You may have observed that when you sell most mutual funds before the end of trading on any given day (1 PM Pacific Time), the cash typically shows up in your account the next trading day.  This is known as a one-day trade settlement cycle. When you buy funds, the shares appear in your account and the cash is debited the very next day.  And why not?  With computers managing all the trading activities, there should be no reason for the transaction to take any longer.  Have you ever wondered, then, why it takes three full days for stock or ETF trades to settle?

There is a difference between trading shares of ETFs and stocks as compared to mutual funds.  The former are traded on the secondary market between brokers and dealers, whereas you (or your broker) are dealing directly with the fund company when buying or selling mutual fund shares.  But the question remains: why are fund companies able to execute the transaction in one day while it takes three for almost everyone else?

The main reason is historical.  According to Jason Zweig in a blog post last year, overnight (one-day) settlement was the norm until 1938, when presumably the volume of daily trades became high enough that regulators allowed brokers to take two days to settle them.  The number of days increased to three in 1946 and, with daily volume exceeding 10 million shares, a full five days by 1968.  Considering that all the paperwork back then was done by hand, five-day settlement seemed like a reasonable time frame to help the brokerage industry avoid drowning in paperwork and/or otherwise end up making lots of trading mistakes.

After “Black Monday” in 1987, when the Dow dropped 22.6% in one day and international stocks also took a beating, regulators began investigating a shortening of the settlement cycle again in order to reduce credit, liquidity, and systemic market risk.  It took until 1995 for them to reduce the cycle back to three days, and that’s where it has remained until now.  But change is coming. On September 5^th the trade settlement cycle – except for U.S. government securities and stock options which are currently on a one-day cycle – is being reduced to two days.

In this current age of computers, one might wonder why they didn’t drop it to one day.  It could be because brokerage firms have become accustomed to making additional profits doing what’s called “playing the float.”  This included temporarily investing the cash they were holding from customers as well as collecting fees on securities they loaned out for a couple of days before having to deliver them.  That may not sound very lucrative but based on the sheer volume of daily trades their income from these activities has been pretty substantial.  Nonetheless, the Depository Trust and Clearing Corporation was able to overcome entrenched industry resistance to lead the way closer to the ideal of overnight trade settlements.

It may not be perfect, but it is a positive and welcome change.