Settlement

Securities transactions do not occur instantaneously; they take time to settle, which is when the transaction finalizes. To understand the process of settlement, we’ll discuss several roles involved in completing financial transactions, including:

• Broker-dealers
• Introducing brokers
• Clearing brokers
• Clearinghouses
• Transfer agents

Broker-dealers

Broker-dealers are financial organizations that primarily help customers buy and sell securities. If you’ve ever placed a trade, a broker-dealer most likely handled your trade. Here’s a list of the five largest broker-dealers (in 2021):

• Fidelity Investments
• Charles Schwab
• Wells Fargo
• Edward Jones
• TD Ameritrade

Assume you place a trade with your broker-dealer to buy shares of stock. When the trade executes, the transaction is locked in. At this point, you know exactly how many shares you purchased, the price paid, and any applicable transaction fees. After the trade execution, a few things must occur in the background for everything to be settled (finalized). The specifics depend on the type of broker-dealer handling the trade.

Introducing brokers

Broker-dealers categorized as introducing brokers are often smaller broker-dealers that primarily maintain relationships with customers and facilitate their trades. Introducing brokers don’t maintain custody of customer assets, meaning they don’t keep possession of their securities. Maintaining custody requires sophisticated technological infrastructures and comes with strict recordkeeping requirements. Additionally, introducing brokers do not process their customers’ trades. Instead, they outsource these responsibilities to clearing brokers (discussed below).

To better understand this, let’s work our way through an example. Assume ABC Brokerage is an introducing broker with dozens of customers in their local area. When a customer wants to place a trade, they call up their representative at ABC Brokerage. ABC Brokerage provides customer service and facilitates the trade, but the order is actually executed through XYZ Brokerage. Introducing brokers (ABC Brokerage) hire clearing brokers (XYZ Brokerage) to maintain custody, process trades, and provide clearing services (we’ll discuss all of these below).

Clearing brokers

Many large broker-dealers are categorized as clearing brokers, which are broker-dealers that maintain custody, process orders, and provide clearing services in addition to facilitating trades for their customers (and the customers of introducing brokers).

Clearing brokers must be appropriately connected to the financial markets to process orders. Broker-dealers offering these services are responsible for ensuring “best execution” standards for their customers. In most cases, this means obtaining the best possible price. As we’ll learn in the secondary market chapter, many securities trade in more than one market. If a stock is trading in five different markets, the clearing broker is responsible for finding the market that can execute the trade efficiently at the best price.

Clearing brokers also act as intermediaries between their customers and clearinghouses.

Clearinghouses

A clearinghouse is an organization responsible for ensuring trades are properly finalized. Investors never need to worry about a transaction failing due to one side not fulfilling their end of the transaction. For example, let’s assume an investor executes a stock sale at $50, but the buyer doesn’t deliver the required cash to pay for the purchase. Clearinghouses work behind the scenes to ensure this isn’t an issue. It’s more complicated than this, but a clearinghouse would pay the seller out of their own pocket, then work with the buyer’s broker-dealer to ensure they are reimbursed. A system like this is essential to instill confidence in the financial markets. Would you place a trade if you knew the contra-party (the other side of the transaction) might not fulfill their end of the trade?

The Depository Trust & Clearing Corporation (DTCC) is the primary clearinghouse used in the securities markets. The DTCC is a non-profit, industry-owned organization that clears most trades in the financial markets. To put the importance of their role in the financial markets into perspective, DTCC clears over $2.3 quadrillion of trades annually. And no, that’s not a typo.

Clearinghouses are responsible for ensuring the buyer receives the security, and the seller gets the cash. When a trade finalizes, the clearinghouse sends a report along with the appropriate assets to the broker-dealers (clearing brokers) representing each investor (the seller gets cash, and the buyer receives securities). The broker-dealers update their records and place the appropriate asset in the customer’s account. If it’s a customer of an introducing broker, the clearing broker sends a trade confirmation to the introducing broker, who then informs their customer.*

*While it’s important to understand broker-dealers and their role in finance, the inner workings of trades are usually not heavily tested on the SIE exam. Don’t get too frustrated if you’re confused. The financial system is complicated, but you only need to know the basics.

Transfer agents

As discussed in a previous chapter, transfer agents are organizations that work on behalf of issuers to keep track of investors owning the issuer’s securities. They receive trade reports during the clearing process and update their records accordingly. Transfer agents are also part of the settlement process.

Settlement

As we’ve discussed, several protocols are followed behind the scenes after a trade executes. This is why settlement takes time, even in today’s digital age.

There are two types of settlement: regular-way and cash settlement. Most trades execute through regular-way settlement, the slower of the two options. Regular-way settlement for common stock occurs on the first business day after the transaction (known as T+1 - trade date plus one business day). Ensure you don’t count weekends or holidays towards settlement time frames, as settlement only occurs over business days.

Cash settlement is for investors who need their trades finalized quickly. As long as a cash settlement trade executes before 2:30 pm ET, the trade settles the same day. Broker-dealers may charge a little extra to perform this trade, but it is available to investors.

As you go through these reading materials, you’ll notice that different products have different settlement times (e.g., US government bonds settle in T+1). You will need to memorize various settlement times, and common stock settlement is one of the most tested on the exam.