Freeriding

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For other uses, see Freeride.

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Free ride is a term used in the stock-trading world to describe the practice of using an under-capitalized cash account to carry out what essentially amounts to margin buying. Since stock transactions usually settle after three business days, a crafty trader can buy a stock and sell it the following day (or the same day), without ever having sufficient funds in the account. Under U.S. and certain other regulatory systems, these types of trades are illegal.

1 Securities trading
2 Economics
3 External links

[edit] Securities trading

Freeriding's most common usage today in the brokerage world refers to a person who covers the cost of buying a security with the sale of the same security.

This is closely related to a Good Faith Violation which is not having enough cash funds in your account to cover a purchase.

[edit] Trade Day + 3 Days

In the United States, stocks take three days to settle. If you buy on Monday, you don't pay for the purchase until Thursday. This is known at trade day plus 3 days or T+3.

This three day settlement period is considered an extension of credit from the broker to the customer. Because the transaction is considered a credit issue, the Federal Reserve Board is responsible for the rule which is officially called Regulation T.

[edit] Federal Reserve Board- Regulation T

If a brokerage customer is approved for margin on the account there will be a line of credit to "cushion" the three day settlement period. This credit allows customers to trade while the cash settles. For accounts without margin (cash accounts), stock traders must have enough cash in the account to pay for any purchases the day they are due. A client in good faith agrees to make full payment of settled funds or deposit securities within the three day settlement period and not to sell before making such payment.

[edit] Freeriding Violation

The Securities and Exchange Commission states "In a cash account, you must pay for the purchase of a stock before you can sell it. If you buy and sell a stock before paying for it, you are freeriding, which violates the credit extension provisions of the Federal Reserve Board. If you freeride, your broker must freeze your account for 90 days."

If someone is trading rapidly and using all the cash available in the account to buy and sell, that person will likely get a "freeriding violation."

Freeriding results when you buy and sell the security before you have fully paid for it, and it is subject to a mandatory 90 day cash up front restriction. Clients can still trade, but they lose the ability to make purchases with unsettled sale proceeds.

An example of another violation is: If a customer has $0 in cash and no margin agreement with his broker, and buys $10,000 of ABC on Monday. On Tuesday morning the customer sells all $10,000 of ABC. The customer needs to get $10,000 in by Thursday or there will be no cash on settlement. Whether he gets the money in by settlement or not this is still a trading violation.

If the customer deposits the money by settlement this is considered to be a good faith violation. The main difference between a good faith violation and freeriding is the eventual deposit of funds to cover the buy. In freeriding the buyer sells the security with no deposit of the funds to pay for the initial purchase.

The Federal Reserve considers this a good faith violation an abuse of credit and requires the broker keep track of these violations and eventually restrict the account if the trader gets three violations in one year. This is compared to the freeriding violation which results in an automatic restriction.

A liquidation violation occurs when the client sells a security to satisfy a cash obligation for the purchase of a different security after trade date. This is a violation because the sell of the second security will not be settled by the time the first purchase settles. This has the same penalties as a good faith restriction. It can restrict an account but there is not the fed requirement to do so on the first violation.

[edit] Economics

In microeconomics, an agent is said to be freeriding when it does not pay for its share of the cost of producing a public good. This may or may not be a problem. See the free rider problem for further discussion.