How does cash settle with Interactive Brokers?

Settlement in the United States

A banking operation needs time to be cleared (or settled). When do an operation, you can see it visible on your banking interface, but it has probably not be settled yet. It means that both parties of the operation have not yet cleared it.

Historically, operations have taken very long to settle on US banks and brokers. In the very early days, it took up to two weeks (hundreds of years ago), but these days, it takes between one and three days.

When we use a broker like Interactive Brokers, these settlement periods can be seen in three different places:

• Deposits
• Currency conversions
• Stock transactions

Sometimes, you may encounter the name Regulation T. This is the name of the rule from the Federal Reserve. In essence, by trading without settlement, you are effectively getting credit from your broker and all credit issues must be regulated.

Often, when you encounter this system, Interactive Brokers will tell you that you do not have enough cash available to trade. And typically, investors are surprised because they just did a deposit or a currency conversion, and they think they should have enough money. The problem is that the cash is visible already (this is instant), but has not yet settled.

Operation settlement with Interactive Brokers

We can now look at the details of these operations with Interactive Brokers. I focus on operations for simple investors, like me. So I will not cover options and other derivatives.

The first operation that must settle is a bank deposit. Usually, these operations take between two and five business days to settle, depending on the type of wire you are using. However, Interactive Brokers generally makes an exception for buying stocks and converting currencies. It means that the money is typically available on the same day for trading, but you have to wait until it settles if you want to withdraw it. So, unless you need to withdraw this money quickly, this first settlement period should be pretty transparent.

The second operation that must settle is a currency conversion. Most currency pairs at IB will settle in two business days. So, if you send CHF to your account and then convert it to USD to buy your favorite US ETF, you will need to wait two business days before you can buy the US ETF. During these two days, the cash will be visible on the interface, but IB will warn you that you do not have enough cash settled for the operation. This can sometimes make it cumbersome to trade with a US broker.

The third and final operation we are interested in is buying and selling stocks. These operations settle in one business day (T+1 settlement is the official name). So, when you buy an ETF or a stock, the operation will not be cleared until the next business day. I am focusing here specifically on operations on American stock exchanges. Indeed, settlement periods are different for different stocks. So, it is likely that some operations settle slower if you use multiple stock exchanges.

For buying stocks, this is rarely an issue, but this may be an issue when selling stocks. Indeed, when you sell some securities, the proceedings will only be available on the next business day. If you need the money, this could be an issue, so it is essential to know about this rule. And there is another place where it is essential to learn about that rule because this can lead to violations, as we will see in a section below.

Overall, it is important to know about these settlement periods, but there is not much we can do except wait. However, there are some exceptions to cash settlement that are worth knowing as well.

Exceptions to cash settlement

There are a few exceptions to cash settlement.

The first exception is having a margin account. With a margin account, you do not have to wait for the cash to be settled to use it. Since you can invest on margin, you can also invest on unsettled cash. Having a margin account means you never have to wait for cash settlement. Of course, having a margin account is not always a good. If you do not know what you are doing, you may end up on margin without wanting it or, even worse, ending up with a margin call.

The second exception is if the broker matches some orders internally. This means that instead of going onto the stock exchange, the broker matches two of its customers to do an operation. For instance, if one investor is willing to buy X while another is willing to sell X. In this case, the settlement would be instant. I am not sure how frequent this is, since brokers are only allowed to do that if this does not provide a worse execution than if they went to the stock exchange.

It also seems that some brokers offer operations on unsettled cash to some of their customers. Based on some threshold (age and size of account), some brokers seem to let customers trade on unsettled cash.

Overall, the only significant exception to settlement is using a margin account. This allows to always trade instantly without issues.  But for most people, it is probably better to simply wait until cash settles rather than switch to a complex account (with some risk).

Settlement and violations

For passive investors, it should not be an issue, but delayed settlement can lead to violations. The basic rule is that investors must pay for a security before they sell it.

The first kind of violation of that rule is a good faith violation. If an investor sells shares of any stock on a day and then buys another stock on the same with the money from the proceedings, it is a good faith violation because the buy operation was made with unsettled cash. A good faith violation is considered an abuse of credit. Brokers keep track of them and are required to restrict accounts that do four or more violations in a year.

The second kind of violation is a freeriding violation. If an investor buys shares of any stock and then sells this same stock before settlement, resulting in paying for the stock with itself, it is a freeriding violation. For instance, if you buy shares of Nvidia on day one with (without cash being settled) and then sell the stock on the same day, you have effectively paid (the next day, on settlement) the stock with itself. The SEC requires brokers to restrict accounts on the first freeriding violation.

As a passive investor, these cases are not very realistic. Moreover, Interactive Brokers generally detects and prevents these violations before they occur. But it is interesting to know about them if you are ever subject to them.

Conclusion

If you are a simple passive investor like me, you do not have to worry too much about cash settlement and all this complexity. It only matters to know that some operations need time to settle. And in most cases, we can simply wait for the cash to be settled to do our operations.

However, if you are planning to invest more actively, it is important to know about settlement in depth and how to avoid violations. Active investors need to trade quickly, and they cannot afford to wait between operations.

Many investors choose a margin account to avoid these issues. It is a valid choice, but it is essential to know what we are doing when using a margin account. Indeed, it becomes easy to buy more stocks than we can afford (with leverage) and in the worst cases, we can end up losing a lot of money.

If you would like to learn more about this broker, take a look at my guide on using Interactive Brokers.

What about you? What do you think about these cash settlement rules?

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