When trading stocks, settlement refers to the official transfer of securities from the buyer's account to the seller's account. And, while many investors, especially those who trade through an online brokerage, assume this happens instantaneously, the reality is that it takes a few days for the settlement process to occur.
The three-day settlement rule
The Securities and Exchange Commission (SEC) requires trades to be settled within a three-business day time period, also known as T+3. When you buy stocks, the brokerage firm must receive your payment no later than three business days after the trade is executed. Conversely, when you sell a stock, the shares must be delivered to your brokerage within three days after the sale. In other words, if you make a purchase trade on Monday, the shares would actually have to arrive in your account, and your money would have to arrive in the seller's account, on Thursday.
In addition to stocks, the T+3 rule also covers bonds, municipal securities, mutual funds (if traded through a broker), and several other securities transactions.
In practice, the three-day settlement rule is most important to investors who hold stocks in certificate form, and would have to physically produce their shares in the event of a sale. While the rule technically applies to stocks held in electronic form in a brokerage account, you'll rarely if ever run into a settlement issue with a completely electronic trade.
However, in cash accounts, the fact that it takes three days for trades to settle can affect your ability to sell a stock, buy another stock, and then sell that stock in a period of less than three days. In other words, it may create a problem if you attempt a selling transaction on a stock you own, but whose purchase hasn't settled yet.
Why it's important
There are a couple of reasons the three-day settlement rule is important.
First and foremost, the rule helps maintain an orderly and efficient market by limiting the possibility of defaults. In other words, if a trade has an unlimited amount of time to settle, or for the shares to be delivered to the buyer's account, there's no telling how much money the buyer or seller could gain or lose before the trade is formally settled. In a plunging market, long settlement times could result in investors unable to pay for their trades. By limiting the amount of time to settle, the risk of financial complications is minimized.
The three-day rule also has important implications for dividend investors. If you look at a stock quote through your brokerage, you may see that a certain company has declared a dividend payable to "shareholders of record" as of a certain date.
However, in order to be a shareholder of record, your purchase of that stock must be settled. In order to ensure that you are an official shareholder by this dividend date, known as the record date, you'll need to actually buy the shares at least three business days prior, before a date known as the "ex-dividend" date.
For example, a quick look shows that Microsoft declared a $0.36 dividend payable to shareholders of record as of May 19, 2016. However, in order to be entitled to the dividend, you would need to buy shares on or before May 16, 2016 -- three business days prior. The following day, May 17, is known as the ex-dividend date, because it's the first day shares will trade without that dividend attached.
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