How do settlements work in the US market?

How do settlements work in the US market?

Last updated: 29 Nov, 2021 | 02:45 pm

How do settlements work in the US market?

Settlement refers to official transfer of securities to the buyer's account and cash to the seller's account. For all stock trades, settlement occurs on T+2 days meaning two business days after the order execution day. For example, if you were to execute an order on Monday, it would typically settle on Wednesday.

Why is there a delay in actual settlement?

In the past, market transactions were done manually rather than electronically. Investors would wait for the delivery of the security in an actual certificate form, and payment happened upon receiving the certificate. Since delivery times could vary and prices always fluctuate, market regulators set a period of time in which securities and cash must be delivered. Some years ago, the settlement date for stocks was T+5 or five business days after the transaction date. Until recently, a settlement was set at T+3. Today, it's T+2 or two business days after the transaction date.

What are settled and unsettled funds: 

Funds are considered to become settled only after the settlement period (T+2) has ended. Only the cash you deposit or transfer into your brokerage account for trading and settled proceeds of fully paid shares qualify as 'settled funds.”

Funds are considered unsettled from the time you place a trade order until the completion of the settlement period. As stocks have a two-business-day settlement period (T+2), funds generated by selling stock are considered unsettled for the two-day period following the trade date, since the sale is not technically completed. A user can still use these unsettled funds for trade in good faith.

What are settlement violations?

Stock settlement violations occur when new trades to buy are not properly covered by settled funds. The major type of violation is “Good Faith Violation.”

Good Faith Violations (GFV) occurs when an investor buys a security and sells it before paying for the initial purchase in full with ‘settled funds’. Only cash or the sales proceeds of fully paid for securities qualify as 'settled funds.' 

Example 1

Wallet balance = $0.00

Kumar sold $10,000 worth of Google stock on Monday 8 pm IST. The funds from the sale are expected to settle on Wednesday, implying that he will get $10,000 proceeds on Wednesday. 

On Monday 10 pm IST, he buys Apple stock for $10,000. If Kumar sells Apple stock before  Wednesday (the settlement date of the Google sale), the transaction would be deemed a good faith violation. This is because he has sold the stock of Apple before the account had sufficient funds to fully pay for the purchase of Apple stock. 

Example 2 

  • Wallet balance = $10,000, all of which is settled
  • On Monday 9 pm IST, Harish buys $10,000 of Google stock
  • On Monday 11 pm IST, he sold this Google stock for $10,500. The funds from the sale are expected to settle on Wednesday.

At this point, Harish has not incurred any violation. However:

  • Near market close on Tuesday 1 am IST, Harish buys $10,500 of Tesla stock
  • On Tuesday 1.30 am IST, he sells this Tesla stock and incurs a good faith violation
  • This trade is a violation because Harish sold Tesla before Monday's sale of Google stock settled and those proceeds became available to pay for the purchase of Tesla stock

Consequences: If you incur 3 or more good faith violations in a 12-month period, the brokerage firm will restrict your account. This means you will only be able to buy stocks if you have sufficient settled cash in the account. This restriction will be effective for 90 calendar days.