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What is the Settlement Date?

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Explanation

The settlement date is when the trade is finally closed as the buyer pays 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, 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 other financial instruments, the transactions are broken down into two key dates – transaction and settlement. Transaction date refers to the date when the trade got initiated. However, the trade does not settle on the transaction date as there is some time gap for making the payment and transferring the asset ownership. Therefore, the transaction and settlement dates don’t fall on the same day.

The settlement date occurs after the specified time has elapsed after the transaction date, which mentions 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 and settlement dates is the settlement period. It is to be noted that the date doesn’t occur on exchange holidays and weekends[Saturday & Sunday], and it shifts to the next business day.

Example of Settlement Date

Below are the following examples :

Example #1

Since the transaction date is 1st December 2023, the security should ideally settle after one business day on 2nd December 2023, a Wednesday.

Example #2

Let us assume that a trader purchases a company stock on 25th November, a Wednesday. Since it is an equity stock, the trade must be settled in T+2 days. Determine the settlement date of the transaction.

Given that the transaction date is 25th November 2023, the transaction should ideally be settled after two business days on 27th November 2023, a Friday. But the 26th of November 2023 is a holiday because of Thanksgiving, and then the 28th and 29th of November 2023 are weekends. Now, we know that the settlement date excludes exchange holidays and weekends. Therefore, the date is 30th November 2023, which is a Monday.

Risks of Settlement Date

Credit Risk refers to the risk of loss emanating from the buyer’s inability to meet the contractual trade obligations. Some reasons for the credit risk include liquidity issues or unanticipated market volatility between the transaction and settlement dates.

Settlement Risk 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 specify the number of business days at the end of which the transaction has to be complete, i.e., assets/ securities have to deliver 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, people execute transactions electronically, which previously done manually. Once the buyers receive the delivery of the assets, they pay for them.

Importance

The importance can ascertain on the following basis:

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 receive in exchange for the particular securities for buying any other security until the trade settlement. Hence, the date is equally important for the buyers and the sellers of the assets.

Accounting: In settlement date accounting, the trader recognizes the transaction on their 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 compared to transaction date accounting. Accounting is a conservative approach that accurately captures a company’s cash position.

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 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.