GameStop hearing: What are ‘settlement times’ and why do they matter in stock trading?

If you tuned in to Thursday’s congressional hearing on the GameStop purchasing frenzy, you might have heard a few specialized stock market terms that have suddenly been nationally spotlighted. Like “settlement times,” for example.

That’s a concept several of the hearing’s star witnesses, including Robinhood’s chief executive, Vlad Tenev, have referenced in their written testimonies. Specifically, Tenev and other Wall Street leaders are calling for faster settlement times in stock market trading.

If you’re wondering what that means, here are your questions, answered:

What are settlement times?

Settlement times refer to when stock trades are, um, settled. When a buy or a sell is ordered, the cash doesn’t change hands immediately, but rather at the time of settlement—which currently occurs on a T+2 basis, or two business days after the fact.

Why do they matter to stockbrokers?

That’s because of rules set by the Depository Trust & Clearing Corporation (DTCC), a central stock market hub through which millions of buy/sell transactions are processed. Because sellers aren’t actually compensated until two days later, at the end of any trading day, the DTCC may require brokers to put up collateral for the net amount of money owed across all of its transactions. When buys and sells are roughly equal, that could be nothing. But when there are many buys and few sells (ahem, GameStop), that could be very large.

What’s the point of those rules?

The DTCC exists to protect investors and the stock market by ensuring brokers can actually back up the trades they make. It’s all about risk mitigation—and with Robinhood and GameStop, things got very, very risky.

What happened there?

Some brokers, such as Robinhood, let investors trade on margin, which means the investor pays typically between 50%-90% of the purchasing price while the broker backs the rest with an interest loan. However, with volatile stocks such as GameStop, which could drop precipitously within hours, there’s a risk that the broker—which must hold a stock until a trade is cleared—won’t have the funds for purchases made at their original, higher prices two days later. If that happens, the DTCC has to handle the default—thus the greater the risk, the greater the collateral.

Eventually, Robinhood just didn’t have the cash to pay the collateral—hence the liquidity crisis and trading restrictions.

So how would faster settlement times help?

The less time there is for potential volatility between trade orders and settlements, the less collateral a broker will have to put up.

“The existing two-day period to settle trades exposes investors and the industry to unnecessary risk and is ripe for change,” Tenev wrote in his testimony.