Settlement of securities is a business process whereby securities or interests in securities are delivered, usually against (in simultaneous exchange for) payment of money, to fulfill contractual obligations, such as those arising under securities trades.
In the U.S., the settlement date for marketable stocks is usually 3 (three) business days after the trade is executed, and for listed options and government securities it is usually 1 (one) day after the execution.
As part of performance on the delivery obligations entailed by the trade, settlement involves the delivery of securities and the corresponding payment.
A number of risks arise for the parties during the settlement interval, which are managed by the process of clearing, which follows trading and precedes settlement. Clearing involves modifying those contractual obligations so as to facilitate settlement, often by netting and novation.
Nature of settlement
Settlement involves the delivery of securities from one party to another. Delivery usually takes place against payment, but some deliveries are made without a corresponding payment (sometimes referred to as a free delivery). Examples of a delivery without payment are the delivery of securities collateral against a loan of securities, and a delivery made pursuant to a margin call.
Traditional (physical) settlement
Prior to modern financial market technologies and methods such as depositories and securities held in electronic form, securities settlement had involved the physical movement of paper instruments, or certificates and transfer forms. Payment was usually made by paper check upon receipt by the registrar or transfer agent of properly negotiated certificates and other requisite documents. Physical settlement securities still exist in modern markets today mostly for private (restricted or unregistered) securities as opposed to those of publicly (exchange) traded securities, however payment of money today is typically made via electronic funds transfer (in the U.S., a bank wire transfer made through the Federal Reserve’s Fedwire system). Physical/paper settlement involves higher risks, inasmuch as paper instruments, certificates, and transfer forms are subject to risks electronic media are not more or less such as loss, theft, counterfeit, and forgery (see indirect holding system).
Electronic settlement
The electronic settlement system came about largely as a result of Clearance and Settlement Systems in the World’s Securities Markets, a major report in 1989 by the Washington-based think tank, the Group of Thirty. This report made nine recommendations with a view to achieving more efficient settlement. This was followed up in 2003 with a report, Clearing and Settlement: A Plan of Action, with 20 recommendations.
In an electronic settlement system, electronic settlement takes place between participants. If a non-participant wishes to settle its interests, it must do so through a participant acting as a custodian. The interests of participants are recorded by credit entries in securities accounts maintained in their names by the operator of the system. It permits both quick and efficient settlement by removing the need for paperwork, and the simultaneous delivery of securities with the payment of a corresponding cash sum (called delivery versus payment, or DVP) in the agreed upon currency.
Immobilization and dematerialization
Immobilization and dematerialization are the two broad goals of electronic settlement. Both were identified by the influential report by the Group of Thirty in 1989.
Immobilization
"Economic immobilization" redirects here. For the concept in macroeconomics, see Economic immobility.
Immobilization entails the use of securities in paper form and the use of a Central Securities Depository or more than one, which is/are electronically linked to a settlement system. Securities (either constituted by paper instruments or represented by paper certificates) are immobilized in the sense that they are held by the depository at all times. In the historic transition from paper-based to electronic practice, immobilization often serves as a transitional phase prior to dematerialization.
The Depository Trust Company in New York is the largest immobilizer of securities in the world. Euro clear and Clear stream Banking, Luxembourg are two important examples of international immobilization systems. Both originally settled Eurobonds, but now a wide range of international securities are settled through them including many types of sovereign debt and equity securities.
Dematerialization
Dematerialization involves dispensing of paper instruments and certificates altogether. Dematerialized securities exist only in the form of electronic records. The legal impact of dematerialization differs in relation to bearer and registered securities respectively.
Regular business days from trade date; dates/terms to settle instruments
| Instrument | Days to Settle in US |
|---|---|
| Stocks | 3 (3 days after trade date or "T + 3") |
| Money Market Mutual Fund | Typically 1 ("T + 1" or "next day"), though can be 0 ("same day") |
| Options | 1 |
It is important to note that, in the U.S., the settlement date/terms for a securities trade is also associated with the character or basis on which the securities trade and settle:
- Regular way (RW) – that is, the normal time frames and manner – example, stocks normally are T+3
- When issued (WI) – short for "when, as, if issued" – signifying a conditional transaction in a security authorized for issue which has not yet been or may never be actually issued. Settlement occurs if and when the security is actually issued and/or the exchange or NASD/FINRA rules that the trades are to be settled. Based on the nature of some securities, sometimes when issued’s are never actually issued. For example, US Treasury securities, stock splits and new issues typically trade on a "WI" basis
- Cash – same day settlement, that is, delivery on trade date.
- Delayed delivery – securities are expected to be delivered past normal timeframes/windows. Example, new issue muni’s (municipal bonds) often trade on a DD or WI basis (often a month after trade date as disclosed in the note of sale to allow for printing and shipping of the debenture/certificates). Like equities though, muni’s can be settled RW, WI or cash, as well as DD or other mutually agreed terms.
- Ex-dividend – the terms of the stock trade are that the price and settlement amount "excludes" a pending dividend declaration (buyers of a stock on or after ex-dividend declaration date but prior to payable date).
- Ex-rights – similar in effect as ex-dividend. A security that trades/settles without any entitlement to a pending rights offering declared on the stock.