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How T+2 Settlement Affects ETF Investors

2018-05-28T22:28:23+00:00August 28th, 2017|Categories: Discount brokers|Tags: , |20 Comments

These days we’re used to financial transactions that happen instantly. Buy groceries with your debit card and you see your bank account updated immediately. Send a friend money with an Interac transfer and it’s in their hands in seconds. Yet when you buy or sell an ETF or mutual fund, the trade doesn’t settle for three business days, a practice known as T+3. It’s a convention that seems as outdated as traveller’s cheques.

The good news is this is about to change: on Tuesday, September 5, markets in Canada and the United States will be moving to a T+2 cycle, with settlement two business days after the trade.

This change will mostly affect financial institutions and their intermediaries, but if you regularly buy ETFs, mutual funds, and other investments through an online brokerage there are a number of details you should understand.

Out of order

Before diving into the details, let’s review what settlement means in this context. A trade is considered settled when the buyer has delivered the cash to the seller, at which point ownership of the security officially changes hands. Strictly speaking, you don’t have to pay for your ETF or mutual fund units until three business days after you make the purchase. Depending on your brokerage and account type, you may be able to buy shares with no cash in your account, as long as you deposit that cash before settlement.

Most people don’t do this, of course. Normally we buy ETFs and mutual funds using the cash balances that are already in our accounts. Indeed, the whole idea of a three-day settlement period is largely invisible to buy-and-hold investors. But there are a number of situations when it can cause confusion:

You buy and sell securities with different settlement periods. Stocks, bonds, mutual funds and ETFs all currently use a T+3 settlement period. But several other investments are on a T+1 cycle, with settlement the next business day. These include T-bills, high-interest savings accounts (HISAs) and money market funds. GICs may settle the same day or T+1, depending on the dealer. This means if you sell one investment and buy another with a different cycle, your trades could settle out of order.

Let’s say on a Monday you sell $10,000 worth of an ETF. Though the proceeds will appear in your cash balance immediately, but settlement won’t officially occur until T+3. So if you use that cash to buy a high-interest savings account (T+1), you’ll have a problem. The HISA purchase will settle on Tuesday, but the money won’t actually be available until your ETF sale settles on Thursday. This trade could be rejected by your brokerage, or you’ll be charged two days’ worth of interest.

Canada and the US have different holidays. The settlement cycle is based on business days, which excludes weekends and holidays when markets are closed. This can create problems when markets are closed in Canada but not in the US, or vice-versa.

Consider an investor who sells a US-listed ETF and uses the proceeds to buy one that trades on the TSX. She makes both trades on the Friday in January before Martin Luther King Jr. Day, which is a holiday only in US. The sale of the US-listed ETF will not settle until the following Thursday, but the purchase of the Canadian ETF will settle on Wednesday. Her brokerage may charge her a day’s interest for being out of order.

You buy or sell an ETF near the dividend record date. When an ETF (or individual company) declares it will be paying a dividend, it specifies a record date. To receive the dividend, you must own shares in the ETF on that date. So if the record date is Friday and you purchase the fund on Wednesday or Thursday, your trade would not settle until the following week and you would not receive the dividend. For this reason, ETFs and stocks are said to trade “ex-dividend” on the two days before the record date.

It works the other way around, too. Continuing the same example, if you already owned an ETF with a record date of Friday and you sold it on Wednesday or Thursday, you would still receive the dividend. If you had a dividend reinvestment plan (DRIP) in place, you might even find yourself holding a couple of new shares in the ETF, and these will cost you an extra commission to sell.

When the dust settles

Even after the settlement cycle changes from three days to two on September 5, the issues described above still need to be considered. It will still be possible for trades made on the same day to settle out of order. But the shortened settlement period is generally good news for investors. A few examples:

  • If your trades settle out of order because the securities use a different cycle (such as ETFs and high-interest savings accounts or GICs), you may end up paying only one day’s worth of interest instead of two.
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  • If you convert currency using Norbert’s gambit with the Horizons US Dollar Currency ETF (DLR and DLR.U), your brokerage may require you to wait until the first trade settles before you journal the shares to the other side of your account. With the new T+2 settlement period you’ll be able to do this one day sooner.
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  • If you buy or sell an ETF near the dividend record date, the window for confusion is a little smaller. Once T+2 settlement becomes reality, an ETF will only trade ex-dividend on the one business day before the record date, rather than during the previous two days.