Free Riding Explained:
Broker 'Free Ride' Won't Die Easy
By Eric Gillin
Staff Reporter
02/28/2003 07:00 AM EST
A handful of brokerages are suddenly cracking down on the practice of "free-riding" stock in cash accounts, but the practice is so embedded on Wall Street that it might never be eradicated.
The term refers to buying stock using cash from a trade that hasn't cleared -- in other words, paying for stock with money you don't have. Regulations forbid it, because it typically takes three days for the actual settlement of a trade to occur. But for daytraders and institutional clients, instant money is a luxury they are unlikely to willingly surrender.
"Most brokers look the other way. I've definitely done it, mostly with more active accounts who you wouldn't think there would be a concern about," said one broker, who insisted on anonymity.
The prohibition against free-riding is contained in a Federal Reserve bylaw known as Reg T, adopted in an era when paper stock certificates had to be lined up with trades.
Enforcement of Reg T waned in the late 1990s, ahead of an industry initiative that would've made most trades clear the day they were executed. But that initiative, called T+1, was derailed by Sept. 11, and now Reg T is back in favor with regulators.
"Legally, you're supposed to wait for the trade to clear before using the proceeds to trade again," said Rich Repetto, analyst covering the online brokerage industry at Putnam Lovell.
According to the SEC, "Section 220.8 of Regulation T states that in a cash account, a brokerage may buy a security on your behalf -- or sell a security to you -- if either: (a) You have sufficient funds in the account to cover the transaction; or (b) The firm accepts in good faith your agreement to make a full cash payment for the security before you sell it." (To read the entire text of Reg T, click here.)
How does this work? Let's say you had a cash account and owned $10,000 worth of Microsoft stock. Ready to take your profits, you decide to sell the entire $10,000 and use the cash to buy $10,000 worth of Coca-Cola shares that day.
That's perfectly legal, but if you sell the Coca-Cola shares in the three days before the Microsoft trade clears, you could be breaking the law.
In a cash account, you'd need $10,000 in cash to cover the second trade; that, or a "good faith" agreement with your broker to deposit the $10,000 before the trade officially clears. That rule is either obscure or restrictive enough that many brokers simply look the other way and let clients slide when it comes to good faith; hence, the "free ride."
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