What exactly happens during a settlement period?

Question

As I understand it, the settlement date is the date when ownership of an asset is officially transferred to a buyer. I do not understand why this is not, generally, equal to the transaction date. It seems like something like this could be done in a matter of minutes electronically, however I haven't been able to find any information regarding what actually happens during the settlement period.

What exactly happens during the settlement period? I.e, what process occurs before the settlement date that officially transfers ownership?

I would like to note that I have read the question Why does Charles Schwab have a Mandatory Settlement Period after selling stocks? but did not find a satisfactory answer there.

Answer 1

Securities clearing and settlement is a complex topic - you can start by browsing relevant Wikipedia articles, and (given sufficient quantities of masochism and strong coffee) progress to entire technical books.

You're correct - modern trade settlement systems are electronic and heavily streamlined. However, you're never going to see people hand over assets until they're sure that payment has cleared - given current payment systems, that means the fastest settlement time is going to be the next business day (so-called T+1 settlement), which is what's seen for heavily standardized instruments like standard options and government debt securities.

Stocks present bigger obstacles. First, the seller has to locate the asset being sold & make sure they have clear title to it... which is tougher than it might seem, given the layers of abstraction/virtualization involved in the chain of ownership & custody, complicated in particular by "rehypothecation" involved in stock borrowing/lending for short sales... especially since stock borrow/lending record-keeping tends to be somewhat slipshod (cf. periodic uproar about "naked shorting" and "failure to deliver").

Second, the seller has to determine what exactly it is that they have sold... which, again, can be tougher than it might seem. You see, stocks are subject to all kinds of corporate actions (e.g. cash distributions, spin-offs, splits, liquidations, delistings...) A particular topic of keen interest is who exactly is entitled to large cash distributions - the buyer or the seller? Depending on the cutoff date (the "ex-dividend date"), the seller may need to deliver to the buyer just the shares of stock, or the shares plus a big chunk of cash - a significant difference in settlement. Determining the precise ex-dividend date (and so what exactly are the assets to be settled) can sometimes be very difficult... it's usually T-2, except in the case of large distributions, which are usually T+1, unless the regulatory authority has neglected to declare an ex-dividend date, in which case it defaults to standard DTC payment policy (i.e. T-2)... I've been involved in a few situations where the brokers involved were clueless, and full settlement of "due bills" for cash distributions to the buyer took several months of hard arguing.

So yeah, the brokers want a little time to get their records in order and settle the trade correctly.

Answer 2

During the settlement period, the buyer transfers payment to the seller and the seller transfers ownership to the buyer.

This is really a holdover from the days when so much of stock trading was done by individual human traders, and computers were still not a huge part of the operation. Back then, paper tickets for trades exchanged hands, and the time period was actually 5 days, so 3 days is an improvement.

A settlement period was necessary for everyone to figure out their trades and do what was necessary to make the settlements happen, so it was not always a quick process, mainly because of smaller trading firms that didn't have technology to help them along.

Nowadays, technology makes settlements easy, and they usually occur at the end of the trading day. The trading firms sum up their trades, figure out who they owe, and send lump sum settlements to the counterparties to their trades. If anything, the 3-day period may just be used now to let parties verify trades before settling.

I hope this helps.

Good luck!