Differences Between a Clearing & a Settlement

When you place an order with your broker to trade securities, such as stocks or options, it goes through through a series of steps known as clearing and settlement. Clearing is the term used for the procedures required to process a securities transaction. Settlement refers to the actual payment for and delivery of the securities.

Clearing represents the process of taking care of the documentation and making sure the funds and securities needed to complete a trade are available for transfer. Nearly all securities transactions in the United States are handled through a clearinghouse of the Depository Trust & Clearing Corporation as electronic transactions.

At the conclusion of each business day, a broker sends the days's transactions to the clearinghouse. The clearinghouse is responsible for collecting and delivering securities and payments to the proper destinations. In practice, trades are processed using multilateral clearing. This means the broker aggregates similar transactions and only the net amount is transferred. For example, if your broker has several sales of stock in Company X totaling 1,500 shares and total purchases of 1,200 shares, only the net difference of 300 shares is sent to the clearinghouse. Multilateral clearing reduces the volume of transactions, saving time and money.

Once a trade has cleared, the actual exchange of money for securities takes place. If you are selling shares of stock, your broker takes them out of your account and delivers them to the buyer. Your brokerage account is credited with the sale proceeds minus transaction fees. On the other end, the buyer's account is debited for the amount of the purchase and the securities are credited to her account. Settlement must take place by a specific day. For stock trades, settlement is on the third business day following the trade, abbreviated T + 3.

Other types of securities have different settlement dates. For example, options settle on T + 1, meaning the next business day. Customers must deposit enough money in their brokerage accounts to cover trades by the deadline. Investors who violate this rule can be restricted to making transactions only when they have sufficient settled funds in their accounts.

Today's system of clearing and settlement began to evolve in the 1960s and 1970s to deal with problems stemming from increasing trading volume and the time and expense required to transport paper documents and securities. For investors, clearing and settlement provides safety because each party -- brokers and clearinghouses -- assumes financial responsibility for the securities and funds it handles.