Freeriding: Definition, How It Works, Legality, and Example

What Is Freeriding?

Freeriding is the practice of buying shares or other securities in a cash account and selling them before the purchase has settled. Traders who freeride pay for the shares using money from the proceeds of the sale, violating the Federal Reserve Board’s Regulation T, which can lead to the suspension of their account.

Key Takeaways

• Freeriding involves buying and selling shares before the purchase is settled.
• It violates Regulation T, which governs the use of cash accounts.
• Investors must have enough capital in their cash accounts to cover the purchase before selling the securities.
• Brokers and dealers may suspend or restrict cash accounts for 90 days if freeriding is suspected.
• Freeriding can occur even if the trader has enough money to pay for the trade.

Understanding Freeriding

Regulation T (Reg T) governs how cash accounts are used in trading and the amount of credit that brokers and dealers can provide. One regulation under Reg T requires investors to have sufficient capital in their cash accounts to buy securities before selling them.

Freeriding commonly occurs when a trader buys and sells securities without enough capital in their account to cover the purchase. This is possible because different types of securities have varying settlement dates after a transaction. For example:

• Stock and ETF transactions settle in two business days (T+2).
• Mutual fund and options transactions settle in one day (T+1).

For instance, a trader purchases shares in a company, and the sale settles two days later. When they sell the shares, the proceeds are immediately credited to their account. The trader can use these proceeds to cover the original purchase when it settles, effectively selling the shares before buying them.

Freeriding can also refer to an illegal practice in which an underwriting syndicate member withholds part of a new securities issue and later sells it at a higher price.

This practice is illegal and prohibited by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Brokers and dealers must freeze cash accounts suspected of freeriding for 90 days. During the restriction, traders can still buy securities but must use cash on the same day instead of the settlement date.

Traders can unintentionally commit freeriding if they buy securities with proceeds from an unsettled sale. For example, a trader sells $100 of a stock and uses the proceeds to buy another stock the following day. Since stock trades take two business days to settle, the trader would be freeriding because the first sale would not be finalized until an additional business day. Under federal regulations, their cash account should be restricted for 90 days.

As mentioned earlier, investment bankers and broker-dealers who are underwriting syndicate members may also violate freeriding regulations by reserving shares from an initial public offering (IPO) to sell at a higher price later.

Special Considerations

You can commit freeriding even if you have enough cash to pay for a purchase. Freeriding applies to any sale that occurs before the purchase is settled, regardless of whether the trader has sufficient funds on hand.

To avoid freeriding, traders can use a margin account. A margin account is a loan granted by a broker or dealer to an investor to conduct trades. The securities purchased and any cash deposited by the investor act as collateral, and the investor agrees to pay interest on the loan.

Investors trading in broker-administered margin accounts are less likely to violate freeriding rules because the broker provides cash to cover the transaction, offering protection against freeriding violations.

It’s crucial for investors to research and understand the regulations to avoid inadvertently violating freeriding laws before they start trading.

Example of Freeriding

Here’s a hypothetical example to illustrate how freeriding works. Suppose you own shares of Boston Scientific (BSX) and have no other holdings or cash in your account. On Monday, you decide to sell the shares and use the cash from the sale to buy shares of Johnson & Johnson (JNJ) on the same day. Then, on Tuesday, you decide to sell the JNJ shares— a day before the settlement of your BSX shares.

Because the settlement for the BSX transaction does not occur until Wednesday (T+2), there is no cash to cover the purchase of JNJ shares and the subsequent sale. To avoid freeriding, the investor would have had to wait until after settlement (Thursday) to sell the JNJ shares.

This example highlights how active traders can unintentionally violate freeriding rules if they lack a full understanding of cash account trading rules. One significant challenge with freeriding is that many investors are unaware they are engaging in illegal activity. It is crucial to become familiar with how freeriding works and the SEC rules prohibiting it.