Regulation T - Explained
What is Regulation T?
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Table of ContentsWhat is Regulation T?How Does Regulation T Work?
What is Regulation T?
Regulation T is a Federal Reserve Boards regulation that governs the investors use of a cash account for purchasing securities and regulates the credit extension limit by security brokers and dealers. The regulation prescribes that security brokers or dealers may extend only up to 50% of the total purchasing price of securities as a loan, and the investors must pay at least 50% price in cash.
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How Does Regulation T Work?
Investors can obtain loans from their brokers or dealers for buying securities. In exchange, they need to deposit their assets with the broker or dealer. This is called buying on margin. The Regulation T also provides certain rules regarding the security transactions made through cash accounts. According to Regulation T, an investor must buy securities with cash if he or she has a Cash Account. Investors with Margin Accounts are allowed to obtain a loan from the broker or dealer to fund a portion of their security purchase. The Board of Governors of the Federal Reserve System introduced Regulation T to govern the credit extension and safeguard the investors from larger scale risks. Borrowing money from the brokers or dealers may expose the investors to a sudden loss of a huge amount. Regulation T limits that chance by imposing a cap on the borrowing amount. This requirement is known as the initial margin. The requirement level may become higher for certain brokers and dealers. In order to purchase securities with credit, an investor must open a margin account. The broker-dealer has the right to determine the interest rate payable on the borrowed amount. If the total purchase amount of the securities is $20,000 the investor is allowed to borrow up to $10,000 from his or her brokerage firm, and he or she must pay at least $10,000 in cash. Although, Regulation T or Reg-T was primarily introduced to regulate credit extension it also contains certain rules for governing cash account security transactions. A Security transaction may take up to two days to be completed and only after that the seller of securities receives the selling amount. This may lead to a situation when an investor purchases and sells the same securities without paying for it from his or her cash account. This is known as free-riding. Regulation T prohibits this occurrence. In this case, the brokers are obligated to freeze the investors account for 90 days. It makes it mandatory for the investors to pay cash on the trading date for purchasing the securities.