On December 12, 2006, the Securities and Exchange Commission (SEC) approved a new method of calculating margin requirements for brokerage accounts. New portfolio margining rules, which are scheduled to take effect on April 2, 2007, will provide broker-dealers with greater flexibility in setting requirements.

Portfolio margining, which has been available in Europe for some time, allows a broker to group into one portfolio all of a customer's investments that are tied to a single index or company--for example, an individual stock such as GE, or the S&P 500 Index--and set a collective margin requirement based on the potential gain or loss for that portfolio of securities.

By permitting portfolio margin requirements to be applied across multiple types of assets and tying initial margin requirements to a security's historical price performance, the new rules should make trading on margin more accessible to a broader range of investors. Individual firms will determine whether they choose to offer portfolio margining and which of their clients will be eligible. Programs must be approved by the SEC.

Note: The new portfolio margining rules relax requirements that have been in place for decades. Existing rules base initial margin requirements on set percentages for specific types of securities or strategies. For example, to buy stocks on margin, an investor would have to deposit 50% of the value of that stock in the margin account. These percentages do not take into account whether the risk of one type of investment helps offset the risk of a related security.

Here are some highlights of the new regulations:

A wide range of securities will qualify for portfolio margining

The new rules permit brokers setting margin requirements to take into account equities, listed equity and narrow-based index options, futures contracts and other derivatives that could help offset the risks of an individual investment. The rules represent an expansion of a pilot program that covered only securities and futures based on broad U.S.-based indexes such as the S&P 500.

Margin requirements can be tied to the volatility of a portfolio of related securities

Rather than setting a fixed percentage--for example, having a 50% initial and 25% maintenance margin requirement for each individual security--brokers will be able to set minimum margins based on computer simulations of the potential net gain or loss of a portfolio of related securities. Under most circumstances, the greatest projected net loss will be the margin requirement for that portfolio (however, there is an alternative calculation if that amount is negligible). Under portfolio margining rules, a portfolio of volatile stocks and their derivatives may have a higher margin requirement than a portfolio of more stable securities.

Margin requirements may be lower

The new regulations potentially reduce the amount of securities or cash that clients must keep in a portfolio margin account. By allowing brokers to recognize whether a position is hedged and match margin requirements to its net level of risk, the new rules adopt so-called "risk-based" margining techniques.

Example: An investor might buy a large position in XYZ Corporation. At the same time, the investor might also write several call options on the stock, hoping that the premiums earned from those options will help offset any loss if the stock drops in value. Under the new rules, the broker would be allowed to group all of those investments into a portfolio and calculate margin requirements based on the portfolio's computer-simulated potential net gain or loss.

Margin requirements for various portfolios would be added together to produce an overall requirement for the portfolio margin account. The portfolio margin account can be part of the investor's regular margin account, and any excess securities or cash in the regular account can be used as collateral to meet the portfolio margin requirements without having to be transferred into the portfolio account.

Other changes

The rules also:

• Eliminate the $5 million minimum account threshold required by the Chicago Board of Options Exchange's pilot program.
• Allow an investor to remedy a portfolio margin deficiency within three business days rather than one.
• Prevent portfolios with less than $5 million from including unlisted derivatives as part of a portfolio margin requirement. Also, daytrading in a portfolio margin account of that size is permitted only if the position daytraded is part of a hedging strategy.

Why the new rules?

These changes have been advocated by hedge funds, which often use derivatives to try to manage risk. They represent an expansion of a pilot program proposed by the Chicago Board Options Exchange (CBOE) and the New York Stock Exchange (NYSE), which must approve broker-dealer policies for portfolio margining.

According to the SEC order, widespread implementation of portfolio margining programs by broker-dealers may help reduce excessive margin calls, manage volatility, and permit more financial products to be traded as part of a portfolio margin account. For additional information, see SEC Release No. 34-54919, and SEC Release No. 34-54918.