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Trade settlements

Lesson in Course: Investing basics (advanced, 4min)

We sold an investment. How quickly does it happen?

Eureka!

What it's about: It still takes two days after the transaction date for a trade to settle despite the speed of technology.

Why it's important: Day-trading and making big portfolio-wide adjustments in one day risks running into violations.

Key takeaway: When selling investments to free up cash, plan to trade the week before so the trade settles in time.

Our investments need both a home and access to a marketplace. Brokerages offer both these services; however, circumstances arise when the connections between home and the marketplace get congested. Let's review the basics so we don't run into problems later on down the road.

Clearinghouse

A clearinghouse is a home for our investments. The clearinghouse's job is to handle the confirmation, settlement, and delivery of transactions. 

A clearinghouse does all of the verification work in a sale or purchase

Whenever a broker connects us to a buyer for our shares, the clearinghouse verifies the buyer (confirmation), collects the money from the buyer (settlement), and delivers the shares you sold to them (delivery). Clearinghouses operate in the background, with our clearing broker being the intermediary between us.

Confirmation happens at the marketplace, while settlement and delivery occur at home — cash needs to show up at our house, and the shares need to arrive at the buyer's house. Visually we can imagine buyers and sellers meeting at the market, returning home to get their shares and money, and delivering it to the other's houses. The delivery date is the settlement date.

 

T+2 Settlement date

Whenever we buy or sell a stock, bond, ETF, or mutual fund, we need to be mindful of the transaction date and the settlement date.

Settlement is the actual delivery of our stock or cash

T+2 settlement, the most popular, means that the trade settles two days after the transaction date. Put differently; it takes two days after the market transaction for the cash and securities to arrive at the respective houses. 

 

Congestion

Congestions arrises when we place buy and sell orders during the same day. The problem breaks down due to buying on credit. On the transaction date, we promise a seller that we will pay them with the cash that our buyers will deliver in 2 days. Typically this is ok if everyone is trustworthy. At times of high volatility, rapidly moving prices can cause certain people not to hold up their end of the bargain. This risk is called the counterparty risk.

An example of counterparty risk 

We agreed with a buyer to sell our shares for $50. An hour later, the same shares are now trading for $40. The buyer now has buyer's remorse so they decide not to show up with the cash.

Managing counterparty risk, brokerages will place certain limitations on our ability to purchase and sell securities. 

 

How this impacts us

Violations

Stock settlement violations occur when we make new purchases before we have money settled in our brokerage accounts. 

Understanding trade settlements helps us avoid violations

There are multiple violation types; however, today we will cover good faith violations. Good faith violations occur when we attempt to use unsettled proceeds to settle a purchase.

A good faith violation

We have 100 settled shares of XYZ stock, and sell them for $2,000. The proceeds from the sale will settle on day two (T+2); until then, we have "unsettled" proceeds. We then invest $1,000 of the unsettled proceeds in UVW stock. The next day (the day after trade date: T+1): we sell our UVW stock for $1,500, one day before the XYZ trade settles.

The violation:  We created proceeds in our account, but they won't be settled until day two (T+2). Because we sold our UVW stock prior to the settlement of the XYZ proceeds used to buy it, the sale of UVW results in a good faith violation.

Consequences: Most brokerages will warn us the first time we do it, and if it happens again, our trading will be restricted. Brokerages like Robinhood have implemented day-trading rules to prevent good faith violations.

Taking money out

If we need to withdraw money from our brokerage account to cover bills, we need to settle our trades before doing so. This means planning the sales at least two days before we start the withdrawal process.

Actionable ideas

You are at risk of running into violations if you day-trade or decide to make portfolio-wide adjustments in one day. Both of these actions are extremely risky and not a good idea if you're just starting out. 

When planning your cash needs, remember the T+2 settlement date every time you place a trade. You don't want to be waiting a couple of days for a trade to settle when you needed the cash yesterday.