For daytraders, the free ride is over.
Over the last year, the National Association of Securities Dealers has started cracking down on Regulation T, the rule governing how quickly brokers make the proceeds of stock sales available to clients in cash accounts. During the daytrading boom, online brokerages would bend the rules through a practice called "free-riding," letting trades in cash accounts settle on the same day they were made, and allowing more purchases with that money even though the actual cash didn't yet exist.
Now, the NASD has started looking closely at how brokers, both online and offline, clear their trades. As a result of the stepped-up enforcement of Reg T, investors with cash accounts must now generally wait three days to get the cash from their trades.
recently dropped the bomb on customers, saying they'll now have to wait until a trade has cleared before they can use the proceeds to buy more shares.
"We've implemented a number of mitigation efforts, including communicating with clients that this is an issue facing the entire industry," said Donna Kush, director of corporate communications at the company. "Clients do have options, including switching to a margin account or consolidating their cash accounts."
Reg T, which pertains mostly to cash accounts and not margin, is a vital cog in how stocks trade. By bending the rules and allowing the free ride, brokers run the risk of having the trading system seize up, especially if money were credited for shares that for one reason or another don't clear. If that happens on a wide-enough scale, as funds from one trade are used to fund other trades, disaster could (hypothetically) ensue.
"Free-riding can be kind of a ponzi scheme, where you don't really have the funds in the account to cover the trade," said Ned Bennett, co-founder and CEO of optionsXpress, an online brokerage. "That was never the purpose of a cash account. All firms get a certain amount of latitude, but if you flaunt Reg T, you're undermining what the whole system is built on. You're just setting yourself up for 1929 if you do that."
Given the speed and efficiencies of electronic markets, Reg T is something of a dinosaur, reflecting a time when middlemen, market-makers and paper shares had vastly more important roles. The regulating bodies realized this and set to work on a new standard, called T+1, which would allow trades to clear in just one day, rendering the current rule obsolete. The new system was supposed to go online sometime in 2002, but the whole project was derailed by the events of Sept. 11, 2001.
With T+1 clearing on the horizon, Bennett says, some brokerages played it fast and loose with Reg T, using free-riding to encourage trading volume, especially during the inflation of the dot-com bubble. But with the future of T+1 uncertain, it became urgent to remind the brokerage industry that the future hasn't arrived yet.
"The thing about bending the rules is that it was a little more understandable with T+1 around the corner," said Rachel Barnard, analyst at Morningstar. "There was a T+1 association, but all of that has just lost steam and it looks like its many years off. Now that it's not around the corner, it's unclear what the future is."
What's clear is that enforcement of Reg T is clearly an industrywide problem, and brokers have taken strides to ensure that active traders have margin accounts and rule benders are identified early on.
"We have people, as all brokers do, who break that rule. You run into it more in the online world, but our computer systems catch anyone who does it the first time and we put them on a restricted list," said Mike Hogan, chief administrative officer with HarrisDirect. "The bigger difference between us and Ameritrade and Datek is that we've always had people who do active trading in a margin account, where you don't have a problem."
Indeed, Ameritrade has been feeling the heat more than most after the company purchased Datek, a haven for daytraders. Back in August 2002, the NASD ordered iClearing, a subsidiary of Datek, to stop free-riding in its cash accounts. At the time, there were fears that the charges would lead the NASD to nullify Ameritrade's union with Datek. In the end, the NASD approved the merger, but made sure the combined companies would play by the rules from now on, something that Ameritrade told investors back in October 2002.
After merging, Ameritrade inherited Datek's problem and said it has taken strides to deal with the free-riding issue. When Ameritrade released earnings on Jan. 21, company management told investors in a conference call, "
We are evaluating, designing, testing and implementing processes and procedures and systems to address their restriction. We are also doing all that we possibly can to communicate and educate our clients as to what's going on."
Investors in a cash account who want to return to their day-trading ways should simply switch to a margin account to ensure that trades clear in a timely manner or make sure they have enough cash in their cash accounts to cover them. With T+1 no longer on the horizon, getting a free ride in a cash account will be impossible.