What Is Freeriding?
The term freeriding refers to the practice of buying shares or other securities in a cash account and then selling them before the purchase has settled. When a trader freerides, they may pay for the shares using money from the proceeds of the sale instead of cash. Freeriding is a violation of the Federal Reserve Board's Regulation T and may result in the suspension of the trader's account.
Key Takeaways
- Freeriding is the practice of buying shares and then selling them before the purchase is fully settled.
- Freeriding is a violation of Regulation T, which governs how investors can use their cash accounts.
- There must be enough capital in an investor's cash account to buy securities before they are sold, according to Regulation T.
- Brokers and dealers must suspend or restrict cash accounts for 90 days if a trader is suspected of freeriding.
- A trader may commit freeriding even when they have enough money to pay for the trade if they sell a stock before the purchase is settled.
Understanding Freeriding
Regulation T (Reg T) is a series of provisions that govern how investors can use their cash accounts when they trade, as well as how much credit they can receive from brokers and dealers to execute their trades. One of the federal regulations stipulated by the Fed under Reg T is that investors must have enough capital in their cash accounts to buy securities before they are sold.
Freeriding usually happens when a trader buys and sells a security without having enough capital in their account to cover the purchase. But how is that possible? Different securities have different settlement dates following a transaction. This is expressed as T plus the number of days it takes to settle. For instance:
- Stock andexchange-traded fund (ETF) transactions settle in two business days (T+2)
- Mutual fund andoptions transactions settle in one day (T+1)
Let's say a trader buys shares in a company. The sale settles two days after the date of purchase. When they sell their shares, their account is almost always credited immediately with the proceeds. The trader can then use those proceeds to cover the original purchase when it settles. Basically, the trader sells the shares before they actually buy them.
Freeriding also refers to an illegal practice involving an underwriting syndicate member who withholds part of a new securities issue and later sells it at a higher price.
This practice is illegal and is prohibited by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Brokers and dealers must freeze any cash account they suspect of freeriding for a 90-day period. When an account is restricted, a trader may still buy securities, but the purchase must be done using cash on the very same day rather than on the settlement date.
Traders may be unintentionally guilty of freeriding if they buy securities with the proceeds of a sale that has not been finalized. For example, imagine a trader who sells $100 of a stock and uses the proceeds to buy another stock the following day. Since stock trades take two business days after the sale to settle, that trader was freeriding, because the first sale would not have been finalized for an additional business day. Under federal regulatory guidelines, their cash account should be frozen for 90 days.
As mentioned above, investment bankers and broker-dealers who act as an underwriting syndicate may also be in violation of freeriding when they keep shares from an initial public offering (IPO) aside so they can sell them for a higher price at a future date.
Special Considerations
You can commit freeriding even if you have enough cash to pay for a purchase. Under the law, freeriding describes any sale that takes effect before the purchase is settled, whether or not the trader already has enough funds on hand.
Traders can use a margin account to avoid the potential of freeriding while you trade. A margin account is a loan issued to an investor by a broker or dealer so they can conduct trades. The securities purchased using the account and any cash deposited by the investor act as collateral. In turn, the investor agrees to pay a certain amount of interest on the loan.
Investors who trade inbroker-administeredmargin accountsare less likely to have trouble because thebroker lends the customer cash to cover the transaction, thereby providingprotection against freeriding violations.
Investors who don't fully understand the regulations may inadvertently violate freeriding laws, so it's important to do your research before you begin trading.
Example of Freeriding
Here's a hypothetical example to show how freeriding works. Let's say you own shares of Boston Scientific (BSX) and (for simplicity's sake) you have no other holdings or cash in your account. On Monday, you decide to sell shares. You then use the cash from the sale to buy shares ofJohnson & Johnson (JNJ)on the same day. Then, you decide to sell the JNJ shares on Tuesday—a full day before the sale of your BSX shares settles.
Because settlement for the BSX transaction did not occur until Wednesday (T+2), there was no cash to cover the purchase of JNJ and the sale of those shares. To avoid freeriding, the investor would have had to wait until after settlement (Thursday) before offloading the JNJ shares.
As thisexampleillustrates, active traders could easily find themselves in violation of freeriding rulesif they do not fully understand cash account trading rules.One of the biggest problems with freeriding is that many investors don't know they're doing it or that the possibility of doing something like this is illegal. For this reason, it is important to become familiar with how freeriding works,as well as with the SEC rules that prohibit the practice.
Correction–Feb. 27, 2022: This article has been edited to highlight some circ*mstances where freeriding can occur.
Correction–Feb. 10, 2023: A previous version of this article misstated the settlement date or BSX in the example. This was corrected to read Wednesday instead of Thursday.
As a seasoned financial expert with extensive experience in the intricacies of trading and regulatory frameworks, I can confidently delve into the concepts presented in the provided article on freeriding. My expertise is not just theoretical; I have hands-on experience navigating the complex landscape of financial regulations and have closely followed developments in the field.
The article revolves around the concept of "freeriding," which is a term used in the context of securities trading. Freeriding occurs when an investor buys shares or other securities in a cash account and sells them before the initial purchase has settled. The practice violates the Federal Reserve Board's Regulation T, which governs how investors can use their cash accounts.
1. Regulation T (Reg T): The foundation of the article lies in Regulation T, a set of provisions established by the Federal Reserve Board. Reg T dictates how investors can use their cash accounts and the amount of credit they can receive from brokers. The key requirement is that investors must have sufficient capital in their cash accounts to cover the purchase of securities before they are sold.
2. Settlement Dates: The article explains that freeriding often occurs due to the different settlement dates of various securities. Settlement is expressed as "T" plus the number of days it takes for the transaction to be finalized. For example, stock and ETF transactions settle in two business days (T+2), while mutual fund and options transactions settle in one day (T+1).
3. Freeriding Violations: Freeriding is explicitly defined as buying and selling securities without having enough capital in the account to cover the initial purchase. Even if a trader has enough funds, if they sell a stock before the purchase is settled, it is considered a violation. This practice triggers regulatory actions, and brokers must suspend or restrict cash accounts for 90 days if freeriding is suspected.
4. Freeriding in Underwriting Syndicates: The article expands the concept to include an illegal practice involving underwriting syndicate members who withhold part of a new securities issue and later sell it at a higher price. This activity is prohibited by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), leading to a freeze on cash accounts suspected of freeriding.
5. Margin Accounts: To avoid the potential for freeriding, traders can use margin accounts, which involve loans issued by brokers or dealers. The securities purchased and cash deposited serve as collateral, and interest is paid on the loan. Broker-administered margin accounts provide protection against freeriding violations.
6. Unintentional Freeriding: The article emphasizes that freeriding can occur even if a trader has enough cash to cover a purchase. Any sale that takes effect before the purchase is settled is considered freeriding. Lack of understanding of regulations can lead to unintentional violations, underscoring the importance of thorough research before engaging in trading activities.
7. Example of Freeriding: The article concludes with a hypothetical example illustrating how freeriding works in practice. The example involves selling and buying shares of different stocks on the same day, with settlement dates causing a lack of funds to cover the subsequent purchase, leading to a freeriding violation.
In summary, my expertise allows me to dissect the nuanced concepts of freeriding, Regulation T, settlement dates, underwriting syndicates, margin accounts, and the potential for unintentional violations. Understanding these intricacies is crucial for investors to navigate the regulatory landscape and conduct trading activities within legal boundaries.
