Legal Definitions - margin requirement

A margin requirement refers to the percentage of the total purchase price that an investor must pay in cash when buying securities (like stocks or bonds) using borrowed money from their broker. This practice is known as buying "on margin." The remaining portion of the purchase price is borrowed from the broker. The Federal Reserve Board sets and adjusts these requirements to help manage the amount of credit used for investing and to prevent excessive speculation in the financial markets.

There are two primary types of margin requirements:

• Initial Margin Requirement: This is the minimum percentage of the total purchase price an investor must deposit with their broker at the time of the initial purchase. For instance, if the initial margin requirement is 50%, an investor buying $10,000 worth of stock must pay at least $5,000 in cash, borrowing the remaining $5,000.
• Maintenance Margin Requirement: This is the minimum percentage of equity (the investor's actual ownership stake) that an investor must maintain in their margin account after the initial purchase. If the value of the securities in the account falls and the investor's equity drops below this percentage, the broker will issue a "margin call," requiring the investor to deposit more funds or sell some securities to bring the account back up to the maintenance margin level.

Here are some examples illustrating how margin requirements work:

• Example 1: Initial Investment on Margin

  Imagine an investor named Alex wants to purchase shares of a promising new technology company. The total value of the shares Alex wishes to buy is $30,000. If the current initial margin requirement set by the Federal Reserve is 50%, Alex must deposit at least $15,000 (50% of $30,000) of his own money with his brokerage firm. The remaining $15,000 is borrowed from the broker. This example demonstrates how the initial margin requirement dictates the upfront cash payment an investor needs to make when using borrowed funds to purchase securities.

• Example 2: Market Volatility and a Margin Call

  Consider Maria, who bought $40,000 worth of a pharmaceutical company's stock on margin, initially paying the 50% initial margin requirement ($20,000). Her broker's maintenance margin requirement is 35%. A few months later, unexpected negative news causes the stock price to drop sharply, and the total value of Maria's shares falls to $28,000. At this point, Maria's equity in the account is $28,000 (current value) - $20,000 (amount borrowed) = $8,000. As a percentage of the current account value, her equity is $8,000 / $28,000 = approximately 28.57%. Since 28.57% is below the 35% maintenance margin requirement, Maria's broker will issue a margin call, demanding she deposit additional funds to raise her equity percentage back above the 35% threshold.

• Example 3: Regulatory Intervention to Cool the Market

  During a period of rapid economic growth, the Federal Reserve observes that many investors are extensively using borrowed money to buy stocks, leading to what appears to be an overheated stock market with potential for instability. To mitigate this risk and prevent excessive speculation, the Federal Reserve might decide to increase the initial margin requirement for all new margin purchases from, say, 50% to 60%. This regulatory adjustment means investors would need to contribute a larger portion of their own cash for new margin trades, thereby making it more expensive to borrow and potentially slowing down the rate of credit-fueled stock buying across the market.