Freeriding is a term used in the stock-trading world to describe the practice of buying shares or other securities without actually having the capital to cover the trade. This is possible when recently bought or sold shares are unsettled, and therefore have not been paid for. 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.
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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. 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.
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 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.
Good Faith and Freeriding
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 without ever depositing the funds to pay for the initial purchase. The Federal Reserve considers a good faith violation an "abuse of credit" and requires the broker keep track of them. If the trader gets three violations in one year, the broker is required to restrict the account. This is compared to the freeriding violation which results in an automatic restriction.
Liquidation and Freeriding
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 sale of the second security will not be settled by the time the first purchase settles. A liquidation violation carries the same penalties as a good faith violation.
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.
External links
- What is a Free Ride?: How Free Rides can affect your Individual Retirement Account.
