Opening a margin account

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 involves the customer pledging 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 contains the details of the margin loan, including the method of calculating margin interest, the repayment schedule, and the general terms of the loan. Additionally, a disclosure is provided if the investor’s credit will be checked.

The last part of the margin agreement is the loan consent form. If a customer signs this part of the margin agreement, they’re agreeing 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.