Securities transactions don’t settle instantly. Settlement is the point when the trade is fully finalized: the buyer receives the security, and the seller receives the cash.
To understand how settlement works, it helps to know the main roles involved in completing securities transactions:
Broker-dealers are financial firms that help customers buy and sell securities. If you’ve ever placed a trade, a broker-dealer most likely handled it. Here are five of the largest broker-dealers (in 2024):
Assume you place a trade with your broker-dealer to buy shares of stock. When the trade executes, the key terms are locked in: the number of shares, the price, and any transaction fees. After execution, additional steps happen behind the scenes before the trade is settled (finalized). Exactly who performs those steps depends on the type of broker-dealer involved.
Broker-dealers classified as introducing brokers are often smaller firms that focus on customer relationships and trade facilitation. Introducing brokers don’t maintain custody of customer assets, meaning they don’t hold customers’ securities. Custody requires sophisticated technology and strict recordkeeping.
Introducing brokers also typically don’t process their customers’ trades. Instead, they outsource these responsibilities to a clearing broker (covered next).
Here’s a simple example:
Assume ABC Brokerage is an introducing broker with dozens of local customers. When a customer wants to place a trade, they call their representative at ABC Brokerage. ABC Brokerage provides customer service and takes the order, but the order is actually executed through XYZ Brokerage. In this arrangement, the introducing broker (ABC Brokerage) hires a clearing broker (XYZ Brokerage) to maintain custody, process trades, and provide clearing services (discussed below).
Many large broker-dealers are clearing brokers. A clearing broker maintains custody, processes orders, and provides clearing services, in addition to facilitating trades for:
Clearing brokers must be properly connected to the financial markets to route and process orders. They’re also responsible for meeting best execution standards for their customers. In most cases, that means obtaining the best available price.
As you’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.
A clearinghouse is an organization that helps ensure trades are properly finalized. As an investor, you generally don’t have to worry that a trade will fail because one side doesn’t deliver what they owe.
For example, suppose an investor sells stock at $50 per share, but the buyer doesn’t deliver the required cash. Clearinghouses work behind the scenes to prevent this from becoming the seller’s problem. The details are more complex, but the basic idea is that the clearinghouse can pay the seller and then work with the buyer’s broker-dealer to get reimbursed. This kind of system is essential for confidence in the financial markets. Would you place a trade if you thought the contra-party (the other side of the transaction) might not follow through?
The Depository Trust & Clearing Corporation (DTCC) is the primary clearinghouse used in the securities markets. DTCC is a non-profit, industry-owned organization that clears most trades in the financial markets. To put its role in perspective, DTCC clears over $2.3 quadrillion of trades annually. And no, that’s not a typo.
Clearinghouses help ensure:
When a trade finalizes, the clearinghouse sends a report (and the appropriate assets) to the broker-dealers (clearing brokers) representing each investor. The broker-dealers then update their records and place the correct asset in each customer’s account.
If the customer uses an introducing broker, the clearing broker sends a trade confirmation to the introducing broker, and the introducing broker informs the customer.*
*It’s important to understand what broker-dealers do, but the detailed mechanics of trade processing usually aren’t heavily tested on the SIE exam. Focus on the core roles and the basic settlement rules.
As discussed in a previous chapter, transfer agents work on behalf of issuers to keep track of who owns 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.
Several steps must occur after a trade executes, which is why settlement takes time even in today’s digital markets.
There are two types of settlement: regular-way and cash settlement.
Most trades use regular-way settlement, which is the slower option. Regular-way settlement for common stock occurs on the first business day after the transaction (known as T+1, meaning trade date plus one business day). Don’t count weekends or holidays, since settlement time frames are based on business days.
Cash settlement is used when an investor needs the trade finalized quickly. If a cash settlement trade executes before 2:30 pm ET, it settles the same day. Broker-dealers may charge a little extra for this service.
As you work through these materials, you’ll see that different products have different settlement times (for example, US government bonds settle in T+1). You’ll need to memorize several settlement time frames, and common stock settlement is one of the most tested on the exam.
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