Settlement and Clearing
Settlement is the actual exchange of money and securities between the parties of a trade on the settlement date after agreeing earlier on the trade. Most settlement of securities trading nowadays is done electronically. Clearing is the actual process of updating the accounts of the trading parties. Most security trades are settled in 3 business days (T+3), while government bonds and options are settled the next business day (T+1). Forex transactions where the currencies are from North American countries have T+1 settlement date, while trades involving currencies outside of North America T+2 settlement date. In futures, settlement refers to the mark-to-market of accounts using the final closing price for the day. A futures settlement may result in a margin call if there are insufficient funds to cover the new closing price.
Modern day settlement and clearing evolved as a solution to the paper crisis of securities trading as more and more stock and bond certificates were being traded in the 1960’s and 1970’s, and payment was still made with paper checks. Brokers and dealers either had to use messengers or the mail to send certificates and checks to settle the trades, which posed a huge risk and incurred high transaction costs. At this time, the exchanges closed on Wednesday and took 5 business days to settle trades so that the paperwork could get done.
The 1st solution to this problem was to hold the certificates at a central depository—sometimes referred to as certificate immobilization—and record change of ownership with a book-entry accounting system that was eventually done electronically. The New York Stock Exchange was the 1st to use this method through its Central Certificate Service, which eventually become the Depository Trust Company, then became a subsidiary of the Depository Trust and Clearing Corporation (DTCC). In Europe, Euroclear and Clearstream are the major central depositories. The process of eliminating paper certificates entirely is sometimes referred to as dematerialization.
A further improvement was multilateral netting, which further reduced the number of transactions. Brokers have accounts at central depositories, such as the DTCC, which acts as a counterparty to every trade. So instead of sending payments and securities for each transaction, trades and payments were simply aggregated over the course of the day for each member broker, then were settled at the end of the day by transferring the net difference in securities and funds from 1 account at the depository to another.
For example, if a broker bought 100 shares of Microsoft for a customer and sold 50 shares of Microsoft for another customer, then the broker’s net position is the accumulation of 50 shares of Microsoft, which would be recorded at the end of the market day. If the broker paid $25 per share to buy the 100 shares of Microsoft stock and sold the 50 shares for the same price on the same day, then the net difference plus transaction costs is debited from the broker’s account at the end of the market day, and credited to the account of the central depository. Likewise, only 50 shares of Microsoft would be transferred to the broker's account, since this is the net difference of buying 100 shares and selling 50 shares.