What is Initial Margin?
Initial margin refers to the percentage of the purchase price of a security that must be deposited in cash or eligible collateral when buying securities on margin. It is essentially a good faith deposit needed to access the loan from a brokerage for the remaining value of the securities.
The Federal Reserve Board sets the minimum initial margin requirement under Regulation T at 50% for most exchange-traded securities. This means investors must put down at least 50% of the securities value in cash or collateral. Brokerages can set higher initial margin limits, however.
Initial margin provides security to brokerages and helps limit leverage used by investors. It is a key risk management tool in margin trading and short selling.
How Initial Margin Requirements Work
Initial margin works as follows:
- Investor buys $10,000 worth of stock in a margin account.
- Regulation T requires an initial margin of 50%.
- So the investor must deposit $5,000 initial margin in cash or eligible collateral.
- The brokerage lends the investor the other $5,000 on margin to complete the purchase.
- This provides the investor 2:1 leverage on the investment.
Without the initial margin deposit, the investor would have no skin in the game and less incentive to manage the investment prudently. The initial margin requirement caps the maximum leverage available to margin buyers.
Initial Margin vs. Maintenance Margin
Initial margin differs from maintenance margin requirements:
- Initial Margin – The percentage of the purchase price due upfront to first buy securities on margin. This is usually 50% under Reg T rules.
- Maintenance Margin – The minimum equity balance that must be retained in the margin account over time. This is 25% under Reg T.
Initial margin applies at the time of purchase. Maintenance margin is the ongoing collateral cushion needed to continue holding margined securities. Both help control risks.
What Happens if Initial Margin Isn’t Met?
If the equity in a margin account falls below the initial margin due to investment losses, the investor will receive a margin call from the brokerage. This requires depositing additional cash or securities to meet the initial margin.
If the margin call is not promptly met, the brokerage has the right to unilaterally liquidate assets in the account to satisfy the initial margin requirement. This protects the brokerage from excessive losses on the loan.
Meeting margin calls quickly is crucial to maintaining buying power and avoiding forced liquidations during market declines.
Initial Margin Requirements on Short Sales
Initial margin works similarly for short sales. For example:
- Investor shorts $10,000 worth of stock in a margin account.
- Initial margin requirement is 50%.
- So investor must deposit $5,000 initial margin.
- Brokerage lends and sells the stock, placing $10,000 proceeds into account.
- Investor can use $5,000 of proceeds, with $5,000 held as initial margin.
The initial margin protects the brokerage in case the stock price rises significantly before the position is closed out.
What Can Be Used as Initial Margin?
While cash is most commonly used to meet initial margin requirements, certain securities can also qualify as eligible collateral:
- Cash
- Stocks included in major indexes (S&P 500, Dow Jones, etc)
- ETFs
- Mutual funds
- U.S. Treasury bonds
- Other highly liquid securities
Using existing holdings as collateral allows buying on margin without needing to deposit additional cash funds.
How Brokerages Set Initial Margin Levels
Brokerages follow Regulation T but can institute higher initial margin requirements based on factors like:
- Volatility – Higher volatility assets like biotech stocks may have higher initial margin.
- Liquidation Value – Illiquid securities are riskier for brokerages and may need larger initial margin.
- Accounts – Larger or more active accounts may get lower initial margin requirements.
- Clients – Less creditworthy clients may be required to put more initial margin.
- Market Conditions – Initial margin levels may rise during periods of high volatility or falling prices.
Brokerages need to balance client opportunities with risk management when setting prudent initial margin levels.
Initial Margin Requirements in Futures Trading
In futures trading, exchanges like the CME Group determine initial margin levels based on:
- Volatility – Volatile futures like energies require higher initial margin.
- Liquidity – Active futures have lower levels than illiquid contracts.
- Price – High priced futures need higher initial margin than low priced ones.
- Time to Delivery – Shorter maturity futures carry less risk and lower initial margin.
Exchanges can adjust futures initial margin requirements frequently based on changing risk metrics.
Day Trading and Initial Margin Requirements
Due to their higher risks, day trading accounts often have special initial margin rules:
- Day trading accounts may face 25% initial margin rules under Reg T.
- Brokerages can raise day trading initial margin above the 25% minimum if desired.
- Day traders must exit positions by market close, so brokerages have less time to cover losses.
- The increased leverage risks require a higher cushion to protect brokerages.
Day traders need to maintain sufficient cash and collateral to stay above initial margin minimums as positions fluctuate intraday.
International Initial Margin Requirements
Initial margin requirements outside the U.S. are governed by different regulators:
- Europe – European Securities and Market Authority sets initial margin requirements.
- Canada – The Investment Industry Regulatory Organization of Canada (IIROC) regulates margin accounts.
- Asia – A range of national financial regulators oversee margin lending locally.
- Global Banks – Basel III recommendations help coordinate international bank margin rules.
While specific levels vary, the use of initial margin is a globally accepted risk control practice.
The Benefits of Initial Margin Requirements
Initial margin requirements offer several key benefits:
- Limit excess leverage and risk-taking in margin trading
- Protect brokerages by ensuring skin in the game for investors
- Maintain orderly and prudent securities markets
- Prevent overheated speculation and asset bubbles
- Guard against systemic risks from cascading margin calls
- Standardize margin account management across brokers
The risks posed by unrestrained margin buying make initial margin regulations a necessary investor protection.
The Drawbacks of Initial Margin Requirements
However, some drawbacks to initial margin rules also exist:
- Reduces leverage available for investing strategies
- Can excessively restrict speculative trading
- May worsen market panic during massive sell-offs
- Contributes to collateral buildup at central clearinghouses
- Can incentivize regulatory arbitrage to obtain higher leverage
- Compliance costs incurred by brokerages get passed to clients
Regulators must balance providing adequate leverage access while controlling systemic risks.
Frequently Asked Questions
Q: Why do initial margin requirements exist?
A: Initial margin requirements are designed to limit the risks and leverage used in margin buying. They protect brokerages and the financial system from excessive speculation.
Q: How is initial margin different than maintenance margin?
A: Initial margin is the percentage required upfront when first buying securities on margin. Maintenance is the minimum equity balance needed to continue holding margined securities.
Q: What happens if initial margin requirements are not met?
A: Falling below the initial margin requirement triggers a margin call from the brokerage. This requires swiftly depositing more cash or collateral. If not met, positions face liquidation.
Q: Who determines stock initial margin levels?
A: The Federal Reserve Board sets the baseline 50% initial margin requirement. But brokerages can institute higher requirements based on account types and risk factors.
Q: What securities can be used to meet initial margin requirements?
A: Cash, stocks, ETFs, mutual funds, index funds, Treasuries and other liquid securities are eligible for meeting initial margin requirements.
Q: Do day trading accounts have special initial margin rules?
A: Yes, due to higher risks initial margin can be set at 25% for day trading accounts. Brokerages may also opt for higher requirements.
Q: Are there initial margin regulations outside the United States?
A: Yes, regulators in Europe, Canada, Asia and at global bodies like the Bank for International Settlements prescribe initial margin rules tailored for their jurisdictions.
Q: Does higher initial margin reduce potential investment returns?
A: Yes, higher initial margin limits leverage which can restrict profit potential. But it also protects against losses from excess leverage, so reduces risk-adjusted returns less.
Q: Can brokerages change initial margin levels over time?
A: Yes, brokers can adjust initial margin levels higher based on market volatility, account types, and other risk factors as they deem necessary.
In another related article, A Comprehensive Guide to Mark to Market Accounting
