What is a 'Settlement Period'

A settlement period is the period of time between the settlement date and the transaction date that is allotted to the parties of a transaction to satisfy the transaction's obligations. The buyer must make payment within the settlement period, while the seller must deliver the purchased security within this period. For certificates of deposit and commercial paper, the transaction must be settled on the same day; for U.S. treasuries, it is the next day (T+1). Forex transactions are settled two days after (T+2).

BREAKING DOWN 'Settlement Period'

The Securities and Exchange Commission (SEC) sets securities’ settlement periods. For example, with the three-day settlement period, a stock trade occurring on Friday is settled on Wednesday, as long as no holidays occur during that time. Otherwise it takes an additional day, due to the markets being closed on weekends and holidays. The three-day settlement period for stocks was established when cash, checks and physical stock certificates were exchanged through the postal system. Adequate time was needed for traders to efficiently buy or sell the stocks and send money to their accounts or stock certificates to the purchasers.

Although money is now instantly transferred electronically, the settlement period remains in place as a convenience for traders and brokers. However, most online brokers require traders to have enough funds in their accounts before buying stock. Also, most physical stock certificates no longer exist; securities are typically traded electronically and are backed up by account statements.

Settlement Risk

Traders and institutional investors face settlement risk if either party does not perform its part in a transaction. Traders want their securities paid and recorded efficiently as a means of gaining profits more quickly. Institutional investors such as banks and mutual funds want to hold onto their cash as long as possible and earn more interest for increasing their profits. The Depository Trust and Clearing Corporation (DTCC) protects both parties from settlement risk by having a subsidiary, the National Securities Clearing Corporation (NSCC), clear stock trades, accept and deliver banks’ or brokers’ cash and digitally record trades. The NSCC sends traders and institutional investors automated reports detailing the quantity of shares, price and type of security, confirming that transactions are in the process of settlement.

Reducing the Settlement Period

The Securities Industry and Financial Markets Association (SIFMA), along with other individuals and financial groups, supports shortening the settlement cycle for U.S. equities and corporate and municipal bonds. Rather than having the settlement period remain as trade date plus three days, SIFMA would like it to be trade date plus two days beginning in the third quarter of 2017. Shortening the settlement period would most likely decrease settlement risk, reduce clearing capital requirements, decrease margin and liquidity demands and increase ease of settlement worldwide.

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