There are two dates that are important for investors to know when making an investment: the trade date versus the settlement date.
When a buy or sell order is confirmed in an individual’s brokerage account, that day is known as the trade date. But behind the scenes, the real transaction has yet to take place.
A security has to go through a settlement process to clear from a seller to a buyer. This applies to the trading of almost all securities. An exception is Treasury bills, which can settle on the same day they are transacted.
An investor may notice two different numbers describing the cash balance in his or her brokerage account: the “settled” balance and the “unsettled” balance. Settled cash refers to cash that currently sits in an account. Unsettled refers to cash that an investor is owed but won’t be available for a certain length of time, usually a few days.
For the vast majority of trades an investor will make, there will be a delay between the day a transaction is made and the day the underlying security ownership has been settled—a period known as T+2 in financial markets.
Why the Difference Between Trade and Settlement Date?
Given the state of modern technology, it seems reasonable to assume that everything should happen instantaneously. But the current rules go back decades, way back to the creation of the Securities and Exchange Commission (SEC) in 1934, when all trading happened in person and on paper.
It used to be the case that a piece of paper representing shares of a security had to be in the possession of traders in order to prove they actually owned the shares. Moving this paper around sometimes took as long as five business days after the transaction date, or T+5.
What is the T+2 Rule?
The T+2 rule refers to the fact that it now takes two days beyond a trade date for a trade to settle. For example, if a trade is executed on Tuesday, the settlement date will be Thursday, which is the trade date plus two business days.
Note that weekends and holidays are excluded from the T+2 rule. That’s because stock markets only trade on weekdays. In the U.S., the stock market is open from 9:30 a.m. to 4:00 p.m. Eastern time five days a week.
Today, the T+2 rule is still enforced by the SEC and has been since 2017. Before then, the T+3 rule was the law. Who knows, maybe in the years to come we will see a T+1 rule and eventually the elimination of any settlement rule like this.
But for now, investors who plan on engaging in cash account trading need to know about trade vs. settlement date. Cash accounts are those in which investors trade stocks and exchange-traded funds (ETFs) only with money they actually have today and not borrowed money “on margin.”
Buying and selling without regard for settlement rules can incur trading violations that result in a brokerage limiting an investor’s activity for a time.
Potential Violations of the Trade Date vs. Settlement Date
Why is it important to understand this distinction of trade date vs. settlement date? First, every investor should know the basics of how brokerages work. But more importantly, comprehending this matter can allow investors avoid potentially costly violations of trading rules.
The consequences of these violations could differ according to which brokerage an investor uses, but the general concept still applies. Violations all have one thing in common: They involve trying to use cash or shares that have yet to come under ownership in an investor’s account.
The violations differ only in terms of the exact circumstances under which that happens.
Cash Liquidation Violation
To buy a security, most brokerages require investors to have enough settled cash in an account to cover the cost. Trying to buy securities with unsettled cash can lead to a cash liquidation violation, as liquidating one security to pay for another requires settlement of the first transaction before the other can happen.
Let’s look at a hypothetical example. Say an investor named Sally wants to buy $1,000 worth of ABC stock. Sally doesn’t have any settled cash in her account, so she raises more than enough by selling $1,200 worth of XYZ stock she has. The next day, she buys the $1,000 worth of ABC she had wanted.
Because the sale of XYZ stock hadn’t settled yet and Sally didn’t have the cash to cover the buy for ABC stock, a cash liquidation violation occurred.
Investors who face this kind of violation three times in one year can have their accounts restricted for up to 90 days.
Free Riding Violation
While a free ride might sound like a good thing, in this case it’s definitely not. Free riding violations occur when an investor buys stock using funds from a sale of the same stock.
For example, say Sally buys $1,000 of ABC stock on Tuesday. Sally doesn’t pay her brokerage the required amount to cover this order within the two-day settlement period. But then, on Friday, after the trade should have settled, she tries to sell her shares of ABC stock, since they are now worth $1,100.
This would be a free riding violation. Sally can’t sell shares she doesn’t yet own in order to purchase those same shares.
Incurring just one free riding violation in a 12-month period can lead to an investor’s account being restricted.
Good-faith violations happen when an investor buys a security and sells it before the initial purchase has been paid for with settled funds. Only cash or proceeds from the sale of fully paid-for securities can be called “settled funds.”
Selling a position before having paid for it is called a “good-faith violation” because no good-faith effort was made on the part of the investor to deposit funds into the account before the settlement date.
For example, if Sally sells $1,000 worth of ABC stock Tuesday morning, then buys $1,000 worth of XYZ stock Tuesday afternoon, she would incur a good-faith violation (unless she had an additional $1,000 in her account that did not come from the unsettled sale of ABC).
As we can see by these examples, it’s not hard for active traders to run into problems if they don’t comprehend cash account trading rules, all of which derive from trade date vs. settlement date. Having adequate settled cash in an account can help avoid issues like these.
Investing With Confidence
The trade date is the day an investor or trader books an order to buy or sell a security. But it’s important for market participants to also be aware of the settlement date, which is when the trade actually gets executed.
For many securities in financial markets, the T+2 rule applies, meaning the settlement date is usually two days after the trade date. An investor therefore will not legally own the security until the settlement date. It’s important for investors and traders to know of these rules so they don’t make violations that lead to restricted trading or other penalties.
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