Just a Little Faster

Trade settlement isn't something most investors think about, but it's important and has an interesting history. We tend to take for granted that which we don't see and the process of settling an investment transaction is one of these seemingly invisible things. It just happens. In the past the process has taken several days and sometimes weeks, but a recent change going into effect today is making the process just a little faster.

Hundreds of years ago in Europe, when an investor bought a stock they would have to wait up to two weeks to receive it and become a shareholder. Why so long? Well, that was how long it took to physically transfer the paper shares and money to settle the transaction using a courier. Just buying the shares is not enough. To become a shareholder the transaction also needs to be recorded by the company the shares are for and this used to require lots of manual effort and time.

If you were in London and wanted to buy shares of a company traded in Amsterdam, you could (and often would) do so. Imagine how long it took for a trip on horseback and then a boat ride to make the exchange. Even within London (and eventually New York), couriers would zip back and forth on horseback or carriage carrying payment and delivering shares. Consider not just the time and expense, but the risk involved. What if the courier was robbed, or the ship carrying him sunk?

Jump ahead to the modern era and this waiting, or settlement, period was eventually whittled down to five days. But still the process was very manual. As technology improved investors moved to digital shares from paper certificates in the 1970's, which helped transactions settle faster and more reliably. By 1995, the settlement period was reduced to three days thanks to the internet.

Today, market participants want to leverage technology to make the settlement process even more efficient and less risky. Because of this, trade settlement is now two business days instead of three. In industry jargon, we're now at T+2 instead of T+3, where "T" is the date of the buy or sell transaction and the "2" is the number of business days until settlement.

Why is this important? By having your purchase and sale transactions settle a little faster market liquidity is improved and so-called counter-party risk is reduced. Even though markets are digital and we don't have to worry about our courier being robbed in the dark of night on his way across town, there are benefits to a shorter settlement cycle.

When you buy a stock you're not technically a shareholder of record until the last day of the settlement period, or the settlement date. Say you bought a stock (or bond, ETF, or certain mutual funds) on a Tuesday. Your settlement date now would be Thursday when before the change it would have been Friday. You get to be a shareholder and earn a dividend, for example, a day earlier. Technology supports this, so why wait?

Your risk as a buyer is also reduced by this process being a little faster. While it's atypical for transactions to go awry, a shorter settlement period limits the chance for problems, especially if you're buying a stock that's very actively traded.

As a seller, this shorter settlement period helps in a very practical way in that you get access to your cash sooner. Say you're selling a stock on a Tuesday. Since money and shares still must trade hands (digitally, of course) you can't actually withdraw the sale proceeds until the settlement date. On this date cash is known as "settled funds" and can be wired, journaled, or otherwise moved from your account. You're restricted from doing so beforehand because, technically, the cash isn't really there, even though the brokerage firm displays it and lets you invest it. With the recent change, your money would be there Thursday instead of Friday. Having access to cash one day sooner is obviously helpful.

While some securities, such as Treasury bonds and options, currently settle in one business day, I think it's natural to assume T+2 for stocks and bonds might eventually be T+0. As technology continues to improve there might come a day when we could buy or sell a stock or fund and become a shareholder or have access to the cash the same day. Time will tell but an even shorter settlement cycle would make things that much easier for investors by providing more liquidity and further reducing risk to markets.

Have questions? Ask me. I can help.