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How Risky Is Your Free Ride?

For a little more than a decade now, The SEC has been putting more emphasis on enforcing the legislation that governs cash accounts, commonly known as Reg T. Though, to this day there is still a great deal of brokers looking the other when it comes to trading out of cash accounts before a previous trade clears, and some of which might not even be aware of the breach of compliance. Is it wrong; Should regulators be more aggressive in their scrutiny of daytrading? In the following article by Eric Gillin, found on The Street, the regulation surrounding cash accounts is put under the spotlight to get a better idea of what importance the exitsting rules have and to understand what free-riding is and how it affects the market.

A handful of brokerages are suddenly cracking down on the practice of “free-riding” stock in cash accounts, but the practice is so embedded on Wall Street that it might never be eradicated.


The term refers to buying stock using cash from a trade that hasn’t cleared — in other words, paying for stock with money you don’t have. Regulations forbid it, because it typically takes three days for the actual settlement of a trade to occur. But for daytraders and institutional clients, instant money is a luxury they are unlikely to willingly surrender.


“Most brokers look the other way. I’ve definitely done it, mostly with more active accounts who you wouldn’t think there would be a concern about,” said one broker, who insisted on anonymity.


The prohibition against free-riding is contained in a Federal Reserve bylaw known as Reg T, adopted in an era when paper stock certificates had to be lined up with trades. Enforcement of Reg T waned in the late 1990s, ahead of an industry initiative that would’ve made most trades clear the day they were executed. But that initiative, called T+1, was derailed by Sept. 11, and now Reg T is back in favor with regulators.


“Legally, you’re supposed to wait for the trade to clear before using the proceeds to trade again,” said Rich Repetto, analyst covering the online brokerage industry at Putnam Lovell.

According to the SEC , “Section 220.8 of Regulation T states that in a cash account, a brokerage may buy a security on your behalf — or sell a security to you — if either: (a) You have sufficient funds in the account to cover the transaction; or (b) The firm accepts in good faith your agreement to make a full cash payment for the security before you sell it.” (To read the entire text of Reg T, click here .)


How does this work? Let’s say you had a cash account and owned $10,000 worth of Microsoft (MSFT) stock. Ready to take your profits, you decide to sell the entire $10,000 and use the cash to buy $10,000 worth of Coca-Cola (KO) shares that day.


That’s perfectly legal, but if you sell the Coca-Cola shares in the three days before the Microsoft trade clears, you could be breaking the law. In a cash account, you’d need $10,000 in cash to cover the second trade; that, or a “good faith” agreement with your broker to deposit the $10,000 before the trade officially clears. That rule is either obscure or restrictive enough that many brokers simply look the other way and let clients slide when it comes to good faith; hence, the “free ride.”


“I didn’t even think about it until the other day and then it hit me,” said the broker. “Under Reg T, you really need to wait until it clears.”


Traders can legally perform this kind of trading in a margin account that is funded well enough to cover half of the value of the second purchase. So one solution is to consolidate cash accounts so they have enough money to cover intraday trades, or switch to margin.

The issue, while technical, became a hot topic during the inflation of the dot-com bubble. Four years ago, Arthur Levitt, then chairman of the SEC, in a report to Congress on daytrading, stressed the importance of following the regulations governing cash accounts. “Specifically, the NASD stated that customers may daytrade only in margin accounts, because daytrading in a cash account could amount to free-riding,” he said. “Thus, daytrading firms must be in compliance with both Regulation T and NASD margin rules at all times.”


Under normal circumstances, free-riding isn’t an issue, because there’s enough liquidity to virtually guarantee that a trade will clear after three days. But in unusual circumstances, like in a market panic or a run on a company’s shares, free-riding could strain a brokerage’s capital.


“The issue is about systemic risk and a domino effect. It’s just like if you have people selling short without the cover,” said Peter Huang, professor of law at the University of Pennsylvania. “That’s why they insist you have to clear trades in cash accounts. That’s why you need margin — there could be a chain reaction. If things go well, it’s an insurance policy just like the FDIC, but if there’s a run, there could be a liquidity shock.”


While the violations aren’t likely to shake the fundamental underpinnings of the market, the fact that brokers choose to bend the rules when it suits them harkens to the conflicts between analyst research and investment banking. Aside from the threat of enforcement, there isn’t a lot of incentive in place to play by the rules.


“There’s really no pressure to abide by it at all,” said the anonymous broker. “Remember, a lot of times when you’re selling you want to buy something else. It’s not all day, every day, but it certainly happens, mostly with smaller accounts, I’d say, where they don’t have the extra cash on the side to buy the trade.”


But enforcing Reg T is tricky, because, says Huang, regulating bodies such as the NASD can’t examine how every trade in every account at a broker has been cleared. Also, with so many different regulations and two different types of free-riding — the other is commonly called “free-riding and withholding” and involves IPO shares — many don’t even realize they’re violating the law.


Most online brokers abide by the law, simply because they set up cash accounts so daytrading is impossible. HarrisDirect and E*Trade both confirmed that they do not allow free-riding in cash accounts.


“All our daytraders are set with margin accounts,” said Connie Dotson, chief communications officer at the company. “The cash wouldn’t be available. Our systems are programmed to not allow daytrading at all.”


Few experts expect enforcement to cripple the industry, but it will have an effect on confused customers who grew accustomed to free rides. Forcing compliance could depress trading volume as clients in cash accounts wait for trades to clear and trade less as a result. Ameritrade (AMTD) warned about this possibility months ago in the wake of a NASD investigation into free riding at its merger partner Datek.


Ultimately, the solution might be to restart the T+1 settlement initiative, which would enable trades from cash accounts to clear in one day. Until then, a kind of legal fog is likely to persist.


“Wall Street culture and the letter of the law don’t always coincide, as we’ve seen,” said Huang. “Then you have problems. I think this is a problem, but I understand why people are violating it.”

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