purchase of 100 shares of ABC stock at $30. What is their deposit requirement?

Can you figure it out?

What if an investor purchases less than $2,000? For example, an investor purchases $1,200 of a security. Would it make sense to require a deposit of $2,000 if their maximum loss was $1,200 (assuming the stock became worthless)? No - it wouldn’t. Therefore, investors only must deposit 100% of the transaction if purchasing less than $2,000. Essentially, their account is treated as a cash account.

Margin initial deposit rules for long accounts can be summed up this way:

These rules are a bit different for short accounts. When an investor sells short stock, they can lose more than the initial value of the investment. For example, assume an investor goes short 100 shares at $15. Although the initial short position is only $1,500, the investor could lose an unlimited amount of money if the stock were to rise considerably. If the stock price went to $50, they would be obligated to spend $5,000 buying it back ($50 x 100 shares), resulting in a $3,500 loss ($1,500 short sale - $5,000 repurchase).

Due to the heightened risk of short positions, margin rules always require a minimum deposit equaling the greater of 50% or $2,000. Most importantly - even a small initial short position well below $2,000 will require at least a $2,000 deposit for example:

An investor opens a new margin account and subsequently executes a short sale of 10 shares of ABC stock at $40. What is their deposit requirement?

Even though the position is only worth $400 (10 shares x $40), the investor must deposit a total of $2,000. Unlike long positions, purchases below $2,000 still require a deposit of at least $2,000. If the same example above was switched to a long purchase of 10 shares at $40, the investor would only be required to deposit $400.

Regulation T also relates to settlement for both margin and cash accounts. Although different securities have their own settlement times, Regulation T settlement is always two business days after regular-way settlement. This is the last day the cash for a purchase or the securities for a sale can be delivered.

If an investor does not deposit the required cash or securities for a transaction by Regulation T settlement, the broker-dealer maintaining custody of their account must take action. They can reach out to the appropriate SRO (usually FINRA) and request an extension for the customer, or can close out the position for the client and freeze their account.

If the firm obtains an extension from an SRO, it gives the customer an extra few days to fulfill their obligation. For example, if a customer owes $10,000 for a recent security purchase, they’ll get a few extra days to make the $10,000 deposit. Extension requests occur infrequently and are sometimes denied.

The more common process is liquidating a customer’s account and freezing the account. Again, let’s assume a customer owes $10,000 on a recent security purchase. If the required deposit isn’t made by Regulation T settlement (two days after regular settlement), the firm has the right to liquidate $10,000 of securities in the customer’s account. They’ll keep the $10,000 to pay for the transaction, then freeze the customer’s account.

When a brokerage account is frozen, it’s not completely useless. A customer with a frozen account can still perform transactions, but only if the funds are already in the account. Before the customer makes a security purchase, they must have the required cash in their account to pay for the purchase before the trade is placed. Accounts remain frozen for a period of 90 days.

Equity

One of the most essential margin formulas to be aware of calculates an account’s equity, which represents the customer’s net ownership value. When investing with borrowed funds, investors must factor in the future repayment of those funds to determine what they own in the account. For example, a $50,000 margin account involving a $20,000 loan to the investor results in $30,000 of equity (the account’s net worth).

We’ll discuss two separate equity formulas in this section:

• Long account equity formula
• Short account equity formula

Long account equity

First, let’s establish the formula to calculate equity in a long account:

$$\text{LMV - Debit }=\text{Equity}$$

LMV stands for long market value, which represents the overall value of all (long/owned) securities held in the account. The debit represents the outstanding loan amount (the amount borrowed and owed back to the broker-dealer). The account equity is found when the debit is subtracted from the LMV. Let’s work through an example:

An investor purchases 100 shares of ABC stock at $50 in their newly-opened margin account and deposits their Regulation T requirement.

Can you determine the equity?

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Let’s try another example:

An investor purchases 200 shares of ABC stock at $70 in their newly opened margin account and deposits their Regulation T requirement. The market then rises to $80. What is the equity?

Can you figure it out?

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In addition to understanding the equity formula for initial purchases in a long margin account, you should also know when formula variables change. Let’s look at this example:

A client of yours goes long 400 shares of ZZZ stock at $20 per share. The stock rises to $30, and the investor sells 100 shares. What is the resulting equity formula?

Here’s a clue to answer this question: unless otherwise stated, any sales proceeds in a long account are used to pay back borrowed funds, effectively reducing the debit balance. Can you take it from here?

Short account equity

The same idea of equity applies to a short account, but the formula is a bit different:

$$\text{Credit - SMV }=\text{Equity}$$

The credit represents cash held in a margin account, which comes from two different places. First, a short sale involves selling borrowed securities, which puts cash in the account. Second, the investor deposits a certain amount of money (usually 50%) when creating the short position. The combination of those two cash inflows equals the credit. SMV stands for short market value, which is the overall value of the short securities in the account.

Given the difficulty with the short equity formula, let’s walk through an example together:

An investor sells short 100 shares of XYZ stock at $80 and deposits the required margin.

First, let’s find the credit. The credit equals the amount being sold short (100 shares x $80 = $8,000) plus the amount deposited by the investor. Similar to a long account, the investor must deposit the greater of 50% or $2,000. 50% of $8,000 is $4,000, so that’s what the investor deposits. The combination of the amount sold short ($8,000) and the customer’s deposit ($4,000) leads to the credit balance, which is $12,000*.

*The credit balance represents cash “sitting on the sideline.” Investors must repurchase the stock they sell short, so broker-dealers require their investors to have cash in the account to make the required repurchase in the future. In this scenario, the investor has $12,000 in cash waiting to repurchase the 100 shares.

Next is the SMV. The SMV represents the overall short position of $8,000 (100 shares x $80). Now we can do the formula:

$12,000 (credit) - $8,000 (SMV) = $4,000 (equity)

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Let’s see if you can do one on your own:

An investor sells short 300 shares of BCD stock at $60 and deposits the required margin. The stock then falls to $50. What is the equity?

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In addition to understanding the equity formula for initial sales in a short margin account, you should also know when formula variables change. Let’s look at this example:

A client of yours goes short 100 shares of CDE stock at $200 per share. The stock falls to $150, and the investor buys back 50 shares to close part of the position. What is the resulting equity formula?

Here’s a clue to answer this question: unless otherwise stated, any repurchase of shares to close a short position is funded with the credit balance. Remember, the credit balance represents cash waiting to be used to buy back shares. Can you take it from here?

This video summarizes the important concepts related to margin equity:

Minimum maintenance

Margin accounts increase the normal risks of investing. If an investor purchases shares in a margin account and those shares lose 100% of their value, they lose the overall value of those shares, plus they have to pay back borrowed funds. That’s leverage in a nutshell; increased gain and loss potential.

Minimum maintenance helps ensure customer margin accounts don’t spiral out of control if the market moves against them. Additionally, they help protect the broker-dealer offering the margin account from being stuck with unpaid debts or an unwanted short position. In this section, we’ll explore minimum maintenance for long and short accounts.

Minimum maintenance for long accounts

You will find many numbers and calculations in this section. The Series 66 rarely presents calculation questions, but may ask conceptual questions related to these topics. Don’t get bogged down in the math!

To understand minimum maintenance, we need to first establish another form of the equity formula:

$$\text{Equity \%}=\frac{\text{Equity (in \$)}}{\text{LMV\hspace{0.33em}or SMV}}$$

Let’s assume an investor purchases 200 shares of stock at $30 per share and deposits the required initial margin. The regular equity formula would look like this:

$6,000 (LMV) - $3,000 (debit) = $3,000 (equity)

Now, let’s calculate the equity percentage using the new formula we established above:

Equity % = $3,000 (equity) / $6,000 (LMV) Equity % = 50%

It shouldn’t be a surprise the account is currently at 50% equity. Remember, equity represents the overall amount the investor owns of the margin account. If the investor owns $3,000 of a $6,000 account, they own 50% of the account. Of course, the equity formula (both of them) will change when market values change. Let’s work through an example together:

An investor purchases 200 shares of ABC stock at $300 and deposits the required margin. The market price then falls to $175. What is the equity amount in dollars and percent?

First, let’s establish how the account starts:

$60,000 (LMV) - $30,000 (debit) = $30,000 (equity)

The investor purchases $60,000 of stock (200 shares x $300) in their margin account. The investor must deposit 50% of the overall purchase or $2,000, whichever is greater. 50% of the overall purchase is the greater of the two, so the investor deposits $30,000. The other $30,000 is borrowed from the broker-dealer, which is reflected in the debit.

Next, let’s factor in the decrease in market price to $175 per share:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

When the market falls, so does the LMV. Now the investor holds 200 shares at $175 per share, resulting in an overall LMV of $35,000. The debit does not change because the investor did not borrow more money or pay any borrowed funds back. This leads to a new equity of $5,000.

Last, let’s calculate the equity percentage:

Equity % = $5,000 (equity) / $35,000 (LMV) Equity % = 14.3%

Whether you realize it or not, the investor is in a really bad position. They lost $25,000 of equity when the market fell and are close to their account going “underwater” (owing more than the account is worth). If the market continues to fall, the broker-dealer is at risk of not being repaid the $30,000 they lent to the customer. To avoid something like this happening, FINRA enforces minimum maintenance rules.

The minimum maintenance for long accounts is 25% equity. Meaning, the equity percentage cannot fall below 25% without the investor or broker-dealer moving to remedy the situation. There are three ways to fix a long margin account that falls below minimum maintenance:

1. Investor deposits more money
2. Investor deposits “fully paid” stock
3. Securities are sold

If the investor deposited more money in the margin account, the debit balance would fall and the equity (both in $ and % form) would rise. Let’s demonstrate this using the previous example:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the resulting equity (in $ and % form) if the investor deposited $10,000?

Can you figure it out?

The investor can also deposit “fully paid” securities into the account to increase their equity. In plain terms, this means moving securities the investor owns (typically from another account) into this account. It increases the amount of stock in the account, which serves as collateral for the margin loan. Let’s go back to our example with low equity figures:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the resulting equity (in $ and % form) if the investor deposited $15,000 of fully paid stock?

The last remedy for a long margin account below minimum maintenance is to sell securities. This can be done voluntarily by the customer or proactively by the broker-dealer. When the investor signed the margin agreement, they gave the right to the broker-dealer to sell shares in the account at any time, with or without notice. It might sound cruel, but the broker-dealer can sell any security in the customer’s account to pay themselves back the funds they lent. Of course, it’s important for the broker-dealer to maintain a good relationship with their customer, so most firms will only do this as a last resort.

Let’s look at our account with low equity again:

$35,000 (LMV) - $30,000 (debit) = $5,000 (equity)

What would be the equity (in $ and % form) if the investor (or the broker-dealer) sold $25,000 of stock?

We’ve established minimum maintenance and how to deal with an account that falls below requirements. Now, let’s discuss the way to determine how far an account may fall before it’s at minimum maintenance. Let’s use our original example:

$60,000 (LMV) - $30,000 (debit) = $30,000 (equity)

If the investor was worried about going below the 25% minimum maintenance requirement, they could use this formula:

$$\text{Mkt value at\hspace{0.33em}min. maint.}=\frac{\text{Debit}}{\text{0.75}}$$

This formula tells the investor how far the account would have to fall to be exactly at 25% equity. Let’s do the formula using our example:

Mkt value at min. maint. = $30,000 (debit) / 0.75 Mkt value at min. maint. = $40,000

If the market value were to fall to $40,000, the account would be exactly at 25% equity. You can double-check this using the equity formulas we’ve utilized. First, the equity formula in dollars:

$40,000 (LMV) - $30,000 (debit) = $10,000 (equity)

Next, the equity formula as a percent:

Equity % = $10,000 (equity) / $40,000 (LMV) Equity % = 25%

As you can see, the account is exactly at 25% equity when it falls to $40,000. This is a quick way to determine how far an investor can let their long margin account fall before they’ll have to take action in their account.

Sidenote

Restricted accounts

When an account falls below 50% equity, it becomes restricted. Restricted accounts sound harsher than they are in reality. When an account is below 50% equity, half of any sales proceeds must be used to pay back borrowed funds (another way of saying reduce the debit balance).

We didn’t discuss this in the examples we covered, but investors don’t always use their sales proceeds to pay down the debit balance. In an unrestricted account, an investor could sell securities and withdraw the cash, even with an outstanding debit balance. However, this changes when equity goes below 50%.

Minimum maintenance for short accounts

The same philosophy behind minimum maintenance for long accounts applies to short accounts, but there are some differences in approach. The biggest difference is the amount; short accounts must always maintain at least 30% equity (not 25% like long accounts). If equity falls below 30%, the investor or broker-dealer must move to remedy the situation. Let’s work through an example together:

An investor has an already established margin account with a credit balance of $52,000 and a short market value of $20,000. The account value rises to $45,000. What is the equity amount (in $ and % form)?

First, the equity formula in dollar form:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

Next, the equity formula in percent form:

Equity % = $7,000 (equity) / $45,000 (SMV) Equity % = 15.5%

This account is well below the 30% minimum maintenance requirement. The account is in danger of going “underwater,” which would occur if the market value went above the credit balance. This results in the value of the stock required to be repurchased being more than the cash in the account. There are two ways to fix a short margin account that falls below minimum maintenance:

1. Investor deposits more money
2. Part or all of the short position is closed (repurchased)

Let’s assume our example with low equity:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

If the investor deposited $18,000 of cash in the account, what would be the changes to equity (in $ and % form)?

The other fix is to repurchase shares to close part or all of the short position. Similar to long accounts, the investor may do this voluntarily, or the broker-dealer may do it proactively (the [margin agreement gives them the right to do so). Let’s refresh and use the original low equity example:

$52,000 (credit) - 45,000 (SMV) = $7,000 (equity)

What would the equity change to (in $ and % form) if the investor closed $30,000 of the short position?

Similar to long accounts, a formula can be used to determine at what market value the account would reach minimum maintenance. First, let’s re-use our original example:

An investor has an already established margin account with a credit balance of $52,000 and a short market value of $20,000.

First, let’s look at the dollar-based equity formula:

$52,000 (credit) - 20,000 (SMV) = $32,000 (equity)

Now, let’s calculate the equity in percent form:

Equity % = $32,000 (equity) / $20,000 (SMV) Equity % = 160%

Equity can go above 100% with short accounts (although it does not with long accounts). At an equity level of 160%, this account is in great shape. If the investor was worried about reaching minimum maintenance if the SMV were to rise, they can utilize this formula to determine when this would occur:

$$\text{Mkt\hspace{0.33em}value at min. maint.}=\frac{\text{Credit}}{\text{1.3}}$$

This formula tells the investor how far the SMV would have to rise to be exactly at 30% equity. Let’s do the formula using our example:

Mkt value at min. maint. = $52,000 (credit) / 1.3 Mkt value at min. maint. = $40,000

If the market value were to rise to $40,000, the account would be exactly at 30% equity. You can double-check this using the equity formulas we’ve utilized. First, the equity formula in dollars:

$52,000 (credit) - $40,000 (SMV) = $12,000 (equity)

Next, the equity formula as a percent:

Equity % = $12,000 (equity) / $40,000 (SMV) Equity % = 30%

As you can see, the account is exactly at 30% equity when the SMV rises to $40,000. This is a quick way to determine how far an investor can let their short margin account rise before they have to take action in their account.

This video summarizes the important concepts related to minimum maintenance:

Key points

Margin accounts

• Borrow money for investment (leverage)
• Only suitable for risk-tolerant investors

Margin agreement components

• Hypothecation agreement
• Credit agreement
• Loan consent form

Hypothecation agreement

• Investor pledges securities as collateral
• Must be signed by the customer
• Firms rehypothecate securities to the bank

Regulation U

• Governs B/D to bank relationship
• B/Ds can rehypothecate 140% of debit

Credit agreement

• Margin loan details and specifics
• Must be signed by the customer

Loan consent form

• Allows B/D to lend out securities
• Does not have to be signed

Commingling securities

• Allowed for margin account securities
• Prohibited for cash account securities

Regulation T

• Requires 50% deposit for margin trade

Regulation T settlement

• 2 business day after regular-way settlement

FINRA margin requirement

• Minimum equity of $2,000

Frozen accounts

• Implemented if the customer misses Reg T settlement
• Purchases only occur if cash is in the account
• Lasts for 90 days

Long equity formula

• LMV - debit = equity
• LMV is the long market value
• Debit is the amount borrowed
• Equity is the account’s net worth

Short equity formula

• Credit - SMV = equity
• Credit is the amount sold short plus the amount deposited
• SMV is the short market value
• Equity is the account’s net worth

Combined equity formula

• LMV + credit - debit - SMV = equity
• Can be rewritten in multiple ways

Minimum maintenance for long accounts

• 25% equity requirement
• If falling below, must:
  • Deposit cash
  • Deposit fully paid securities
  • Sell securities

Restricted accounts

• Below 50% equity
• Half of sales proceeds must pay down the debit balance

Minimum maintenance for short accounts

• 30% equity requirement
• If falling below, must:
  • Deposit cash
  • Close short position