T+2 Settlement is Coming!

On Wednesday, the SEC announced settlement time for equities would be shortened from three to two days. In the vernacular, we are moving from T+3 to T+2 settlement on September 5th 2017. This is fairly exciting, at least for me. I hope my clients should appreciate it, even if they don't know that it is happening.

Briefly, settlement is what happens after a trade is agreed upon. Trades take milliseconds. You type in an order, say, buy 42 shares of VB, double check your work, confirm the order and hit execute. By the time you refresh your screen the VB is purchased. Your broker will show you the shares in your account and a negative amount by your cash. This negative amount will linger for a few days. Have you ever wondered why? Settlement time. The trade has been executed and everyone generally agrees that now you own shares of VB and the other guy has sold the shares. However, you still have to deliver the cash to him and he has to give you shares of VB in return.

I'll note here that this settlement schedule applies to equities and ETFs only. In general, the mutual fund settlement process is an overnight wire, CDs are specific to the date of issue and things like leveraged loans are a time consuming process involving a lot of fax machines apparently.

It makes sense that some time should pass before this all gets taken care of. It is cheaper, after all, for your broker to net out trades at the end of the day and send payment to other brokers, dealers and banks all in one package instead of millions of times a day. Currently, this process takes three days. There is no real reason it takes three days except that everyone really needs to be on the same page about it and take the same amount of time. This is being cut down to two days.

So why does that matter? How will it affect you?

For the end consumer, you may at first only notice that the annoying negative amount (of phantom positive amount in the case where you are the seller) of cash sitting in your account will not be there as long. Again, you will only have that accounting entry on display for two days before money actually moves out of (or into!) your account. This means that you can place another trade faster, have better assurance that the money will arrive and withdraw and otherwise use the money faster.

With shorter settlement times, for the same trade volume, there should be less debt in the trading system. This should make our markets more robust in times of stress, as there will be less worry about an individual or broker not being able to pay the money that has been floated to them. This is called margin trading.When a trade is agreed upon, the money is not exchanged immediately (see above description). Instead, a promise to pay is created - this is margin debt. Since trading is continuously ongoing, margin debt is proportional to the amount of trading multiplied by the settlement time. If settlement time decreases, so does margin debt. If there is less debt, trading partners can be more assured that they will be repaid and can have more confidence in trading during times of stress.

For the individual, this generally means that their broker will allow them to place trades quicker, as the funds will settle quicker.

Generally speaking, you cannot withdraw money from your account if it is not there. If the funds have not settled, the money is not there. If you have some spending that makes sense to come from an investment account, this is critical. Generally, you need money when you need it, but investment accounts will only give it to you three days later. Make that two days now and the process of getting your money back from investments just got easier!

Settlement is a background activity that affects a lot of aspects of trading. While the changes will be subtle, they are important, and should make the investing experience better for most end users, and the markets more robust for all participants.