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Regulation T is a legal restriction on stock trading in the United States. It applies to investors who buy on margin, meaning they borrow money from their broker to buy stocks. Regulation T means investors must put in money matching or exceeding the money they borrow.
Buying on margin involves investing more than the amount of cash you actually hand over up front. It can apply to a variety of investments styles, but in relation to Regulation T, usually simply involves borrowing money from the broker to buy stocks or other securities. This increases the potential return of the investment, but also increases potential losses.
There is a legal restriction known as the minimum margin requirement. This details the proportion of the total investment at any particular time that must be covered by the investor's own cash. If the security the investment is in falls in value, the broker makes a margin call, meaning the investor will need to give more money to the broker to restore the proportion. In most cases, this process is guaranteed by the investor using other securities he owns as collateral. If the investor needs to give more cash to the broker, these other securities are automatically sold.
Historically, the minimum margin requirement was very high, which proved problematic. This is because if stock prices fell, more investors needed to give extra cash to their brokers to maintain the margin requirement. This often involved selling off other securities. The increase in sell-offs drove stock market prices down further, which in turn meant even more investors had to give extra cash to their brokers, creating a vicious circle. This pattern has been cited as a significant factor in the 1929 stock market crash.
Since that time, minimum margin requirements have been much lower. Regulation T is the law that gives the Federal Reserve the power to set the minimum margin requirements. In 1974, the level was set at 50%, meaning that anyone buying on margin must give at least half the investment's value to the broker at the start, with the amount provided as a loan by the broker restricted to half the investment's value.
It is important to remember that Regulation T is only a legal limit. A broker may impose tighter margin requirements to give themselves greater protection. These requirements will usually vary, depending on the trading history and reliability of the investor.
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