Cash vs Margin Brokerage Accounts
Understanding the Types of Brokerage Accounts You Can Open
When you open a brokerage account, you must choose between a cash account and a margin account. There are major differences between the two, both positive and negative. Determining which is most appropriate for your situation is an important decision that could have significant ramifications for your family down the road depending on how you manage your financial affairs.
Cash accounts do not permit any borrowing of money (trading on margin) from the broker or financial institution.
Any trades must be fully paid, in cash, by the required settlement date. This has the practical effect of restricting the ability to place trades more often as there may not be available cash settled and ready to deploy within your account at the moment you want to place a buy order. Likewise, you will need to wait until settlement to make a withdrawal of cash raised from a sell order. Stocks held in a cash account are not lent out to short sellers. With no margin debt, investors holding securities within a cash account will never be subject to a margin call within the account nor will they have to worry about rehypothecation or hyper-rehypothecation. Cash accounts cannot short stock. Cash accounts must behave much more conservatively when dealing with options (e.g., any calls that are written must be fully covered and any puts that are written must be fully secured by cash reserves in the event of exercise, etc.)
Margin accounts allow the convenience of borrowing money from your broker, either to leverage returns or for cash flow convenience as pertains to settling trades or creating a de facto line of credit for your working capital needs. Without your knowledge, securities you hold in your margin account can be lent out to short sellers to generate additional income for the broker.
Under certain circumstances, if this happens and the short sellers cover the dividend payment you are entitled to receive, you will not be allowed to claim the dividend as "qualified dividend" subject to much lower tax rates, but must instead pay ordinary personal taxes on it. This could result in you paying practically double the tax rate you otherwise would have paid because your broker was trying to earn more profit for its own income statement at your expense. Additionally, you may be subject to rehypothecation or hyper-rehypothecation risk.
Trade Settlement Requirements for Cash Accounts
When trading stocks, bonds, options, or Treasury securities, so-called "regular way settlement" requires you to deliver the cash (if you are buying) or asset (if you are selling) by the end of a certain number of days following the trade date itself. This is often expressed as "T + [insert the number of days here].
According to the Securities and Exchange Commission, or SEC, for many years, the typical settlement schedule was T + 5. However, more than a decade ago, the current trade settlement requirements for cash accounts were put in place. They are as follows:
- Options (Calls and Puts) = T + 1
- U.S. Treasury Bills, Bonds, and Notes = T + 1
According to FINRA, "The Federal Reserve Board's Regulation T and SEC Rule 15c3-3 provide for the possibility of extensions of credit by broker-dealers to investors when they have not promptly paid for a securities transaction." This makes it possible to extend the trade settlement an additional two days, for an effective T + 5. Specifically, Regulation T states that if the shortfall exceeds $1,000 in value, the broker must make a choice: liquidate the position or apply for an exemption from the regulators. SEC Rule 15c3-3 states that if a long-held security (read: one not sold short) has not been delivered within 10 business days following settlement, the broker must buy replacement securities for the customer or apply for an exemption from the regulators.
Due to the fact that your broker is responsible for settling trades even if you don't come up with the required cash or securities, it has the right to penalize you with fees, as well as take other remedial measures to protect its own interest if you fail to honor your financial commitments. Imagine that you entered a buy order for shares of common stock but didn't come up with the cash to pay for them when the trade went to settlement. The broker would have to make it up out of its own pocket then decide to sell the shares to recover its funds. If the stock price declined in the meantime, it can go after you for the amount it lost on the transaction as a result of the movement in market value. This could expose you to substantial losses.
If you repeatedly fail to settle trades within your cash account, your broker can close your account and ban you from doing business with the firm. Additionally, if you trade too rapidly to the point you are buying shares with the float generated from the settlement process, you can be slapped with a so-called Regulation T violation, which will result in your account being frozen for 90 days.