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 perform high-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 should not 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 maintain a high risk tolerance and can 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 through amplified gains and losses. An investor utilizing margin may make a higher return when they choose 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. The game provides a 100% return (doubles your money) if you win, but takes away your money if you lose. With a win, you turn the $10,000 into $20,000, a better return than if you only started with your $5,000. A loss results in you losing your $5,000 and your friend’s $5,000 that you owe back to them. This is a good example of how leverage works.
Borrowing money for gambling works the same way as investing. Investors make a better return if they make the right investment, but also lose more if they’re wrong. Margin accounts are subject to considerable risk, so they’re only suitable for risk-tolerant investors who can withstand losing significant amounts of money.
Margin accounts require more than just a basic new account form. First, 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:
*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.
Once margin disclosures have been provided, customers must complete and sign the margin agreement. This agreement contains three notable subsections:
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 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 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.
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