When you buy or sell securities, there's a settlement period before the transaction is finalized. The settlement period is the window of time between when the buyer pays for the security and when they actually take ownership. Currently, the settlement period for most securities is T+2, or "trade date plus two days," but in 2024, that will be shortened to T+1, or "trade plus two days." Let's unpack what all this means for you and your investments.
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What is a settlement period?
What is a settlement period?
A settlement period is the time between when you buy a security and when your brokerage firm receives your payment. Under the current T+2 rule, investors have two business days after executing a trade to settle the transaction.
Business Day
A business day is a unit of time that includes the operational hours of banks, financial markets, and government agencies. In the U.S., a business day is any weekday that is not a public holiday.
In other words, if you buy a stock on Monday, you have until the end of the day on Wednesday to deliver payment to your brokerage firm. Or if you sell a stock on Monday, you have until day's end on Wednesday to deliver the securities certificate.
T+2 applies to most securities, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds bought and sold through a brokerage firm. However, government securities and stock options settle in one business day after the trade.
When does T+1 take effect?
When does T+1 take effect?
In February 2023, the U.S. Securities and Exchange Commission (SEC) announced it would shorten the standard settlement period from two trading days (T+2) to one trading day (T+1). The T+1 rule is expected to take effect in May 2024. The SEC first proposed the rule in 2022 in response to the meme stock fiasco that unfolded in early 2021.
Retail investors banded together to buy shares of heavily shorted stocks like GameStop (GME 0.89%) and AMC (AMC -2.58%) and drive up their prices. When you short a stock, you're essentially borrowing shares and selling them with the goal of buying them back at a lower price, then returning them. But as retail investors caused share prices of struggling companies to soar, traders rushed to find shares to cover their positions. The extreme volatility put brokerages at risk of running out of funds; some brokerages, including Robinhood, temporarily halted trading of the shares in response.
The shortened settlement period is intended to reduce risks should a similar event occur. Reducing the settlement cycle helps lower the risk that a buyer will default by refusing to pay or that a seller will default by refusing to turn over their shares.
Reducing the settlement cycle could also lower margin costs. To offset the risk of default during extreme volatility, clearinghouses often require brokerages to hike margin deposits. That's why Robinhood had to pause trading of the heavily shorted shares on its platform.
Previously, the settlement period for most securities was T+3, or three business days. The SEC adopted the current T+2 rule in 2017.
CBOE Volatility Index (VIX)
The Chicago Board Options Exchange Volatility Index, or VIX, is an index that gauges the volatility investors expect in the stock market.
What if you violate the settlement rules?
What if you violate the settlement rules?
A settlement violation occurs when there are insufficient funds to cover a securities purchase. The SEC has three levels of settlement violations:
- Good faith violation. You buy a stock with unsettled funds, then sell it before the funds have settled. If you incur three violations within a 12-month period, your brokerage firm may restrict your account so that you can only make trades with settled funds for 90 days.
- Freeriding violation: You buy a stock with unsettled funds, then sell it to cover the cost of your purchase. For instance, if you bought $1,000 worth of Company XYZ on a Monday, under the T+2 rule, you'd have until Wednesday to sell. A freeriding violation occurs if you sell your Company XYZ shares for $1,100 on Thursday and use that money to cover the purchase. A single violation can result in your account being restricted to trading with settled funds for 90 days.
- Cash liquidation violation: You buy a stock, then cover the purchase by selling another security afterward. The violation occurs because you don't have settled funds to cover the cost by the settlement date. Three violations in a 12-month period will result in your brokerage restricting your account to using settled funds for 90 days.
Failing to settle a transaction by the settlement date can also result in your account being frozen, interest and penalty charges, forced liquidation of assets, and legal action.
Example of a settlement period
Example of a settlement period
Suppose you buy $10,000 worth of Company ABC shares on a Wednesday. You'd have until the end of Friday to deposit enough funds to cover the purchase under the T+2 rules. But that window will shrink to one day when T+1 takes effect in 2024, meaning you'd have to settle it by Thursday. If you're the seller in this transaction, you'd have until Friday to deliver the stock certificate under T+2, or Thursday under T+1.
But let's say on Thursday, you sell shares of Company XYZ for $11,000. The ABC transaction remains unsettled by Friday. But the funds from the XYZ sale won't settle until Monday. Because you didn't have settled funds to cover the purchase -- even though the XYZ sale will cover the cost -- you've committed a cash liquidation violation.
Robin Hartill, CFP® has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
