How Do I Explain the Settlement Period in Stock Trading?

Stock trades still settle in three days, although they don't need to.

Stock trades still settle in three days, although they don't need to.

When you buy or sell stock, your trade takes place instantly, but your settlement takes three days. The settlement period in stock trading is a vestige of a former time, when money and services moved much more slowly. Electronic networks now allow the instant transfer of money, but the settlement period has survived, a matter of convenience for brokers as well as traders.

Background

The Securities and Exchange Commission (SEC) sets the basic rules for stock trading. The SEC-mandated settlement period for stock trading is three business days, meaning days when the market is open. If your trade takes place on a Friday, then settlement happens on the following Wednesday. If you trade on Monday, settlement is on Thursday (assuming no holidays). At one time, when cash, checks and physical stock certificates moved by mail, a settlement period was necessary so that traders could make a purchase or sale quickly, but also needed a few days to get cash into their account, or stock certificates to the buyer.

Electronic Trading

In the digital age, the concept of the settlement date has survived, although for many traders it has no significance. Most online brokers, for example, insist that you fund your account before trading and have available cash to make any stock buys. For the most part, physical stock certificates are a thing of the past; most securities only exist as entries in a data-storage system, backed up by account statements. Therefore, no physical delivery takes place, and a stock you buy appears on your screen immediately.

Settlement Shorthand

Settlement periods vary, depending on the security involved. Brokers use "T+" as shorthand to show the settlement period. For stocks, settlement is T+3, meaning "transaction date plus three days." The standard period for mutual funds is T+1, as it is for U.S. Treasury bonds. Forex (foreign currency) transactions settle in T+2. Some brokers offer extended settlement under specific circumstances, such as a transaction with a foreign stock exchange.

Settlement Risk

The three-day settlement period is more than a convenience for institutional investors such as banks and mutual funds. The big traders continue to earn interest on their cash for every day they can keep it in their accounts. In return, both parties accept "settlement risk," or the chance of the other party not delivering on the trade. To guarantee against this, the Depository Trust and Clearing Corporation serves as a semi-official trade agent. The DTCC "clears" all stock trades by accepting and delivering cash for brokers and banks and keeping a record of all transactions in a digital system.

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