When you buy or sell shares of stock or other types of securities, you usually get immediate confirmation that your order has been completed and at what price. However, even though your newly purchased shares now show up in your brokerage account, the trade is not official. Market rules allow a few days -- called trade settlement -- for an investment transaction to become official.
Purpose of Trade Settlement
The time period granted for trade settlement allows both parties of the investment transaction to complete his side of the deal. The seller may need to bring stock certificates to his broker, and the buyer has time to bring money to her broker. In the modern world of electronic stock trading, both the stock shares and money usually are held already by the respective brokers, but even if this is the case, the trade becomes official after the number of days designated by trade settlement rules. On the last day of the settlement period, the buyer becomes the owner of record.
The settlement period for most types of securities is three days. The commonly used abbreviation is T+3 settlement. When you buy stock, the trade settles and you become the shareholder of record on the third business day following the trade date. Exchange-traded funds, corporate and municipal bonds and broker traded mutual funds all have T+3 settlement. Government bonds, listed options and mutual fund shares purchased directly from the fund sponsor settle the next business day, T+1. The settlement rules are set by the Securities and Exchange Commission. The SEC changed the settlement rule in 1995; prior to the change, securities settlement was T+5.
Effects of Settlement
Investors should understand what the three-day settlement period means. If you sell shares, the broker cannot send you the money until the three days after the trade. The money may show in your brokerage account, but you cannot withdraw it until the trade settles. If you are the buyer and the share price went down during the settlement period, not paying in the three days does not get you out of the trade. If you do not pay for the shares, the broker sells the shares and charges you for any losses and probably a penalty. Selling shares during the three-day period to profit without paying for the shares is prohibited and is called freeriding. Freeriding applies to cash brokerage accounts. If you want to trade more frequently, use a margin brokerage account.
Shareholder of Record and Dividends
When you buy shares, you are not the shareholder of record until settlement completes on the third business day. To receive a declared stock dividend, you must be a shareholder of record on the record date listed in the dividend declaration. Because stock trades take three days to settle, any investor who buys shares less than three days before a dividend record date does not receive the dividend. In stock market jargon, a stock goes "ex-dividend" two business days before the dividend record date.
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