Freeriding

What Is Freeriding?

The term freeriding refers to the practice of buying and selling shares or other securities in a cash account without having the money to cover the trade. When a trader freerides, they pay for the trade using money from the proceeds of the sale instead.

Freeriding is a violation of the Federal Reserve Board's Regulation T, resulting in a suspension of the trader's account. The term also refers to an illegal practice involving an underwriting syndicate member who withholds part of a new securities issue and later sells it at a higher price.

Understanding Freeriding

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

Let's say a trader buys shares in a company. It takes three days to settle. When they sell their shares, their account is almost always credited immediately with the proceeds. The trader can then use those proceeds to cover the original purchase when it settles. Basically, the trader sells the shares before they actually buy them.

This practice is illegal and is prohibited by the Securities & Exchange Commission (SEC) and the National Association of Securities Dealers. Brokers and dealers must freeze any cash account they suspect of freeriding for a 90-day period. When an account is restricted, a trader may still buy securities, but the purchase must be done using cash on the very same day rather than on the settlement date.

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

Special Considerations

You can use a margin account to avoid 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 using the account and any cash deposited by the investor act as collateral. In turn, the investor agrees to pay a certain amount of interest on the loan.

Investors who trade in broker-administered margin accounts are less likely to have trouble because the broker lends the customer cash to cover the transaction, thereby providing protection against freeriding violations.

Example of Freeriding

Say you decide to sell shares of Boston Scientific (BSX) on Monday. You then use the cash from the sale to buy shares of Johnson & Johnson (JNJ) on Tuesday. You sell those JNJ shares on Wednesday, a full day before your sale of BSX shares settles.

Because settlement for the BSX transaction did not occur 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 avoid freeriding, the investor would have had 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 do your research before you begin trading.

As this example illustrates, active traders could easily find themselves in violation of freeriding rules if they do not fully understand cash account trading rules. One of the biggest problems with freeriding is that many investors don't know they're doing it or that the possibility of doing something like this is illegal. For this reason, it is important to become familiar with how freeriding works, as well as with the SEC rules that prohibit the practice.