What is Settlement Date?
The term “settlement date” refers to the date on which the trade is settled either through the exchange of the securities and cash or netting out for a transaction that took place a few days back. The gap between the transaction date and the settlement date varies across securities and from one exchange to another. The date is clearly specified in the security document.
Explanation
The settlement date is when the trade is finally closed as the buyer makes the payment to the seller and the seller transfers the securities/ assets to the buyer. It varies from one security to another. For instance, for stocks and bonds, it is two business days after the trade and it is denoted by T+2, while for government securities and options, it is the very next day or T+1.
When Does Settlement Date Occur?
When investors purchase bonds, stocks, or any other financial instruments, the transactions are broken down into two key dates – transaction and settlement dates. Transaction date refers to the date when the trade actually got initiated. However, the trade is not settled on the transaction date as there is some time gap for making the payment and transferring the asset ownership. Therefore, the transaction date and the settlement date doesn’t fall on the same day.
The settlement date occurs after the specified time has elapsed after the transaction date, which is mentioned in the security document. For instance, if the document says that the settlement date is T+2, then it means that the trade will be settled after two [business] days from the transaction date. The time gap between the transaction date and the settlement date is known as the settlement period. It is to be noted that the date doesn’t occur on exchange holidays as well as weekends[Saturday & Sunday], and it is shifted to the next business day.
Example of Settlement Date
Following are an example are given below:
Example #1
Let us assume that a trader trades on government security online on 1st December 2020, which is a Tuesday. Given that it is government security, the trade has to be settled in T+1 day. Determine the settlement date of the transaction.
Given that the transaction date is 1st December 2020, the security should be ideally settled after one business day on 2nd December 2020, which is a Wednesday.
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Example #2
Let us assume that a trader purchases a company stock on 25th November, which is a Wednesday. Given that it is an equity stock, the trade has to be settled in T+2 day. Determine the settlement date of the transaction.
Given that the transaction date is 25th November 2020, the transaction should be ideally settled after two business days on 27th November 2020, which is a Friday. But 26th November 2020 is a holiday on account of Thanksgiving and then 28th and 29th November 2020 are weekends. Now, we know that the settlement date excludes exchange holidays and weekends. Therefore, the date is 30th November 2020, which is a Monday.
Risks of Settlement Date
There are two main risks associated with – credit risk and settlement risk.
- Credit Risk: It refers to the risk of loss emanating from the buyer’s inability to meet the contractual trade obligations. Some of the reasons for the credit risk include liquidity issues or unanticipated volatility in the market during the time period between the transaction and settlement dates.
- Settlement Risk: It occurs when either the seller or the buyer fails to honor their part of the contract. For instance, the seller might be unable to deliver the underlying asset in exchange for the payment or the buyer might fail to make the payment in time after the transfer of the asset ownership.
Breaking Down Settlement Date
The financial markets clearly specify the number of business days at the end of which the transaction has to be completed, i.e.the assets/ securities have to be delivered in exchange for the payment. The difference between the transaction date and the settlement date is owing to the time required by the seller to deliver the assets. Nowadays, the transactions are executed electronically which were previously done manually. Once the buyers receive the delivery of the assets, they make the payment for the assets.
Importance
The importance can be ascertained on the basis of the following:
- Regulation: According to regulatory bodies, the prospective buyer can’t resell the particular securities until the trade settlement, while the seller can’t use the funds to be received in exchange for the particular securities for buying any another security until the trade settlement. Hence, the date is equally important for the buyers and the sellers of the assets.
- Accounting: In the case of settlement date accounting, the transaction is recognized in the trader’s balance sheet only when the trade is finally settled. Therefore, in the case of month-end transactions, there is a likelihood that the trading month will be different in date accounting as compared to transaction date accounting. Accounting is a conservative approach and it captures the cash position of a company more accurately.
Conclusion
So, it can be seen that the settlement date is a very important aspect of any transaction as it signifies when the trade has been actually settled, which is usually after certain days from the trading date. Further, accounting based on date is also a better indicator of the actual cash position of a company.
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