Cash Account

A margin account is the only type of account in which investors can engage in short selling.

What a Cash Account Can Hold

The name "cash account" causes confusion for some investors who think only cash can be held in the account. Cash accounts can hold a wide range of stocks, bonds, mutual funds and exchange-traded funds, and other securities, as well as cash.

Once an investor pays in full for securities in a cash account, those securities are considered "fully paid securities," and the brokerage firm is required to promptly obtain, and thereafter maintain, possession or control of them. If an investor does not want the brokerage firm to use the securities, the investor can pay off the debit balance, which represents a loan of money from the brokerage firm to the investor or for the investor's benefit, or instruct the brokerage firm to transfer securities into the cash account. If a margin account has a debit balance or a short position, the brokerage firm may require the investor to pay off that debit balance or deposit other margin before transferring securities to the cash account.

Option transactions can also be made in a cash account. Under Rule 4210(f)(2)(N) of the Financial Industry Regulatory Authority, known as FINRA, a member may make option transactions in a customer's cash account, provided that the transaction is permissible under Regulation T, Section 220.8, or that the conditions stated in subparagraph (ii) are met for a spread of the kind described there.

How Regulation T Treats the Cash Account

Regulation T is issued by the Board of Governors of the Federal Reserve System pursuant to the Securities Exchange Act of 1934. Its principal purpose is to regulate extensions of credit by brokers and dealers, and it also covers related transactions within the Board's authority under that Act. It imposes, among other obligations, initial margin requirements and payment rules on certain securities transactions.

Part 220 provides a margin account and four special purpose accounts in which to record all financial relations between a customer and a creditor. Any transaction not specifically permitted in a special purpose account shall be recorded in a margin account. Part 220 does not preclude any exchange, national securities association, or creditor from imposing additional requirements or taking action for its own protection. Part 220 does not apply to financial relations between a customer and a creditor to the extent that they comply with a portfolio margining system under rules approved or amended by the Securities and Exchange Commission, to credit extended by a creditor based on a good faith determination that the borrower is an exempted borrower, to financial relations between a customer and a broker or dealer registered only under section 15C of the Securities Exchange Act of 1934, or to financial relations between a foreign branch of a creditor and a foreign person involving foreign securities. Part 220 includes sections headed Margin account (Section 220.4), Good faith account (Section 220.6), Broker-dealer credit account (Section 220.7), and Cash account (Section 220.8). Under Section 220.3(b)(1), the requirements of one account may not be met by considering items in any other account.

In Regulation T, a creditor means any broker or dealer, any member of a national securities exchange, or any person associated with a broker or dealer, except for business entities controlling or under common control with the creditor. A customer includes any person or persons acting jointly to or for whom a creditor extends, arranges, or maintains any credit, or who would be considered a customer of the creditor according to the ordinary usage of the trade.

Custody of Fully Paid Securities

Rule 15c3-3 of the Securities and Exchange Commission defines the term fully paid securities as all securities carried for the account of a customer in a cash account as defined in Regulation T, as well as securities carried for the account of a customer in a margin account or any special account under Regulation T that have no loan value for margin purposes, and all margin equity securities in such accounts if they are fully paid. The term does not apply to any securities purchased in transactions for which the customer has not made full payment.

Under Rule 15c3-3(b)(1), a broker or dealer shall promptly obtain and shall thereafter maintain the physical possession or control of all fully-paid securities and excess margin securities carried by a broker or dealer for the account of customers.

Permissible Transactions in a Cash Account

Section 220.8(a) of Regulation T sets out the permissible transactions in a cash account. Under Section 220.8(a)(1), in a cash account a creditor may buy for or sell to any customer any security or other asset if there are sufficient funds in the account, or if the creditor accepts in good faith the customer's agreement that the customer will promptly make full cash payment for the security or asset before selling it and does not contemplate selling it prior to making such payment.

Under Section 220.8(a)(2), a creditor may buy from or sell for any customer any security or other asset if the security is held in the account, or if the creditor accepts in good faith the customer's statement that the security is owned by the customer or the customer's principal, and that it will be promptly deposited in the account.

Under Regulation T, an investor can buy securities in a cash account provided that there are sufficient funds in the account, or if the brokerage firm accepts in good faith that the investor will promptly make full cash payment for the security. In a cash account, an investor must pay for the purchase of a security before selling it.

Time Periods for Payment

Section 220.8(b)(1) of Regulation T provides that a creditor shall obtain full cash payment for customer purchases within one payment period of the date any nonexempted security was purchased, the date any when-issued security was made available by the issuer for delivery to purchasers, or the date any "when distributed" security was distributed under a published plan. The paragraph also reaches a refunding security: payment is due within one payment period of the date a security owned by the customer has matured or has been redeemed and a new refunding security of the same issuer has been purchased by the customer, provided that the customer purchased the new security no more than 35 calendar days prior to the date of maturity or redemption of the old security, the customer is entitled to the proceeds of the redemption, and the delayed payment does not exceed 103 percent of the proceeds of the old security. A nonexempted security means any security other than an exempted security.

Regulation T defines the payment period as the number of business days in the standard securities settlement cycle in the United States, as defined in paragraph (a) of Rule 15c6-1 of the Securities and Exchange Commission, plus two business days.

For the purchase of a foreign security, Section 220.8(b)(1)(ii) provides for full cash payment within one payment period of the trade date or within one day after the date on which settlement is required to occur by the rules of the foreign securities market, provided this period does not exceed the maximum time permitted by Part 220 for delivery against payment transactions.

If a creditor purchases for or sells to a customer a security in a delivery against payment transaction, Section 220.8(b)(2) gives the creditor up to 35 calendar days to obtain payment if delivery of the security is delayed due to the mechanics of the transaction and is not related to the customer's willingness or ability to pay. If any shipment of securities is incidental to consummation of a transaction, Section 220.8(b)(3) provides that a creditor may extend the payment period by the number of days required for shipment, but not by more than one additional payment period.

With a cash account, an investor is expected to pay the full amount for all securities purchased by the settlement date.

Extensions of the Payment Period

Section 220.8(d)(1) provides that, unless the creditor's examining authority believes that the creditor is not acting in good faith or that the creditor has not sufficiently determined that exceptional circumstances warrant such action, the examining authority may upon application by the creditor extend any period specified in paragraph (b) of the section, or authorize transfer to another account of any transaction involving the purchase of a margin or exempted security, among other actions. Under Section 220.8(d)(2), applications shall be filed and acted upon prior to the end of the payment period, or in the case of the purchase of a foreign security within the period specified in paragraph (b)(1)(ii), or the expiration of any subsequent extension.

The 90 Day Freeze

If an investor buys and sells a security before paying for it, the investor is freeriding. Freeriding is not permitted under the Federal Reserve Board's Regulation T and may require the investor's broker to freeze the investor's cash account for 90 days. During this 90 day period, an investor may still purchase securities with the cash account, but the investor must fully pay for any purchase on the date of the trade.

Section 220.8(c)(1) of Regulation T provides that if a nonexempted security in the account is sold or delivered to another broker or dealer without having been previously paid for in full by the customer, the privilege of delaying payment beyond the trade date shall be withdrawn for 90 calendar days following the date of sale of the security. Cancellation of the transaction other than to correct an error shall constitute a sale.

Under Section 220.8(c)(2), the 90 day freeze shall not apply if, within the period specified in paragraph (b)(1) of the section, full payment is received or any check or draft in payment has cleared and the proceeds from the sale are not withdrawn prior to such payment or check clearance. It also does not apply if the purchased security was delivered to another broker or dealer for deposit in a cash account which holds sufficient funds to pay for the security. In that second case the creditor may rely on a written statement accepted in good faith from the other broker or dealer that sufficient funds are held in the other cash account.

An investor may avoid having a freeze placed on the cash account by fully paying for the securities by the settlement date with funds that do not come from the sale of the securities.

Cash Account on the Examination

The content outline for the Securities Industry Essentials examination lists "Cash" and "Margin" among the bullets under Topic 3.2.1, Account Types and Characteristics, in Section 3, Understanding Trading, Customer Accounts and Prohibited Activities. Options, discretionary versus non-discretionary, fee-based versus commission, and educational accounts are the other bullets listed there. The Rules list that follows Topic 3.3.3 includes Regulation T of the Federal Reserve Board, FINRA Rule 2264 on the Margin Disclosure Statement, and FINRA Rule 4210 on Margin Requirements. Freeriding appears in Topic 3.3.1, Market Manipulation, in the line "backing away, freeriding". Candidates should check the current outline before the examination.

Common Misunderstandings

A cash account holds only cash. Cash accounts can hold a wide range of stocks, bonds, mutual funds and exchange-traded funds, and other securities, as well as cash.

A cash account lets an investor borrow for a purchase. An investor using a cash account is not allowed to borrow funds from a broker-dealer in order to pay for transactions in the account.

Short sales are made in a cash account. A margin account is the only type of account in which investors can engage in short selling.

An investor can buy in a cash account and sell before paying for the purchase. In a cash account, an investor must pay for the purchase of a security before selling it, and buying and selling a security before paying for it is freeriding.

A freeze stops all activity in the account. During the 90 day period, an investor may still purchase securities with the cash account, but the investor must fully pay for any purchase on the date of the trade.

Selling a security before paying for it always leads to a 90 day freeze. Under Section 220.8(c)(2), the freeze does not apply if, within the period in paragraph (b)(1), full payment is received or a check or draft in payment has cleared and the proceeds from the sale are not withdrawn prior to such payment or check clearance.

Key Points

A cash account is a brokerage account in which the investor must pay the full amount for securities purchased and may not borrow from the broker-dealer to pay for them.

Regulation T governs an investor's use of a cash account to purchase securities, and Section 220.8 is the cash account section.

A purchase in a cash account is permitted if there are sufficient funds in the account or if the creditor accepts in good faith the customer's agreement to make full cash payment promptly, before selling the security.

Full cash payment is due within one payment period, which Regulation T defines as the number of business days in the standard securities settlement cycle plus two business days.

Buying and selling a security before paying for it is freeriding, and it may lead to a 90 day freeze of the cash account.

A margin account is the only type of account in which investors can engage in short selling.