What is Reg T?

Reg T, short for Regulation T, is a regulation established by the Federal Reserve Board that governs the amount of credit that broker-dealers can extend to investors for buying securities. The purpose of Reg T is to prevent excessive speculation and protect the financial system from the risks associated with excessive leverage.

The history of Reg T dates back to the 1920s when the United States experienced a period of economic boom known as the Roaring Twenties. During this time, the stock market was growing at an unprecedented rate, and many people were investing in stocks using borrowed money. This led to a speculative bubble, which eventually burst in October 1929, triggering the Great Depression.

In response to the Great Depression, the U.S. government passed several laws to regulate the financial system, including the Securities Act of 1933, the Securities Exchange Act of 1934, and the Banking Act of 1933, also known as the Glass-Steagall Act. The Glass-Steagall Act separated commercial and investment banking activities and established the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits.

Reg T was established in 1934 as part of the Securities Exchange Act. It was designed to prevent the excessive use of credit in the securities market, which had contributed to the stock market crash of 1929. Reg T limits the amount of credit that broker-dealers can extend to customers for buying securities and requires customers to deposit a minimum amount of cash or margin with their broker-dealer before buying securities.

Under Reg T, broker-dealers are required to collect a minimum margin of 50% of the purchase price of a security from their customers. This means that customers must deposit at least half of the purchase price in cash or margin with their broker-dealer before buying the security. The remaining amount can be borrowed from the broker-dealer in the form of a margin loan.

For example, if an investor wants to buy $10,000 worth of stock, they must deposit at least $5,000 in cash or margin with their broker-dealer. The remaining $5,000 can be borrowed from the broker-dealer in the form of a margin loan. The margin loan is secured by the stock, and the investor pays interest on the loan until it is repaid.

Reg T also establishes a maintenance margin requirement, which requires customers to maintain a minimum amount of equity in their margin account. The maintenance margin requirement is set at 25% of the market value of the securities in the account. If the market value of the securities falls below the maintenance margin requirement, the broker-dealer may issue a margin call, requiring the customer to deposit additional cash or margin to bring the account back into compliance.

Reg T applies to all securities traded on U.S. exchanges, including stocks, bonds, and options. It also applies to short sales, which are transactions in which an investor borrows securities from a broker-dealer and sells them in the market, with the intention of buying them back later at a lower price to profit from the price difference.

Reg T has several benefits for investors and the financial system. It helps prevent excessive speculation and reduces the risk of financial crises caused by excessive leverage. It also promotes market stability by ensuring that investors have a minimum amount of equity in their margin accounts and reducing the risk of margin calls.

However, Reg T also has some drawbacks. It can limit the ability of investors to use leverage to amplify their returns, which may reduce their investment opportunities. It can also increase transaction costs for investors, as they must deposit a minimum amount of cash or margin with their broker-dealer before buying securities.