Trade settlement is the process of transferring securities into the account of a buyer and cash into the seller's account following a trade of stocks, bonds, futures or other financial assets. In the U.S., it normally takes three days for stocks to settle.
Trade and Settlement Dates
The date an order is filled is the trade date, whereas the security and cash are transferred on the settlement date. The three-day stock settlement period is represented by
which means the settlement date (S) is the trade date (T) plus three business days. For example, shares traded on Tuesday will settle on Friday. Bonds, mutual funds and other securities have different settlement periods. The settlement period provides the time necessary for clearing firms to ensure the orderly transfer of shares and cash to the proper accounts. During this time, the transfer agent of the company that issued the traded securities updates its records to reflect the change of ownership.
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The settlement date is important for deciding who receives a stock dividend. The dividend goes to the owners of the stock at the end of the dividend record date, which is set by the stock issuer, usually quarterly. Since stocks must settle in order for ownership to transfer, the settlement date for a trade must be no later than the dividend record date for the buyer to receive the dividend. Since it takes three days for the stock to settle, buyers who want the dividend must purchase the stock no later three days before the record date, when the stock is still selling "cum dividend," or with dividend. The next business day, which is two days before settlement (S-2), is the ex-dividend date, on which the stock trades without the dividend. Shares purchased on or after the ex-dividend date don't receive the current dividend, which is paid a week or two later, on the payment date.
Similar considerations apply to bonds that pay periodic interest.
Settlement date also is important for determining whether a trader is freeriding -- a violation of trading regulations in which a cash-account trader sells a security before buying it. A cash account doesn't have access to loans from the broker, as would be the case in a margin account. As an example of freeriding, suppose a trader owns $10,000 of settled XYZ stock in a cash account that contains no other securities or cash. On Monday, the trader sells the XYZ shares and buys UVW shares worth $9,000. So far so good, because both trades will settle on Thursday, so the proceeds from the sale will pay for the purchase. However, the trader sells the UVW shares on Tuesday without adding cash to the account. That's freeriding, because the investor sold shares two days before paying for them, on the settlement date. Freeriding can result in the broker freezing the trader's account for 90 days, during which time all purchases must be fully paid in cash on the trade date.