Account opening

Margin disclosure document

Opening a margin account requires more than just a basic new account form. In addition to the typical account opening rules, customers must be provided with a margin disclosure statement, which details the primary risks an investor is exposed to when utilizing this type of account. FINRA Rule 2264 requires broker-dealers to make the following customer disclosures in this statement:

• You can lose more than you deposit
• The broker-dealer may liquidate your securities without contacting you*
• The broker-dealer can selectively choose what securities are sold
• The broker-dealer can increase house requirements** without notice
• You are not entitled to time extensions to fulfill margin calls***

*A broker-dealer would typically liquidate (sell) securities if there is a threat of the account falling below regulatory or firm requirements. These requirements are commonly called ‘minimum maintenance,’ which is covered later in this unit. Margin loans are risks for broker-dealers, as the customer may be unable to repay the loan if their security values decline quickly. To avoid this issue, the firm may sell any security at any time to repay outstanding margin loans.

**‘House requirements’ refers to rules that are more stringent than margin regulations. For example, Regulation T (covered in the next chapter) is a Federal Reserve rule requiring investors to deposit at least 50% in an initial margin transaction (e.g., the customer deposits $5,000 to make a $10,000 stock purchase). The firm could impose house requirements that require customers to deposit 75% in an initial margin transaction. House rules can always be more stringent than Federal Reserve or FINRA margin rules, but never less stringent.

***Margin calls are requests to customers to deposit additional funds to meet regulatory or house margin requirements. We will discuss margin calls later in this unit.

The margin agreement

Once margin disclosures have been provided, customers must complete and sign the margin agreement. This agreement contains three notable subsections:

• The hypothecation agreement
• The credit agreement
• The loan consent form

The hypothecation agreement

The hypothecation agreement has a bizarre name, but it involves pledging securities as collateral for margin loans. Like a home is pledged as collateral for a mortgage (if the mortgage goes unpaid, the bank owns the house), securities held in a brokerage account serve as collateral for margin loans. If a customer borrows money from their broker-dealer and cannot repay the loan, the broker-dealer may 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, these institutions typically 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 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 (140% of $10,000) of the customer’s securities to the bank as collateral for the loan.

After rehypothecating securities to banks, broker-dealers receive and re-loan borrowed bank funds 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. For example, ABC Bank charges XYZ Broker-Dealer 8% for a margin loan collateralized by rehypothecated securities owned by XYZ’s customers. XYZ Broker-Dealer then re-loans the funds to its customers at a 12% interest rate. The 4% interest rate spread is profit to the broker-dealer.

The credit agreement

The credit agreement contains the details of the margin loan. This part of the margin agreement includes how the broker-dealer calculates their margin interest, repayment schedule, and general loan terms.

The loan consent form

The last part of the margin agreement is the loan consent form. A signature on this form allows the broker-dealer to lend a customer’s 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 repurchasing the security after the price falls. Borrowed securities typically are obtained from other broker-dealer customers with margin accounts. This occurs behind the scenes; margin customers are typically unaware of when their securities are being borrowed.

A customer’s securities can be commingled with other customer securities when the loan consent form is signed. Commingling means a customer’s stocks, bonds, and other securities are be held jointly with other customer securities (e.g., Customer A’s stock is lent to Customer B’s account for a short sale). 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. However, the hypothecation and credit agreements must be signed to open a margin account.