Purpose credit is credit that is provided to someone for use in securities trading. It is typically extended to clients by a broker although other purpose credit arrangements can be made. Without purpose credit, individuals who trade in securities would be limited to what they can afford at a given time and securities markets would be much more sluggish. Freeing up credit allows for rapid trading and the ability to take risks in order to access large rewards.
In a typical purpose credit arrangement, a client and a broker work out an agreement in which the broker agrees to extend a loan to a client for the purpose of trading in securities. The client must provide a security for the loan. This can take the form of cash on deposit in an account with the broker or it may be provided with other securities held in an account at the brokerage. The broker is assigned an interest in the assets used to secure the loan so that in the event the loan is not repaid, the broker has a method for recovering the debt.
The account that secures a client's purpose credit is known as a margin account. People are required to meet a maintenance requirement to have a margin account. According to this requirement, a set percentage of the total amount of the loan must be kept on deposit. If a client does not have enough money to meet the minimum maintenance requirement, the broker issues a margin call. Margin calls alert clients to the fact that their accounts are not in order and they need to sell stock or deposit more cash on account in order to be current again.
Regulators monitor purpose credit and other aspects of the securities trading industry. There are minimum requirements in place that must be followed by brokers and other representatives. If these requirements are not met, regulators can intervene. A brokerage may be fined or subjected to other penalties for failing to comply with financial regulations and putting clients at risk.
People interested in trading securities must be careful with purpose credit. There is a potential to make a lot of money by buying the right stock at the right time. Conversely, it is possible to experience a significant loss by making a poor buying choice. While brokers can provide advice and guidance if they are asked to do so, they cannot prevent all mistakes. Taking on more purchase credit than can realistically be repaid can be a dangerous decision.