Margin accounts require more than a basic new account form. To open a margin account, the customer must complete and sign a margin agreement. This agreement has three parts:
The hypothecation agreement is the customer’s pledge of securities as collateral for a margin loan. A helpful comparison is a mortgage: a home secures the loan, and securities in the brokerage account secure the margin loan. If the customer borrows from the broker-dealer and can’t repay, the broker-dealer can liquidate (sell) securities in the account to satisfy the debt.
Broker-dealers aren’t banks and typically don’t keep large amounts of cash available to lend. Instead, they rehypothecate (re-pledge) customers’ securities to a bank in exchange for a loan. The bank-broker-dealer relationship is governed by Regulation U, which permits the broker-dealer to rehypothecate securities up to 140% of the customer’s loan amount. For example, if a customer borrows $10,000 on margin, the broker-dealer may rehypothecate $14,000 of the customer’s securities to the bank as collateral.
The broker-dealer then lends the bank’s money to customers at a slightly higher interest rate. The broker-dealer’s profit comes from the spread between:
The credit agreement lays out the margin loan’s terms, including how margin interest is calculated, the repayment schedule, and other general loan provisions. It also includes a disclosure if the firm will check the investor’s credit.
The final part of the margin agreement is the loan consent form. If the customer signs it, they authorize the broker-dealer to lend their securities to other customers, typically to facilitate short sales. In a short sale, the investor borrows securities, sells them, and hopes to buy them back later at a lower price. The borrowed securities generally come from other customers who have margin accounts. This lending happens behind the scenes; margin customers typically won’t know when their securities are being borrowed.
When a loan consent form is on file, the customer’s securities may be commingled with other customers’ securities. In practice, this means the customer’s stocks, bonds, and other investments may be held in other customer accounts. This is not permitted for cash accounts: fully paid securities 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 that the customer is not required to sign. By law, the hypothecation agreement and the credit agreement must be signed to open a margin account.
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