Stock transactions are subject to the settlement guidelines outlined by the Securities and Exchange Commission (SEC) and commonly referred to as T+2. This means that the settlement date is the transaction day, plus two extra days.
Previously, the SEC utilized a T+3 rule until T+2 was adopted in 2017 in order to keep pace with technological advancements in trading. T+2 applies to most commonly traded securities, such as stocks, bonds and mutual funds.
What's a Cash Account?
There are two primary types of brokerage accounts for buying and selling securities like stocks. Such accounts are either cash accounts or margin accounts, according to FINRA.
Cash accounts require that all sales must be covered by the level of funds actually deposited into the account. In contrast, margin accounts allow traders to use cash and also loans from the brokerage, which accumulate interest. Margin requirements must be met to avoid margin calls to increase the value of the margin account.
Cash accounts are considered safer for newer investors, while margin accounts are typically opted for by more experienced traders. The potential loss of value in margin accounts makes them much riskier. Cash accounts, on the other hand, are much more straightforward, and losses are capped by the investment amount.
There are specific rules around the settlement of purchases made through cash accounts. Purchased stock cannot be sold before a settlement.
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How Do Funds Settle?
Settlement is required in order to ensure that all transactions are covered. Other types of securities may be subject to different settlement timelines. The rules for settlement are quite clear and running afoul of settlement rules can result in a violation.
A cash transfer into an account is considered settled funds. In a margin account, the available margin value for borrowing is considered settled. Finally, the funds from a settled transaction in a cash account are also considered to be settled.
Cash accounts require that all funds be fully settled before they can be used for trades. The settlement date is important because market volatility impacts the outcomes of trades. In the past, cash settlement could take a week. This meant those funds were tied up for several days.
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What Is a Settlement Violation?
Breaking the settlement rules results in what is known as cash account trading violations. Unlike trading on margin, cash accounts dictate that all transactions must be paid in full by the settlement date. This makes following all regulations regarding settled funds very important.
There are three types of settlement violations that can occur: good faith, freeriding and cash liquidation. Each of these violations may incur a penalty from your brokerage. It is important to know the rules of settlement for cash accounts to avoid such penalties.
- A good faith violation means that securities have been bought and sold without waiting for the initial settlement. Funds must be settled before securites can be liquidated, or it is considered a violation of good faith.
- Freeriding is when securities are sold to cover the amount of a purchase of the same securities. This also violates the Federal Reserve Board's Regulation T.
- A cash liquidation violation occurs when a trader buys securities and then sells other securities to cover the cost after the purchase date. All funds must be settled prior to purchase.
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Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.