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/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.

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 a long position. A short position needs the greater of a per-share dollar floor or a percentage of current market value, and the floor jumps sharply for lower-priced short stock: $5/share or 30% of CMV at $5 a share and above, but $2.50/share or a full 100% of CMV below $5. Short accounts carry a higher requirement than long accounts 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 sets the MAINTENANCE margin, and for short positions that maintenance level depends on price: 30% (or $5/share, whichever is greater) at $5 a share and up, but a much steeper 100% (or $2.50/share) below $5. 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, 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, as long as the account stays above 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)

Do Exempt Securities Get Lower Margin?

Government and certain sovereign debt get a reduced margin schedule under FINRA's exempt-securities margin rule because they carry less price risk than equities:

• All other exempt securities (for example, municipal bonds): 7% of market value
• Investment-grade corporate debt: 10% of current market value
• Other listed or margin-eligible non-equity securities: the greater of 20% of current market value or 7% of principal amount

Exam Tip: Gotchas

Do not apply the 50%/25%/30% equity schedule to government or exempt debt. The maturity-tiered 1-6% schedule (or the flat 7% and 10% rates) replaces it for those instruments because they carry much less price risk than a common stock position.

What Should You Check on Exam Day?

• Separate the two mandatory agreements (credit, hypothecation) from the one optional agreement (loan consent).
• Reg T sets the 50% initial margin; FINRA's maintenance-margin rule sets the 25% long / 30% short (or $5/share, whichever is greater) maintenance margin and the $2,000 equity floor. Never confuse who sets which, and watch for a short position priced under $5 a share, which jumps to 100% (or $2.50/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.