Fail

What Is Failure to Deliver?

Failure to deliver (FTD) occurs in finance when one party to a trade fails to meet their contractual obligation to deliver a tradable asset or cash by the agreed-upon trade settlement date. This often happens when a seller is unable to provide the securities they sold, or a buyer does not have the necessary funds to complete the purchase. Failures to deliver are a crucial aspect of market regulation and securities trading, as they can indicate inefficiencies or potential issues within the settlement system. The Securities and Exchange Commission (SEC) actively monitors and publishes data on fails-to-deliver in the United States¹².

History and Origin

The concept of timely delivery in financial transactions has existed as long as markets themselves. However, the formal tracking and regulation of failures to deliver became more prominent with the increased complexity and volume of modern financial markets. In the United States, the Securities and Exchange Commission (SEC) has been instrumental in establishing rules to ensure efficient settlement. Following periods of market stress and concerns about certain trading practices, particularly short selling, the SEC adopted Regulation SHO in 2004. This regulation was designed to strengthen and modernize short sale oversight by introducing "locate" and "close-out" requirements, directly addressing issues that contribute to a failure to deliver¹¹. The regulation aimed to ensure that a broker-dealer has reasonable grounds to believe a security can be borrowed and delivered before a short sale is executed¹⁰.

Key Takeaways

• A failure to deliver (FTD) represents the inability of a party to fulfill their obligation in a securities trade by the settlement date.
• FTDs can occur due to various reasons, including operational errors, administrative delays, or in instances of naked short selling.
• The Securities and Exchange Commission (SEC) publishes data on fails-to-deliver and has implemented rules like Regulation SHO to mitigate their occurrence.
• Persistent failures to deliver can lead to concerns about market integrity, potentially affecting liquidity and investor confidence.
• Closing out FTDs involves purchasing or borrowing the underlying securities to complete the transaction, often under specific regulatory timelines.

Formula and Calculation

Failure to deliver is not typically calculated by a formula in the same way a financial ratio would be. Instead, it is a count or aggregate value of shares that were not delivered. The SEC publishes "fails-to-deliver" data, which represents the aggregate net balance of shares that failed to be delivered as of a particular settlement date. This figure is a cumulative number of all fails outstanding up to that day, plus new fails that occur, minus fails that settle⁹.

While there isn't a formula for FTD itself, the value reported by the SEC can be understood as:

$\text{FTD}_{\text{Current Day}} = \text{FTD}_{\text{Previous Day}} + \text{New Fails} - \text{Fails Settled}$

Where:

• (\text{FTD}_{\text{Current Day}}) = Total outstanding fails to deliver on the current settlement date.
• (\text{FTD}_{\text{Previous Day}}) = Total outstanding fails to deliver from the prior period (though the SEC notes this is not a direct relationship⁸).
• (\text{New Fails}) = Securities that failed to be delivered on the current day.
• (\text{Fails Settled}) = Securities for which the delivery obligation was fulfilled on the current day.

The data is usually reported by CUSIP number, ticker symbol, issuer name, price, and the total number of fails-to-deliver for that security⁷.

Interpreting the Failure to Deliver

The presence of a failure to deliver, or a significant volume of FTDs, can be interpreted in several ways within the context of market volatility. While FTDs can arise from benign causes like administrative errors or temporary liquidity issues, persistent or large-scale failures to deliver can raise flags about potential market inefficiencies or even manipulative practices. Regulators, such as the Securities and Exchange Commission, monitor this data as a potential indicator of unusual trading activity or issues within the clearing house system. High FTD numbers for a particular security might suggest difficulty in borrowing shares, especially in the context of short selling, or a disconnect between reported trading volume and actual share availability.

Hypothetical Example

Consider a hypothetical scenario involving "XYZ Corp." stock. An investor sells 1,000 shares of XYZ Corp. on Monday, expecting to deliver them by the trade settlement date, which is typically two business days later (T+2). However, by Wednesday, the investor's custodian or broker-dealer has not received the shares for delivery, perhaps because the investor sold shares they did not yet own and could not successfully borrow them in time. In this instance, a failure to deliver has occurred for 1,000 shares of XYZ Corp. The party on the other side of the trade, the buyer, will not receive their shares as expected. To resolve this, the selling party or their broker-dealer would need to take action to "buy in" the shares or borrow them to fulfill the delivery obligation, often incurring additional costs or penalties. This process is part of the Continuous Net Settlement system, which aims to net out obligations and identify failures to deliver efficiently.

Practical Applications

Failures to deliver appear in several practical contexts within investing, markets, and regulation. Regulators use FTD data to monitor market activity and identify potential areas of concern, particularly related to compliance with Regulation SHO, which requires broker-dealers to locate shares before executing a short sale⁶. This data is made public by the Securities and Exchange Commission to provide transparency into the settlement process⁵.

In market analysis, analysts and investors sometimes examine FTD data for specific securities to gauge potential underlying issues, though it is not a direct indicator of wrongdoing. While a failure to deliver can occur for various reasons, including routine operational issues, persistent FTDs in a particular security might prompt further investigation into borrowing availability or unusual trading patterns. Additionally, the broader regulatory environment surrounding short selling and settlement, influenced by events like market downturns, often leads to discussions and amendments to rules like the former Uptick rule or the current Regulation SHO, reflecting ongoing efforts to balance market efficiency with investor protection. Research by Federal Reserve banks, for example, explores the implications of short selling regulations on market dynamics.

Limitations and Criticisms

While failures to deliver are tracked by regulators, their presence alone is not definitive proof of illegal activity or market manipulation. FTDs can result from various reasons, including legitimate administrative errors or delays in the trade settlement process. The reported FTD data represents a cumulative balance and does not indicate the age of the fails, making it difficult to discern how long specific delivery failures have persisted⁴.

Critics sometimes argue that the public FTD data does not fully capture the extent of settlement issues or the potential impact of certain trading strategies, such as naked short selling, where shares are sold without being borrowed or located. Concerns have been raised that persistent failures to deliver could create "phantom shares," theoretically diluting a company's stock value, though academic studies on this impact present mixed findings. The complexity of the modern clearing house and Continuous Net Settlement systems also makes it challenging for external observers to fully interpret the implications of FTD data. While regulations like Regulation SHO aim to reduce FTDs, the inherent nature of a global, interconnected financial market means that occasional delivery failures remain a part of the system.

Failure to Deliver vs. Naked Short Selling

Failure to deliver and naked short selling are related but distinct concepts in securities trading. A failure to deliver refers to a situation where a seller does not provide the securities or a buyer does not provide the funds by the scheduled trade settlement date. It is a transactional outcome—a breach of the delivery obligation.

Naked short selling, on the other hand, is a specific type of short selling where an investor sells shares without first borrowing them or ensuring they can be borrowed. This practice is largely restricted by regulations like Regulation SHO in the United States, which requires a broker-dealer to have reasonable grounds to believe the security can be borrowed before a short sale is effected.
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While naked short selling can lead to a failure to deliver if the seller cannot acquire the shares by settlement, not all failures to deliver are a result of naked short selling. FTDs can also occur due to operational glitches, administrative errors, or issues with a long sale where the seller genuinely owns the shares but they are not delivered on time. The key distinction is that naked short selling is an action or strategy that attempts to sell unborrowed shares, whereas a failure to deliver is the consequence of any transaction where the delivery obligation is not met by the settlement deadline, regardless of the underlying reason.

FAQs

Why do Failures to Deliver occur?

Failures to deliver can happen for various reasons. These include administrative errors, technical issues, insufficient shares available for borrowing (especially in the context of short selling), or a buyer lacking sufficient funds. In some cases, it can also stem from restricted practices like naked short selling where a seller never secured the shares they sold.

How does the SEC regulate Failures to Deliver?

The Securities and Exchange Commission (SEC) regulates failures to deliver primarily through Regulation SHO. This regulation imposes "locate" requirements, meaning that before a short sale, a broker-dealer must have reasonable grounds to believe the shares can be borrowed and delivered. It also includes "close-out" requirements, which mandate that if a delivery fails, the responsible party must take action to close out the fail by purchasing or borrowing shares within specific timeframes. The SEC also publishes aggregated FTD data for transparency.
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What are the consequences of a Failure to Deliver?

For the market, persistent failures to deliver can sometimes lead to concerns about liquidity and overall market integrity. For individual parties, a failure to deliver means the transaction is not complete. The party that failed to deliver may face penalties, fees, or be forced to "buy in" the shares at potentially higher prices to fulfill their obligation. If a broker-dealer is involved, they must take steps to resolve the fail to prevent it from becoming a long-term outstanding issue. In extreme cases, widespread or systemic failures could pose a systemic risk to the financial system, though regulatory frameworks are in place to mitigate such scenarios.