Freeriding

Regulation T is issued by the Board of Governors of the Federal Reserve System pursuant to the Securities Exchange Act of 1934, known as the Act. Its principal purpose is to regulate extensions of credit by brokers and dealers, and it imposes, among other obligations, initial margin requirements and payment rules on certain securities transactions.

Under Section 220.8(a)(1) of Regulation T, 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), in a cash account, 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.

Payment Period and Full Cash Payment

Under Section 220.8(b)(1), a creditor must obtain full cash payment for customer purchases within one payment period of the date any nonexempted security was purchased, any when-issued security was made available by the issuer for delivery to purchasers, any "when distributed" security was distributed under a published plan, or 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 the customer purchased the new security no more than thirty-five 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.

For the purchase of a foreign security, Section 220.8(b)(1)(ii) requires 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 Regulation T for delivery against payment transactions.

Under Section 220.2, payment period means 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, known as the SEC, in Title 17 of the Code of Federal Regulations at section 240.15c6-1(a), plus two business days. Except as provided in paragraphs (b), (c), and (d) of Rule 15c6-1, a broker or dealer must not effect or enter into a contract for the purchase or sale of a security, other than an exempted security, a government security, a municipal security, commercial paper, bankers' acceptances, or commercial bills, that provides for payment of funds and delivery of securities later than the first business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction.

Under Section 220.8(b)(2), if a creditor purchases for or sells to a customer a security in a delivery against payment transaction, the creditor has up to thirty-five 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. Under Section 220.8(b)(3), if any shipment of securities is incidental to consummation of a transaction, a creditor may extend the payment period by the number of days required for shipment, but not by more than one additional payment period.

The Ninety Day Freeze

Under Section 220.8(c)(1), 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 is withdrawn for ninety calendar days following the date of sale of the security. Cancellation of the transaction other than to correct an error constitutes a sale. Under Section 220.2, nonexempted security means any security other than an exempted security, as defined in section 3(a)(12) of the Act.

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

When the Freeze Does Not Apply

Under Section 220.8(c)(2), the ninety day freeze does 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. The ninety day freeze 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 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.

Extension, Transfer and Waiver

Under Section 220.8(d)(1), 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, it may upon application by the creditor extend any period specified in paragraph (b) of the section, authorize transfer to another account of any transaction involving the purchase of a margin or exempted security, or grant a waiver from the ninety day freeze.

Under Section 220.8(d)(2), applications must 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.

Terms Used in the Cash Account Rules

Under Section 220.2, creditor means any broker or dealer, as defined in sections 3(a)(4) and 3(a)(5) of the Act, any member of a national securities exchange, or any person associated with a broker or dealer, as defined in section 3(a)(18) of the Act, except for business entities controlling or under common control with the creditor.

Foreign security means a security issued in a jurisdiction other than the United States. Delivery against payment, payment against delivery, or a C.O.D. transaction refers to an arrangement under which a creditor and a customer agree that the creditor will deliver to, or accept from, the customer, or the customer's agent, a security against full payment of the purchase price.

Trading Permitted in a Cash Account

An investor can sell a fully-paid for and settled security held in a cash account. The investor may purchase another security with the proceeds from that sale as long as the investor does not sell the newly purchased security prior to the settlement of the first sale. By doing this, the investor will have made full cash payment for the newly purchased security before selling it.

In the investor bulletin of the SEC on trading in cash accounts, an investor who uses the proceeds from a sale of securities that has not settled yet to purchase a security cannot sell the purchased security prior to the settlement of the first sale without adding additional cash to the account to cover the purchase price of the purchased security, and a sale in that situation constitutes freeriding.

Good Faith Violations

In the Investor Insights article Frequent Intraday Trading: Understanding the Basics, published by the Financial Industry Regulatory Authority, known as FINRA, when an investor buys securities in a cash account, the investor must pay for securities in full before selling them. Buying and selling the same security in a cash account before paying for it is known as free-riding, a violation of the Federal Reserve's Regulation T that can lead to strict account restrictions.

An investor can also incur what is known as a good faith violation by purchasing a security with cash from a transaction that has not settled yet and then selling the security before the proceeds used to fund the purchase have settled.

Exam Relevance

The Securities Industry Essentials examination content outline lists, under Topic 3.3.1, Market Manipulation, the bullets Definition of market manipulation and Types of market manipulation with market rumors, pump and dump, front running, excessive trading, marking the close, marking the open, backing away, and freeriding named in parentheses. Candidates should check the current outline before the examination.

Common Misunderstandings

Freeriding requires a profit on the sale. An investor who buys and sells a security before paying for it is freeriding.

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

A freeze stops the investor from buying. During the ninety-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 fully paid security and buying another with the proceeds is freeriding. An investor can sell a fully-paid for and settled security held in a cash account, and may purchase another security with the proceeds as long as the newly purchased security is not sold prior to the settlement of the first sale.

Cancelling a purchase avoids a sale. Cancellation of the transaction other than to correct an error constitutes a sale.

Every sale before payment starts a freeze. The ninety day freeze does not apply if, within the period specified in paragraph (b)(1), 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.

The freeze can never be waived. The creditor's examining authority may, upon application by the creditor and unless it believes that the creditor is not acting in good faith or has not sufficiently determined that exceptional circumstances warrant such action, grant a waiver from the ninety day freeze.

Key Points to Retain

An investor who buys and sells a security in a cash account before paying for it is freeriding.

Freeriding is not permitted under Regulation T.

Under Section 220.8(c)(1), the privilege of delaying payment beyond the trade date is withdrawn for ninety calendar days following the date of sale of the security.

During the ninety-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.

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