What it is:
How it works (Example):
When an investor sends an order to his or her broker, that trade information is sent to a clearinghouse (for example, the National Securities Clearing Corporation). The clearinghouse processes and records the trade, and then issues a report to the broker/dealers involved that includes their net securities positions and the money to be settled among the parties.
The NSCC forwards settlement instructions to the Depository Trust & Clearing Corporation (DTCC), asking it to electronically transfers the ownership of the securities from the selling broker's account to the buying broker's account. The DTCC also transfers funds from the buying broker's bank account to the selling broker's bank account.
The brokerages then adjust their clients' accounts accordingly. The process is similar for institutional investors. For most stock trades, this takes three business days to occur. For option trades, fund settlement usually takes one business day.
Funds settlement also occurs for dividend payments. Foreign markets may have different settlement procedures or times to completion.
Why it Matters:
Funds settlement is an important "back-office" function, and the faster it occurs, the more it reduces market risk by ensuring that trades are executed properly. Fast funds settlement also increases investor confidence in the markets by ensuring that their trades are completed on time and that they won't lose their funds to bankrupt brokerage firms or intermediaries. It also requires participants to have the money in their accounts as their trades are made (or arrange for credit before the trade is placed).