|This article does not cite any sources. (September 2007)|
Free riding (also known as Freeriding or Free-riding) is a term used in stock-trading to describe the practice of buying and selling shares or other securities without actually having the capital to cover the trade. In a cash account, a free riding violation occurs when the investor sells a stock that was purchased with unsettled funds.
The Federal Reserve Board's Regulation T requires brokers to "freeze" accounts that commit freeriding violations for 90 days. Accounts with this restriction can still trade but cannot purchase stocks with unsettled sale proceeds (stocks take three days to settle).
Freeriding can be avoided by using a margin account.
Trade Day + 3 Days
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.
Free Riding 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 free riding, which violates the credit extension provisions of the Federal Reserve Board. If you free ride, 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.
S.E.C. Enforcement Actions
Apart from credit rule violations inherent in free riding, the more significant and direct harm can come when the customer never pays or deposits to cover the trade, leaving the broker to hold the bag (if the trade was a success, the broker nets the trades, but if it was not, the customer should deposit the difference). The Securities and Exchange Commission has brought successful civil injunctive enforcement actions against free riders, with follow-on criminal prosecutions by the U.S. Attorney in New York, where significant prison sentences were imposed, for both credit and antifraud violations where it was clear that the customer never intended to cover the trade and was only using a succession of brokers to play the market, hoping for success, and causing serious losses to brokers. See SEC v. Schlomo Teitelbaum, SEC News Digest http://www.sec.gov/news/digest/1981/dig061181.pdf (civil injunctive action, injunction granted) and http://www.sec.gov/news/digest/1981/dig012381.pdf (criminal prosecution, concurrent 18 months sentence).
Good Faith and Free Riding
The main difference between a good faith violation and free riding is the eventual deposit of funds to cover the buy. In free riding 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 free riding violation which results in an automatic restriction.
Liquidation and Free Riding
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.
In microeconomics, an agent is said to be free riding when it does not pay for its share of the cost of producing a public good. This may be a problem. See the free rider problem for further discussion.