The SEC's T+1 settlement rule will transform stock trading: Here's what you need to know.

By Gordon Gottsegen

New rule taking effect May 28 will require trades to settle in one business day

On May 28, a new rule will go into effect that will affect almost every stock, bond, and ETF trade in U.S. markets. But will it affect your investing?

Well, yes and no.

This new rule establishes the "T+1" settlement cycle, and it relates to how long it takes for securities transactions to "settle."

What is settlement? Let's say you buy or sell a stock through your broker. Usually you get a confirmation of that trade right away, but that doesn't necessarily mean the transaction has settled. For that to happen, the stock has to be transferred from the seller's portfolio to the buyer's portfolio, and the money deducted from the buyer's account and sent to the seller's. So "settlement" is the official delivery of both securities and money between the two parties.

Settlement doesn't always happen the same day a trade is placed, known as the transaction date. Currently, we're in a "T+2" settlement cycle, where U.S. financial institutions have two business days to settle all applicable security transactions. When this new regulation goes into effect, institutions will now have one business day to settle.

Thus, "T+1" refers to the requirement for securities trades to settle in one business day from the transaction date.

The T+1 settlement cycle will apply to the following securities:

StocksCorporate bondsETFsMunicipal securitiesSome mutual fundsLimited partnerships that trade on exchanges

Starting May 28, all securities that traded on a T+2 settlement cycle will transition to T+1. Meanwhile, some other securities, including options and government securities like Treasurys, are already on a next-day settlement schedule-meaning they will match up with the securities listed above.

Why does T+1 settlement matter?

There are two main reasons why financial industry groups have been pushing for the T+1 settlement cycle: risk reduction and efficiency.

"There is a time-tested golden rule of clearing and settlement, which is the sooner you can get it done the better," Brian Sussman, senior vice president of global operations at Interactive Brokers, told MarketWatch.

That's because the longer it takes for a trade to settle, the higher the chance of the security or money not being there. Let's say there's an issue with the buy side and it turns out the account isn't properly funded, or there's some accounting error and the seller doesn't own the correct number of shares. This is called a failure to deliver (FTD). Brokerages and clearinghouses generally have protections in place to prevent this from happening, but FTDs can happen, and the longer the period between the transaction and settlement, the greater the risk.

Archive: How a change to a crucial piece of stock-market 'plumbing' could help all investors (October 2021)

Reducing that risk is one of the reasons that industry players have been pushing to get to a T+1 settlement cycle since the 1990s, when the settlement cycle was still at T+5. Over the years, the U.S. has moved to a T+3 settlement cycle, then T+2 and now finally T+1.

During that time, the financial industry has evolved and introduced new forms of technology and automation. This leads to the second major reason: efficiency.

Securities like stocks can exchange hands multiple times a day. The more transactions in a day, the more accounting work that has to be done by the brokers, the DTC and clearinghouses. When multiple days pass between transaction and settlement, it can effectively create an accounting backlog. So shortening that time makes the settlement process more efficient, and promotes the adoption of more automated and efficient systems across the industry.

How does T+1 settlement affect me as an investor?

Best-case scenario, investors might not notice the transition to T+1, but they still stand to benefit from it.

"While the change to T+1 will be largely seamless for retail investors, they will benefit from the overall reduction in risk created by the move to T+1 settlement," Tom Price, managing director and head of technology, operations and business continuity at Sifma, told MarketWatch. "Reducing risk in the system makes for healthier markets, and that is always better for investors."

Even if the change is largely invisible for investors, there are a few things they might notice. For example, proceeds from selling a security should hit investors' accounts faster, which also means that money can be reinvested faster. The flip side is true too, meaning investors have to have their funds ready sooner before they buy securities, which may affect things like currency exchange when an investor wants to buy a security in a foreign market.

However, as Price says, the main takeaway for retail investors is the reduction of risk.

Besides that, most of the changes brought by T+1 will be felt by brokers, clearinghouses and other institutions, since they're the ones who have to process trades and settlement on the back end. But many of these institutions have spent years preparing for the new settlement cycle and have put in the work for everyone to be prepared for the transition.

Will we ever see a T+0 settlement cycle?

With T+1 settlement being something years in the making, a logical next question is, can we move even faster and do same-day or real-time settlement cycles? After all, cryptocurrencies settle in real time thanks to the blockchain. But for other securities, this may create more problems than it solves.

"The challenge with T+0 is not whether or not the NSCC's platform can do it, or whether [brokerages] could change the code for our systems. The challenge is largely around financing and efficiency," Sussman of Interactive Brokers told MarketWatch.

Crypto trades can happen in real time because they are prefunded, but prefunding the entire U.S. stock market is an entirely different beast due to the sheer volume and complexity of the market. On top of that, getting the U.S. stock market to trade at T+1 already involves many tight, same-day turnarounds. Getting things to move even faster may introduce additional risks that aren't present with a T+1 cycle.

So with T+0 potentially creating more issues than it's worth, the T+1 settlement cycle may be the sweet spot. To many of the financial professionals who have spent years working to get T+1 adopted, it represents a Goldilocks settlement cycle-less risky than T+2, less risky T+0, just right. And for investors, hopefully it represents a big step toward more efficient markets.

-Gordon Gottsegen

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

05-25-24 0811ET

Copyright (c) 2024 Dow Jones & Company, Inc.