Federal Calls: How It Works, Examples, and Management
BP
Summary:
Federal calls, mandated by Regulation T, are initial margin calls issued to investors when their margin account lacks sufficient equity for new purchases. This article explores the purpose, mechanics, and implications of federal calls in margin trading.
Compare Investment Advisors
Compare the services, fees, and features of the leading investment advisors. Find the best firm for your portfolio.
Understanding federal calls
A federal call, also known as a Regulation T (Reg T) call, is a critical component of margin trading governed by the Federal Reserve Board’s Regulation T. Essentially, it’s a demand for additional funds when an investor’s margin account lacks the necessary equity to fulfill the initial margin requirement for new purchases of securities.
Regulation T stipulates that brokers can lend investors up to 50% of the total purchase price of a stock for initial purchases, known as the initial margin. This means investors can essentially borrow half the purchase price from the broker, with the remaining half provided by their own funds or other equity in the account.
Example:
Imagine you want to buy 1,000 shares of a stock valued at $10 per share, totaling $10,000. With a margin account, you could acquire these shares for as little as $5,000, with the brokerage covering the remaining $5,000 through a margin loan. However, if you lack the necessary funds or equity to cover your share of the purchase price, you’ll receive a federal margin call from your broker.
Regulation T requirements
While Regulation T sets the minimum requirements, brokerage firms often have their own, more stringent requirements. For instance, a firm might require investors to provide 65% of the purchase price upfront, leaving only 35% to be covered by a margin loan.
If an investor fails to meet a federal call by depositing the required funds or securities, brokers have the right to force the sale of securities in the account to cover the margin deficiency.
Purpose of federal calls
The primary purpose of Regulation T and federal calls is to mitigate financial risk in the securities markets. By limiting the amount of leverage investors can use, regulators aim to prevent excessive speculation and maintain market stability.
Excessive use of margin can magnify both gains and losses, posing a systemic risk to the financial markets. Federal calls serve as a safeguard against this risk by ensuring investors have sufficient equity to support their trading activity.
Managing federal calls: comprehensive examples
Consider the following scenario to better understand how federal calls operate:
Example 1: buying on margin
John decides to buy 100 shares of XYZ Company at $50 per share, totaling $5,000. With a margin account, he only needs to put up $2,500 (50% of the purchase price) while borrowing the remaining $2,500 from his broker. However, if the value of the shares falls and John’s equity in the account drops below the initial margin requirement, he’ll receive a federal call from his broker demanding additional funds to restore the required margin.
Now, let’s examine a scenario where an investor fails to meet a federal call:
Example 2: failure to meet a federal call
Sarah receives a federal call from her broker after her margin account falls below the initial margin requirement due to a decline in the value of her securities. Despite the warning, Sarah fails to deposit the required funds or securities to satisfy the call. As a result, her broker liquidates some of her securities to cover the margin deficiency. Sarah not only incurs losses from the forced sale but also faces additional penalties, including account restrictions and potential revocation of margin privileges.
Strategies to avoid federal calls
Investors can employ various strategies to minimize the risk of receiving federal calls:
Asset allocation
Diversifying investments across different asset classes can help mitigate the impact of market fluctuations on a margin account. By spreading risk, investors can reduce the likelihood of their account falling below the initial margin requirement.
Risk management
Implementing risk management techniques, such as setting stop-loss orders and regularly monitoring account positions, can help investors identify and address potential margin deficiencies before they trigger federal calls.
Frequently asked questions
What triggers a federal call?
A federal call is triggered when an investor’s margin account lacks sufficient equity to meet the initial margin requirement for new purchases of securities.
How can investors satisfy a federal call?
Investors can satisfy a federal call by depositing cash equal to the call amount or by depositing marginable securities valued at least twice the call amount by the trade date plus four business days.
What are the consequences of not meeting a federal call?
Failure to meet a federal call can result in forced liquidation of securities, account restrictions, or revocation of margin privileges.
Can brokerage firms set their own margin requirements?
Yes, brokerage firms have the right to establish their own margin requirements, known as house requirements, as long as they are higher than the minimum requirements set by Regulation T.
Are investors notified before receiving a federal call?
While most brokers attempt to notify their customers of margin calls, they are not required to do so. Investors should closely monitor their margin accounts and address any deficiencies promptly to avoid potential consequences.
What risks are associated with margin trading?
Margin trading carries inherent risks, including the potential for losses exceeding the initial investment. Investors should carefully consider their risk tolerance and investment objectives before engaging in margin trading.
Key takeaways
- Federal calls, governed by Regulation T, are initial margin calls issued to investors for new purchases in margin accounts.
- Investors must maintain sufficient equity to meet the initial margin requirement or risk receiving a federal call from their broker.
- Failure to satisfy a federal call can result in forced liquidation of securities and other adverse consequences.
- Regulation T aims to moderate financial risk in the securities markets by limiting the use of leverage.
Share this post: