Settlement Date Meaning
Settlement date is the date on which the cash and assets are exchanged or the trade is settled through netting out a process for a trade that took place a few days back, the gap between the trade and the settling of the same varies from security to security and from one exchange to another, and is specified in the security document, commonly for shares it is 2 business days after the trade.
Explanation
The gap between the date on which trade occurs and the date on which it settles is for completing the paperwork or the transfer process and also providing the time for the transfer of payment, so even if it is an online trade, it takes a few day’s time to reflect.
The standardized number of days is mentioned on the trade contract, however, at times, the actual number of days is more than the specified number due to some errors that might occur or due to a public holiday. Traders are conveyed the same to avoid a situation of panic.
Example
To bring more clarity to the concept suppose a trader trades on security online on a Tuesday dated June 5th so this is his trade date but the security settles after 2 business days, so ideally the settlement date should be June 7th i.e. a Thursday but due to some unforeseen circumstances, Thursday is declared as a public holiday so the actual settlement is done on June 8th or Friday.
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How to Calculate Settlement Date?
- With effect from 5th September 2017, the Securities Exchange Commission or the SEC adopted the T+2 convention in which the securities trade would settle after 2 business days from the Trade date, which was earlier T+3, i.e. 3 business days. This was done because of improvement in technology and to increase the efficiency of trades and markets.
- Prior to this, with effect from 7th June 1995, the SEC adopted the T+3 convention, with a few exceptions, in which the securities trade would settle after 3 business days from the Trade date.
- In the case of most currency trades, the T+2 convention is followed but there are a few currency pairs that are an exception to this rule and settle according to the T+1 convention.
- Historically, trades were settled in as long as days and it was only from the 1970s onwards that this was first reduced to T+7, then followed by T+5 conventions to the currently used convention.
Risks
The time gap between the two dates causes the chances of default from either party to increase. The seller might not deliver the securities or the buyer might not make the payment. This can impact the following trades undertaken by these traders because most times the traders pledge the same securities or money for other transactions so if they are not received in time, their other trades might get impacted. This risk is at times also known as the credit risk.
Further, it can lead to counterparty risk when one party fulfills his side of the trade but the other party doesn’t fulfill his side of the trade such as the security being transferred and payment not made.
Settlement Date vs Trade Date
- Meaning – Trade date is the date on which the traders executed the transaction and therefore it is also known as the transaction date. While as explained before, the settlement date is the date on which securities and cash are exchanged or the trade is netted out.
- Control – Traders only have their control over the trade date because it is their decision on when to buy or sell, however, the settlement date is prescribed to them by either the exchange or the security contract in which they have traded.
- Online Transaction – Even in online transactions, the trade date is when your holdings reflect the transaction but the cash is deducted and the securities are actually credited to your account on the settlement date by the broker.
- Taxation – For calculation of tax liability for the year, trade date is considered so if a trade is executed on the last day of the year while it is settled in the following year, it is considered for the year just ended and the tax benefits or losses are from this trade are considered in that year only.
Importance
- Regulation – According to certain regulators, the trader who has bought security cannot resell it till the trade is settled and the trader cannot use the funds he will receive from the sale of a security to buy another security till the time the trade has settled so the traders need to be mindful of such regulations. Violation of such regulation is often termed as ‘free-riding’.
- Accounting – When settlement date accounting is followed, the transaction is recorded in the trader’s balance sheet only once it is settled and therefore, this might change the month in which the trade is recorded in comparison to the trade date based accounting. Settlement accounting, therefore, is more conservative, we can draw the analogy of accrual accounting and cash accounting wherein, the cash flow statement is a better reflector of the cash position of the company similarly, the settlement date accounting is a better indicator of the trader’s cash position.
Conclusion
Settlement date is the date on which the assets are exchanges, payment is made or trades are netted off. This date is generally after the Trade date, which is the date on which the trades actually execute the transaction and is sometimes known as the transaction date too.
The gap between the trade date and the settlement date varies for different markets but the most common convention that has been recently adopted by the SEC is the T+2 convention, which makes it 2 business days after the trade date. Settlement date accounting is considered analogous to the cash-based accounting system and is a more conservative approach that shows the clear cash position of a trader in comparison to the trade date accounting.
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