Margin Accounts

A margin account lets a customer borrow money from the firm to buy securities, or borrow securities from the firm to sell short. Because the customer is taking on a loan either way, opening a margin account requires extra documentation and federal and self-regulatory organization (SRO) margin percentages the exam tests directly.

What Documents Open a Margin Account?

Before an account can trade on margin, the customer must sign a margin agreement. The agreement has up to three parts:

• Credit agreement: states the terms of the loan, including how interest is charged. Required.
• Hypothecation agreement: the customer pledges securities as collateral for the loan. Required.
• Loan consent agreement: lets the firm lend the customer's margin securities to others. This part is optional, and the customer can open a margin account without signing it.

The credit and hypothecation agreements are mandatory; the loan consent is the one piece a customer may decline. Both mandatory agreements must be signed promptly after the first margin transaction; they do not have to be signed before the account is opened. On the exam, this timing rule comes from the NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents.

What Does the Risk Disclosure Warn About?

The firm must give the customer a margin risk disclosure statement at or before opening the account. In plain terms, it warns the customer that:

• They can lose more money than they deposited
• The firm can sell securities in the account to cover a shortfall, without contacting the customer first
• The customer cannot choose which securities are sold
• The firm can change its margin requirements at any time

Cash vs. Margin: What Gets Signed?

• A cash account needs no customer signature to open.
• A margin account requires the customer to sign the margin agreement, promptly after the first margin transaction.

Exam Tip: Gotchas

The loan consent agreement is optional; the credit and hypothecation agreements are not. A customer can have a fully functioning margin account without ever consenting to having their securities loaned out. Unlike a cash account, a margin account does require the customer's signature.

Who Sets Margin Requirements, and How Much?

Two different bodies set two different margin numbers:

• Regulation T's 50% initial margin has applied since 1974 to both long and short equity positions. To buy $10,000 of stock on margin, the customer deposits at least $5,000.
• FINRA's maintenance margin kicks in after the position is open: 25% of current market value for marginable stock held long.
• Short stock at $5/share or above requires the greater of $5/share or 30% of current market value.
• Short stock below $5/share requires the greater of $2.50/share or 100% of current market value. Short accounts carry a higher requirement because short-position risk is theoretically unlimited.
• The customer must deposit margin equal to the greater of Regulation T's initial requirement, FINRA's maintenance requirement, or the $2,000 minimum equity floor (cash need not exceed the purchase cost).

Exam Tip: Gotchas

The exam loves the WHO-sets-WHAT distinction. Regulation T (Federal Reserve Board) sets the INITIAL margin at 50%. FINRA's maintenance-margin rule (FINRA's margin requirements rule) sets the MAINTENANCE margin. For a short position the maintenance level is higher than for a comparable long position, and it is higher still for low-priced stocks, because a short seller's potential loss is open-ended. Broker-dealers may impose higher "house requirements," but may never go lower than Reg T or FINRA minimums.

What Happens When Equity Falls Below the Maintenance Level?

• If equity drops below the maintenance requirement, the broker-dealer issues a margin call.
• The customer must deposit additional cash or securities to bring the account back above the maintenance level.
• If the customer fails to meet the call, the broker-dealer may liquidate securities without the customer's consent, and is not required to give a specific number of days to respond before doing so.

What Is Rehypothecation, and How Far Can It Go?

• Rehypothecation is when the broker-dealer pledges the customer's margined securities as collateral for its own borrowing, typically from a bank.
• It is permitted under SEC rules adopted under the Securities Exchange Act of 1934, but the broker-dealer may rehypothecate up to 140% of the customer's debit balance (the amount the customer has borrowed) and no more.

What Is a Special Memorandum Account (SMA)?

• The SMA is a bookkeeping entry, not a separate account, that tracks excess equity in a margin account.
• Excess equity arises when securities rise in value above the Reg T requirement, or when the customer deposits more than required.
• The customer may use the SMA to buy additional securities or withdraw cash, subject to the applicable margin requirements. A withdrawal must leave equity at or above the greater of $2,000 or the maintenance margin requirement.
• The SMA can never have a negative balance.

Which Securities Cannot Be Bought on Margin?

Some positions require 100% cash, not margin:

• Options with 9 months or less remaining to expiration
• New issues and new mutual fund shares, for the first 30 days after distribution by a selling-group member
• Penny stocks (low-priced OTC equity securities not listed on a national exchange)

What Margin Applies to Exempt and Debt Securities?

Exempt and debt securities get a reduced maintenance schedule instead of the 25% equity requirement:

What Should You Check on Exam Day?

• Separate the two mandatory agreements (credit, hypothecation) from the one optional agreement (loan consent).
• Reg T sets 50% initial margin; FINRA sets maintenance and the $2,000 equity floor. For short stock, use the greater of the per-share floor or percentage requirement; the applicable figures change below $5/share.
• A missed margin call lets the firm liquidate without notice or consent; the customer does not get a guaranteed grace period.
• Rehypothecation is capped at 140% of the customer's debit balance.
• Non-marginable securities need 100% cash: options with 9 months or less to expiration, and new issues/new fund shares for their first 30 days.