Brokerage firms offer two primary account types: cash and margin accounts. Cash accounts require customers to pay 100% for each security transaction and prohibit strategies that involve unlimited loss potential (e.g., short sales). They are the most common and popular account type offered by broker-dealers.
Margin accounts allow customers to borrow money for investment purposes and use higher-risk strategies. In fact, margin accounts are required for short sales and any other strategy involving unlimited risk (e.g., short naked calls). Generally, this type of account shouldn’t be opened for investors with low risk tolerances or fiduciary accounts*.
*It’s possible a discretionary or trust account may be opened as a margin account. For a discretionary account, the owner must have a high risk tolerance and be able to financially withstand considerable losses. For a trust account, the trust agreement must clearly allow a margin account to be opened on behalf of the trust.
When customers borrow money for investment purposes, they obtain leverage, which amplifies both gains and losses. Using margin can increase returns when the investment performs well, but it can also increase losses when the market moves against the investor.
Imagine you have $5,000 of your own money and borrow another $5,000 from a friend. You then take all $10,000 to the casino and bet it on one game. The game provides a 100% return (doubles your money) if you win, but you lose your money if you lose.
That’s the basic idea of leverage: borrowing increases the size of both the potential upside and the potential downside.
Borrowing money for investing works the same way. Investors can earn a higher return if they choose the right investment, but they can also lose more if they’re wrong. Because margin accounts involve considerable risk, they’re generally suitable only for risk-tolerant investors who can withstand significant losses.
Margin accounts require more than just a basic new account form. First, customers must be provided with a margin disclosure statement, which explains the primary risks an investor is exposed to when using this type of account. FINRA Rule 2264 requires broker-dealers to make the following customer disclosures in this statement:
*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, since the customer may be unable to repay the loan if security values decline quickly. To reduce this risk, 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.
Once margin disclosures have been provided, customers must complete and sign the margin agreement. This agreement contains three notable subsections:
The hypothecation agreement authorizes the customer to pledge securities as collateral for margin loans. A helpful comparison is a mortgage: a home serves as collateral for a mortgage loan, and if the loan isn’t repaid, the lender can take the home. In a margin account, securities held in the brokerage account serve as collateral for margin loans. If a customer borrows money from their broker-dealer and can’t repay the loan, the broker-dealer may liquidate (sell) the securities in the account to pay off the loan.
Broker-dealers are not banks and typically don’t have large amounts of cash available to lend. As a result, they often rehypothecate (re-pledge) 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 bank funds and then re-loan those funds to customers at 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 contains the details of the margin loan. This part of the margin agreement explains how the broker-dealer calculates margin interest, the repayment schedule, and the general loan terms.
The last part of the margin agreement is the loan consent form. Signing this form allows the broker-dealer to lend a customer’s securities to other customers for short sales. Short sales involve borrowing securities from a broker-dealer, selling them, and (ideally) repurchasing the security after the price falls. Borrowed securities are typically 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.
When the loan consent form is signed, a customer’s securities can be commingled with other customer securities. Commingling means a customer’s stocks, bonds, and other securities may 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 can’t be done with cash accounts, since 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.
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