Stock trades that remain unsettled for extended periods of time can be detrimental to the financial markets, particularly in times of market turmoil. The longer it takes for a trade to be settled, the likelihood increases that investors who have lost a lot of money in a market slump will not be able to pay for the trades.
As a result there is a so-called stock three-day rule that requires security transactions to be settled within three business days. Saturdays and Sundays do not count as business days in securities trading.
Identification of Settlement
Settlement in stock trading means when the ownership of securities is formally transferred from one investor or company to another. Prior to June 7, 1995, the limit for settlement time was a five-day window. Requiring trades to be settled within a three-day window, or as the Securities and Exchange Commission (SEC) calls it "T+3," reduces the likelihood of default. What this means is that the "T" represents the trade day, and the plus three represents the three business days an investor has to pay for securities purchased or deliver securities sold.
Violating trading settlement regulations may incur freeride, cash liquidation or good faith penalties per the brokerage Fidelity. These violations may result in restrictions against the offending brokerage account. Examples of violations may include selling then buying or purchasing then selling to cover trade costs in order to circumvent the three-day rule for cash settlement.
For example, if an account has no available cash for trading prompting the account owner to sell $10,000 of ABC stock to cover a purchase of $10,000 of XYZ stock on the same day, this would violate good faith. The sale of ABC stock would have to settle before the account owner could use those funds to purchase the XYZ stock. Similarly, buying stocks without adequate cash in the account, then selling later to cover the purchase costs is a violation of cash settlement.
Read More: What Are Day Trading Rules for a Cash Account?
Function of the 3-Day Rule
The NASDAQ states that the three-day rule exists under the SEC to reduce the likelihood of defaults. This is because differing or unlimited settlement times could create wild variations in gains or losses.
As experienced traders know, the prices of securities go through unpredictable cycles of volatility. In large volume trading, risk increases. Furthermore, the longer it takes to settle a trade, the more likely it is that buyers and sellers who have suffered great loss will not be able to pay for recent transactions.
Another implication for the three-day rule is in determining when a buyer becomes a "shareholder of record" for the purpose of determining whether a shareholder is eligible for receiving a dividend payment within a specific time period. Sales must be settled before the ex-dividend date.
Minimizing the time limit permitted for settlement of trades minimizes the amount of money that changes hands, further reducing the level of risk. With the advent of electronic trading, transfer of ownership can be accomplished much faster.
Read More: Why Do Trades Take 2 Days to Settle?
What the 3-Day Rule Covers
The three-day settlement rule not only applies to stocks, but also to many bonds and mutual fund shares as well. Stock options, on the other hand, settle the day following the trade. This provision limits manipulation of stock prices and minimizes risks for the parties involved. Government securities also settle on the day after trading, but the prices of government securities are not easily manipulated through trade volume.
Different brokerage companies operate under different rules as to how the three-day rule is enforced. Some firms sell the securities involved in the transaction if payment is not remitted during the allowed time. Losses sustained by the brokerage can then be passed along to the investor. In other situations, the brokerage may charge investors a fee if the provisions of the three-day rule are not met properly.
Read More: Can You Buy and Sell Stock Options the Same Day?
Vicki A Benge began writing professionally in 1984 as a newspaper reporter. A small-business owner since 1999, Benge has worked as a licensed insurance agent and has more than 20 years experience in income tax preparation for businesses and individuals. Her business and finance articles can be found on the websites of "The Arizona Republic," "Houston Chronicle," The Motley Fool, "San Francisco Chronicle," and Zacks, among others.