Cash Accounts

There are two basic types of securities accounts that a customer can open. One is a cash account. The other is a margin account. At one time, a cash account was the most frequently used type of securities account. However, because of the use of money market accounts, wrap accounts and general margin accounts, the margin account has probably lapsed the cash account as the most widely used type of brokerage account. Notwithstanding this fact, we have decided to provide general educational information concerning the cash account, how it works and some of the rules to which it is subject to. However, please keep in mind that this post is not designed to be complete in all material respects. Thus, it should not be relied upon as providing legal or investment advice. If you have any questions concerning its content, please contact a qualified professional.

Before talking about cash accounts, we want to remind you that we have provided information in other sections of this site concerning margin accounts.

A cash account is a type of brokerage account in which the investor must pay the full amount for securities purchased. An investor using a cash account is not allowed to borrow funds from his or her broker-dealer in order to pay for transactions in the account (trading on margin). The credit extension provisions of the Federal Reserve Board’s Regulation T govern an investor’s use of a cash account to purchase securities. In particular, Regulation T authorizes a broker-dealer to use a cash account to purchase a security for an investor if: There are “sufficient funds” in the account; or the broker-dealer accepts in good faith the investor’s agreement that the investor will promptly make “full cash payment” for the security before selling it and does not contemplate selling the security prior to making such payment.

Some examples of trading that would be permitted in a cash account include:

A. An investor has $10,000 in cash and no securities in a cash account. The investor buys $10,000 worth of ABC stock on Monday and sells it the same day. These transactions are permissible since the investor purchased the ABC stock on Monday with the $10,000 in cash that the investor had in the cash account. Since the investor purchased the ABC stock with cash, the investor may sell this stock at anytime.

B. An investor holds $10,000 of fully paid for and settled ABC stock in a cash account. The investor does not hold any additional cash or securities in the cash account. The investor sells all the ABC stock on Monday. On Friday, the investor buys $10,000 worth of XYZ stock.

These transactions are permissible because an investor can sell a fully-paid for and settled security held in a cash account. The $10,000 proceeds from the sale of the ABC stock would have settled on Thursday. Therefore the investor would have “sufficient funds” in the cash account on Friday to purchase the XYZ stock.

As noted above, in a cash account, an investor must pay for the purchase of a security before selling it. If an investor buys and sells a security before paying for it, the investor is “freeriding.”

The following example illustrates “freeriding:”

An investor holds $10,000 of fully paid for and settled ABC stock in a cash account. The investor does not hold any additional cash or securities in the cash account. The investor sells all the ABC stock on Monday and buys $10,000 worth of XYZ stock on the same day. On Tuesday, the investor sells all of the XYZ stock without adding any additional cash to the account. The settlement date on the sale of the ABC stock that the investor used to pay for the purchase of the XYZ stock would be Thursday (three business days after the date of the sale). Since the investor used the proceeds from a sale of securities that has not settled yet, to purchase the XYZ stock, the investor cannot not sell the XYZ stock prior to Thursday without adding additional cash to the account to cover the purchase price of the XYZ stock. Since the investor sold the XYZ stock on Tuesday without adding any additional cash to the account, the investor’s actions constitute free riding.

“Free riding” is not permitted under Regulation T, and requires the investor’s broker to “freeze” the investor’s account for 90 days. During this 90-day period, an investor may still purchase securities with the cash account, but the investor must fully pay for any purchase on the date of the trade. An investor may avoid having a “freeze” placed on his cash account by fully paying for the securities by the settlement date with funds that do not come from the sale of the securities.

In a cash account, an investor must pay for the purchase of a security before selling it. If an investor buys and sells a security before paying for it, the investor is “free riding” which is not permitted under the Federal Reserve Board’s Regulation T and may require the investor’s broker to “freeze” the investor’s cash account for 90 days. During this 90-day period, an investor may still purchase securities with the cash account, but the investor must fully pay for any purchase on the date of the trade.

Please keep in mind that the above information is being provided for informational purposes only. It is not designed to be complete in all material respects. Thus, it should not be relied upon as legal or investment advice. If you have any questions concerning the contents of this article, you should contact a qualified professional.

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