Chapter 16: Customer Accounts and Compliance Considerations
Cash Accounts: Understanding the Basics
Detailed Explanations
A cash account is a type of brokerage account in which the investor must pay the full amount for the securities purchased. This is opposed to a margin account, where the investor can borrow part of the purchase price from the broker. Operating a cash account is straightforward: you buy securities and make a payment for them in full by the settlement date.
Settlement Date: It refers to the date by which a transaction must be completed, with funds transferred to settle the purchase or sale. It’s usually two business days after the trade date (T+2).
Examples
Scenario 1: Buying Stocks in a Cash Account
Imagine you purchase 200 shares of a company stock priced at $10 per share. You must deposit $2,000 in the cash account by the settlement date.
Scenario 2: Fund Availability
Let’s say your cash account holds $5,000. You decide to buy shares worth $6,000. The purchase can’t be initiated unless you transfer more funds to make up the shortfall.
Visual Aid
Mermaid Flowchart of a Cash Transaction:
graph LR
A[Trade Initiated] --> B[Order Executed]
B --> C{Margin or Cash Account?}
C -->|Cash| D[Investor pays full price]
C -->|Margin| E[Loan to Investor]
D --> F[Stocks Transferred]
F --> G[Settlement Date]
Key Takeaways
- Cash accounts require the full payment of securities by the settlement date.
- These accounts entail less risk since trades are fully funded by the investor.
- Non-payment can result in a canceled trade and potential penalties.
Advantages of Cash Accounts
- Reduced Risk: Since you are not borrowing money, the risk associated with buying on margin is nil.
- Simplicity: With only your deposited cash, transaction simplicity ensures clarity.
- No Interest Payments: Avoid interest accrual associated with borrowed funds.
Disadvantages of Cash Accounts
- Limited Purchasing Power: You can only purchase securities to the extent of available cash.
- Potential for Missed Opportunities: You might miss lucrative opportunities if your funds are tied up.
Glossary
- Settlement: Process of transferring securities between buyer and seller.
- Cash Account: Brokerage account requiring upfront cash payment.
- T+2: Standard settlement cycle of trades on the second business day post-execution.
Additional Resources
- “Securities Industry Essentials Exam For Dummies with Online Practice” by Steven M. Rice.
- FINRA’s website for educational materials.
- Investopedia’s Cash Account guide.
Quizzes
### Which account requires you to pay in full for securities purchased?
- [x] Cash Account
- [ ] Margin Account
- [ ] Retirement Account
- [ ] Joint Account
> **Explanation:** A cash account requires full payment for any purchase of securities.
### What is a characteristic benefit of cash accounts?
- [x] Reduced Risk
- [ ] Unlimited Purchasing Power
- [x] No Interest Payments
- [ ] Inability to sell short
> **Explanation:** Cash accounts reduce financial risk as purchases are made with available funds, and there are no interest payments involved.
### On which day should the settlement be completed if a transaction occurs on Tuesday?
- [x] Thursday
- [ ] Wednesday
- [ ] Friday
- [ ] Monday
> **Explanation:** Under the T+2 rule, settlement occurs two business days after the trade, so a trade executed on Tuesday will settle on Thursday.
### In what type of account do investors potentially face interest accrual?
- [x] Margin Account
- [ ] Cash Account
- [ ] Silent Partner Account
- [ ] Trust Account
> **Explanation:** Margin accounts allow for borrowing against trades, leading to potential interest accrual.
### Which of the following describes an investor's action in a cash account?
- [x] Buying securities fully paid with cash
- [ ] Borrowing funds against securities
- [x] Avoiding additional borrowing risk
- [ ] Speculating with leverage
> **Explanation:** Investors buy securities with available cash and avoid the pitfalls of borrowing leverage within a cash account.
### What happens if payment for a security purchase isn't made by the settlement date?
- [x] Potential trade cancellation
- [ ] Increased interest rate
- [ ] Additional loan agreement
- [ ] Automatic account closure
> **Explanation:** Failing to settle by the designated settlement date might lead to the trade being canceled and other consequences.
### Why might an investor choose a cash account over a margin account?
- [x] To avoid the complexities of leverage
- [ ] To maximize borrowing potential
- [x] For straightforward funding with deposit
- [ ] To increase overall transaction risk
> **Explanation:** A cash account attracts investors wanting straightforward transactions without borrowing ties, leading to simpler processes.
### How does funding limitation impact cash accounts?
- [x] Limits speculative buying
- [ ] Enhances ability to leverage
- [ ] Decreases associated risks considerably
- [ ] Allows multiple outstanding loans
> **Explanation:** Defined deposit constraints ensure buying remains within available cash, limiting speculative activities in cash accounts.
### In what context might a cash account holder miss opportunities?
- [x] When funds are unavailable
- [ ] When leverage is required
- [ ] During exhaustive trading options
- [ ] Through increased risk tolerance
> **Explanation:** Cash account holders may miss transactions requiring more funds than available leftover balance.
### Can cash accounts be used for short selling?
- [ ] True
- [x] False
> **Explanation:** Cash accounts aren't utilized for short selling, as standard transactions in these accounts require outright purchases.