Lesson 6.3: Customer Accounts - Account Features

Lesson 6.3: Account Features

Introduction

• This lesson covers brokerage accounts (cash and margin) and fee-based accounts.

• Margin is a feature that allows customers to purchase securities by borrowing money to cover a portion of the purchase price.

LO 6.g Differentiate cash, margin, and fee-based accounts.

Cash Accounts

• A cash account is a basic investment account available to anyone eligible.

• Customers must pay in full for purchased securities.

• Payment is expected by the end of the settlement date, which is typically the second business day (T+2) for corporate and municipal securities, known as regular way settlement.

• Federal Reserve Regulation T requires payment no later than two business days after the standard settlement period (T+4).

• Broker-dealers (BDs) strictly enforce settlement rules.

• Certain accounts, like IRAs, retirement plans with contribution limits, and custodial accounts (UTMA/UGMA), must be opened as cash accounts.

Example

• If corporate stock is purchased in a cash account with regular way settlement (T+2), full payment is due no later than T+4.

Buying on Margin (Margin Accounts)

• Margin trading allows customers to increase trading capital by borrowing cash or securities through their BDs.

• Two types of margin accounts:

  • Long Margin Account: Customers purchase securities and pay interest on borrowed money until the loan is repaid.

  • Short Margin Account: Customers borrow stock to sell short, aiming to profit from a decline in value; all short sales must be executed through a margin account.

• Stock can be borrowed from various sources:

  • Member firm executing the short sale.

  • Margin customers of the firm (with permission via a consent to loan agreement).

  • Other member firms.

  • Stock lending firms.

  • Institutional investors.

Advantages of Margin Accounts

• For Customers:

  • Purchase more securities with a lower initial cash outlay.

  • Leverage investments by borrowing a portion of the purchase price.

  • Leverage magnifies both potential returns and losses.
    *Figure 6.1 illustrates cash vs margin purchase

  • Cash Purchase Example:

    • Purchase 1,000 shares of ABC at 20 per share.

    • Increase to 30 per share yields a 50% return ( (\$10,000 \text{ gain } / \$20,000 \text{ initial investment})).

    • Decrease to 15 per share results in a 25% loss ((-\$5,000 \text{ loss } / \$20,000 \text{ initial investment})).

  • Margin Purchase Example:

    • Customer pays $10,000, borrows $10,000 from BD (50% margin) to purchase 1,000 shares of ABC at 20 per share.

    • Increase to 30 per share yields a 100% return ((\$10,000 \text{ gain } / \$10,000 \text{ initial investment})).

    • Decrease to 15 per share results in a 50% loss ((-\$5,000 \text{ loss } / \$10,000 \text{ initial investment})).

• For BDs:

  • Margin account loans generate interest income.

  • Margin customers trade larger positions, increasing commissions.

Hypothecation and Rehypothecation

• Hypothecation: Pledging customer securities as collateral for margin loans.

  • Requires a signed hypothecation agreement, typically part of the margin agreement.

• Rehypothecation: BDs borrow money from banks using customer securities as collateral.

  • Federal Reserve Regulation U oversees bank lending to BDs based on pledged customer securities.

• Firms cannot commingle customer securities with their own but can commingle securities from different customers if a hypothecation agreement has been signed.

Accounts That May Have a Margin Feature

• Most individual and joint accounts can be margin accounts with proper forms and principal approval.

• Sole proprietor business accounts also qualify.

• Corporate and Partnership Accounts:

  • Check corporate charter or bylaws (partnership agreement) for margin prohibitions.

  • If prohibited, no margin is allowed; if allowed or silent, margin is permitted.

• Trust and Fiduciary Accounts:

  • Trust documents must specifically allow margin; silence implies margin is not allowed.

• Accounts with contribution limits (IRAs, retirement plans) and custodial accounts (UTMA/UGMA) cannot be margin accounts.

• All margin accounts require approval by a firm principal, based on the account type's margin eligibility.

Forms for Margin Accounts

• Three key forms for adding margin borrowing:

  • Credit Agreement

  • Hypothecation Agreement

  • Consent to Loan Agreement

Credit Agreement

• Discloses the terms of credit extended by the BD.

• Includes the method of interest calculation and potential changes in interest rates.

Hypothecation Agreement

• Allows securities in the account to be pledged as collateral for the loan.

• Permits the BD to repledge customer securities to a bank.

• Customer securities must be held in street name (registered in the BD's name) to facilitate this process.

• BD is the nominal owner, while the customer is the beneficial owner with all ownership rights.

Consent to Loan Agreement

• Gives the firm permission to loan customer's margin securities to others (customers or BDs), typically for short sales.

Important Notes

• Credit and hypothecation agreements are mandatory to open a margin account.

• The loan consent form is optional but may be required by some BDs.

• BDs must provide customers with a risk disclosure document before opening a margin account and annually thereafter.

Risk Disclosure Document Highlights

• Customers cannot choose which securities are sold to meet a maintenance call.

• Customers can lose more money than initially deposited.

• Customers are not entitled to an extension of time to meet a margin call.

• Firms can increase in-house margin requirements without notice.

Securities Eligible for Margin Borrowing

• Regulation T identifies securities eligible for margin purchase and as collateral for loans.

• Eligible Securities:

  • Exchange-listed stocks and bonds.

  • Nasdaq stocks.

  • Over-the-counter (OTC) issues approved by the Federal Reserve Board (FRB).

  • Warrants.

• Ineligible Securities:

  • Options (calls and puts).

  • Rights.

  • Non-National Market System (non-NMS) securities and OTC issues not approved by the FRB.

  • Insurance contracts.

• Securities That Can Be Used as Collateral After 30 Days:

  • Mutual funds.

  • New issues meeting previous requirements.

• Securities Exempt from Regulation T:

  • U.S. Treasury bills, notes, and bonds.

  • Government agency issues.

  • Municipal securities.

• Exempt securities in margin accounts are subject to the firm's initial deposit requirements but must meet FINRA maintenance requirements.

Key Terms

• Margin: Amount of equity deposited to buy securities in a margin account.

• Marginable: Securities that can be used as collateral in a margin account.

Regulation T and FINRA Initial Margin Deposit Requirements

• Regulation T requires a deposit of 50% of the purchase's market value.

• FINRA requires a minimum of $2,000 or 100%, whichever is less.

• Customers must deposit the greater of the Regulation T requirement or the FINRA minimum. *Figure 6.2 Provides examples of required initial deposits.

  • Purchase > 4,000: Deposit 50% (Regulation T).

  • Purchase between 2,000 and 4,000: Deposit 2,000 (FINRA minimum).

  • Purchase < $$2,000: Deposit 100% of the purchase price (FINRA minimum).

Maintenance Call

• If a stock's value decreases, the customer's equity also drops.

• A maintenance call occurs when equity falls below 25% of the account's market value.

• Customers must deposit additional assets to restore equity to the 25% minimum.

• Failure to deposit funds may result in the BD liquidating assets to meet the 25% requirement.

• FINRA minimum maintenance equity for short margin accounts is the greater of 30%.

• BDs can have higher minimums (house call).

Fee-Based vs. Commission-Based Accounts

• Commission-Based: A commission is charged for each transaction.

• Fee-Based: Customers pay a set fee (monthly or quarterly) for all trading.

  • Fees are often a percentage of the account's value.

• Fee-based accounts are suitable for frequent traders but not for buy-and-hold investors.

LO 6.h Differentiate discretionary and nondiscretionary accounts and trades.

Solicited Trades vs. Unsolicited Trades

• Solicited Trade: Purchase of a specific security is recommended by the BD or representative..

  • Must be marked as solicited on the trade ticket.

• Unsolicited Trade: Trade placed by the client without suggestion from the BD or representative.

  • Must be marked as unsolicited on the trade ticket.

Discretionary Trades

• Customers grant trading authority to an RR to place trades without preauthorization.

• Requires specific authorization (Power of Attorney).

• Trades must be marked as discretionary.

• Three As of Discretion:

  • Action (buy or sell).

  • Amount (shares or dollars).

  • Asset (what is being bought or sold).

• If a representative chooses one or more of the three As, the trade is discretionary.

• Time and Price Authority:

  • Allowing the representative to choose the time or price of execution is not considered discretion.

• Discretionary trading requires:

  • Client's written agreement granting discretionary authority.

  • Principal's written approval of discretionary trading authority.

• Discretionary trades must be approved by a principal promptly after entry.

• Clients can revoke discretion in writing.

• Discretion is granted to the representative, not the BD, and ends if the representative leaves the firm.

Wrap Accounts

• Firms provide a group of services (asset allocation, portfolio management, executions, administration) for a single fee.

• Fees are often a percentage of assets under management (AUM).

• Wrap accounts are generally investment advisory accounts, requiring BDs to meet fiduciary requirements under the Investment Advisers Act of 1940 and register as investment advisers.

• Required disclosures include a statement that clients may obtain the same services separately for less cost.