Regulation T
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Prime Brokerage Anatomy™
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Federal Reserve Board’s 12 CFR §220 – Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 — “Regulation T” to friends and relations — permits those buying securities on margin to borrow no more than 50% — or such other percentage as the Federal Reserve Board may from time to time sanction, although it not felt the need to adjust it from 50% since at least 1974 — of the purchase price. It also requires in-scope customers to open a margin account with their broker before entering any margin loan.
Transaction recording
Regulation T requires a prime broker to record all transactions with a customer in a “margin account” or, where permitted,[1] a cash account. Regulation T requires an executing broker to treat the customer as its own customer and record the transaction in its cash or margin account on the premise that the executing broker is extending credit to the customer until the settlement date. However executing brokers generally settle prime brokerage transactions through the prime broker’s broker-dealer credit account (i.e., not the customer’s margin account) at the executing broker, thus treating the customer as the prime broker’s agent, and not a direct customer or debtor in its own right of the executing broker.
Free-riding
Regulation T also restricts certain ostensibly fully-paid-for transactions in a cash account. Owing to the normal two-day settlement cycle a customer could, in theory, buy and then quickly sell a stock and never have to pay the purchase cost (or anything other than the loss it realises, if it realises a loss. Well, not under Reg T, it couldn’t, without getting its account suspended for 90 days. A prime brokerage give-up looks a bit like a freerider trade, without being one, hence ...
The SEC no-action letter relating to executing broker settlements to a prime broker
The SEC no-action letter clarifies that where an investor is executing with one broker to give up to a prime broker, the executing broker trade doesn’t count for the purpose of Reg T, meaning as long as the customer has an account with the prime broker and is financing 50% of the purchase price with the PB, it doesn’t need to do so separately with the executing broker. Thus, the financial world can revolve.
See also
References
- ↑ Transactions in the cash account are predicated on the executing broker accepting in good faith the customer's agreement that all securities sold have already been paid for and all securities bought will be paid for before being sold