Freeriding

What Is Freeriding?

The term freeriding alludes to the practice of buying shares or other securities in a cash account and afterward selling them before the purchase has settled. At the point when a trader freerides, they might pay for the shares utilizing money from the proceeds of the sale instead of cash.

Freeriding is a violation of the Federal Reserve Board Regulation T and may result in a suspension of the trader's account. The term likewise alludes to an unlawful practice including an underwriting syndicate member who withholds part of another securities issue and later sells it at a higher price.

Understanding Freeriding

Regulation T (Reg T) is a series of provisions that oversee how investors can utilize 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 as a rule happens when a trader buys and sells a security without having sufficient capital in their account to cover the purchase. But how can that be? Different securities have different settlement dates following a transaction. This is communicated as T plus the number of days it takes to settle. For instance:

Stock and exchange-traded fund (ETF) transactions settle in two business days (T+2)
Mutual fund and options 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. At the point when they sell their shares, their account is almost consistently credited immediately with the proceeds. The trader can then utilize those proceeds to cover the original purchase when it settles. Essentially, the trader sells the shares before they actually buy them.

This practice is unlawful 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. At the point when an account is restricted, a trader might still buy securities, but the purchase must be finished utilizing cash on exactly the same day rather than on the settlement date.

Traders might be unintentionally guilty of freeriding assuming that they buy securities with the proceeds of a sale that has not been concluded. For instance, envision a trader who sells $100 of a stock and uses the proceeds to buy another stock the next day. Since stock trades take two business days after the sale to settle, that trader was freeriding, in light of the fact that the first sale could not have possibly concluded for an additional business day. Under federal regulatory rules, their cash account ought to be frozen for 90 days.

As mentioned above, investment bankers and broker-dealers who act as a underwriting syndicate may likewise be in violation of freeriding when they keep shares from a initial public offering (IPO) aside so they can sell them at a higher cost at a future date.

You can commit freeriding even on the off chance that you have sufficient cash to pay for a purchase. Under the law, freeriding depicts any sale that takes effect before the purchase is settled, whether or not the trader as of now has an adequate number of funds close by.

Special Considerations

You can utilize a margin account to keep away from 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 utilizing the account and any cash deposited by the investor act as collateral. Thusly, the investor consents to pay a certain amount of interest on the loan.

Investors who trade in broker-administered margin accounts are more averse to have trouble in light of the fact that the broker loans the customer cash to cover the transaction, thereby giving protection against freeriding violations.

Instance of Freeriding

Let's assume you choose to sell shares of Boston Scientific (BSX) on Monday. You then utilize the cash from the sale to buy shares of Johnson and Johnson (JNJ) on Tuesday. You sell those JNJ shares on Wednesday, a full day before your sale of BSX shares settles.

Since settlement for the BSX transaction didn't happen until Thursday (T+1), there was no cash to cover the purchase of JNJ on Tuesday and the sale of those shares on Wednesday. To keep away from freeriding, the investor would have needed to wait until settlement — Thursday — before offloading the JNJ shares.

Investors who don't fully understand the regulations may inadvertently violate freeriding laws, so it's important to investigate as needs be before you start trading.

As this model illustrates, active traders could without much of a stretch wind up in violation of freeriding rules on the off chance that they don't fully understand cash account trading rules. One of the biggest issues with freeriding is that numerous investors don't realize they're making it happen or that the possibility of following through with something like this is unlawful. Thus, it is important to get comfortable with how freeriding functions, as well likewise with the SEC rules that prohibit the practice.

Correction-Feb. 27, 2022. This article has been edited to highlight a few circumstances where freeriding can happen.

Highlights

Freeriding is a violation of Regulation T, which oversees how investors can utilize their cash accounts.
Freeriding is the practice of buying shares and afterward selling them before the purchase is fully settled.
A trader might commit freeriding even when they have sufficient money to pay for the trade on the off chance that they sell a stock before the purchase is settled.
Brokers and dealers must suspend or restrict cash accounts for 90 days in the event that a trader is suspected of freeriding.