Fail to deliver: Meaning, Criticisms & Real-World Uses

What Is Fail to Deliver?

A fail to deliver (FTD) occurs in the financial markets when one party in a trade fails to fulfill its obligation to deliver the required securities or cash by the specified settlement date. This event falls under the broader category of securities settlement and is a critical aspect of market operations. While typically associated with sellers failing to provide shares, a fail to deliver can also occur if a buyer does not have sufficient cash to complete the transaction⁵⁵, ⁵⁶. FTDs can arise from various issues, including operational errors, administrative oversights, or more complex situations like naked short selling ⁵³, ⁵⁴. The timely settlement of trades is fundamental to maintaining orderly markets and safeguarding investor confidence.

History and Origin

The concept of a fail to deliver has existed since the early days of securities trading, stemming from the fundamental requirement that assets exchanged in a transaction must actually change hands. As markets grew more complex, particularly with the rise of practices like short selling, the potential for fails to deliver increased. Regulators became increasingly concerned about the potential for FTDs to disrupt market integrity and facilitate manipulative practices.

In response to these concerns, the U.S. Securities and Exchange Commission (SEC) introduced Regulation SHO in January 2005⁵¹, ⁵². This significant regulatory update aimed to address persistent fails to deliver and curb abusive short selling practices, including the infamous "naked" short selling⁴⁹, ⁵⁰. Regulation SHO established key requirements, such as the "locate" rule, which mandates that a broker-dealer must have reasonable grounds to believe that securities can be borrowed and delivered before executing a short sale⁴⁶, ⁴⁷, ⁴⁸. It also introduced "close-out" requirements, compelling broker-dealers to resolve outstanding FTD positions within specific timeframes⁴⁵. These rules have been amended over time to strengthen their effectiveness and enhance transparency in the market⁴⁴.

Key Takeaways

A fail to deliver (FTD) occurs when a party in a securities trade cannot deliver the assets or cash by the settlement date.
FTDs can result from various factors, including administrative errors, insufficient shares, or the more problematic practice of naked short selling.
The SEC's Regulation SHO was implemented to reduce FTDs and prevent abusive short selling through "locate" and "close-out" requirements.
Persistent fails to deliver can negatively impact market integrity, liquidity, and investor confidence.
Regulatory bodies, such as the SEC and the Clearing house (DTCC), publish data on FTDs to promote transparency.

Formula and Calculation

While there isn't a formula to calculate whether a trade will fail to deliver, financial institutions and clearing houses often impose charges for existing FTDs to incentivize prompt settlement. For instance, the Fixed Income Clearing Corporation (FICC), a subsidiary of the DTCC, collects an interest charge on the settlement value of a trade that fails to deliver. This charge encourages participants to resolve their failed positions quickly.

The daily fails charge can be calculated as follows:

$\text{Daily Fails Charge} = \text{Settlement Value} \times \frac{\text{Interest Rate} - \text{Target Fed Funds Rate}}{360}$

Where:

Settlement Value: The total dollar value of the securities that failed to deliver.
Interest Rate: An annual interest rate applied to the failed position (e.g., 3% as per some FICC guidelines)⁴³.
Target Fed Funds Rate: The target federal funds rate in effect the day before the settlement day, representing the benchmark short-term interest rate⁴².
360: The number of days used for annualizing the rate (a common practice in finance).

This formula quantifies the financial penalty associated with a fail to deliver, highlighting the costs involved when a compliance obligation is not met.

Interpreting the Fail to Deliver

Interpreting fail to deliver data requires nuance, as FTDs can stem from various sources, not all of which are indicative of illicit activity. For instance, a temporary technical glitch or an administrative error can lead to a single fail to deliver. However, a significant and persistent volume of FTDs in a particular security often draws scrutiny, especially from investors interested in short interest and potential market manipulation ⁴⁰, ⁴¹.

The SEC publishes FTD data twice a month, providing transparency into the aggregate net balance of shares that failed to be delivered as of a particular settlement date³⁸, ³⁹. While high FTD numbers can sometimes coincide with periods of intense short selling or volatility, the SEC cautions that FTDs are not necessarily evidence of abusive short selling or naked short selling³⁶, ³⁷. Market participants, including market maker firms, might experience FTDs due to their role in providing liquidity, where they may need to sell shares before securing them, anticipating they can cover the position by the settlement date³⁵.

Hypothetical Example

Consider a scenario involving Company ABC stock, which typically settles on a T+2 basis (trade date plus two business days).

Trade Execution: On Monday (Trade Date, T), Investor A sells 1,000 shares of Company ABC to Investor B.
Expected Settlement: The trade is expected to settle on Wednesday (T+2). This means Investor A's broker-dealer must deliver the 1,000 shares to Investor B's broker-dealer by the end of Wednesday, and Investor B must deliver the cash.
Fail to Deliver: On Wednesday, Investor A's broker-dealer is unable to deliver the 1,000 shares to Investor B's broker-dealer. This could be because Investor A failed to deliver the shares to their own broker-dealer, perhaps due to an unforeseen administrative hold or because they sold shares they didn't yet possess and couldn't acquire them in time.
Resulting FTD: A "fail to deliver" is recorded for these 1,000 shares. Investor B's broker-dealer will now have a "fail to receive."
Resolution Efforts: Investor A's broker-dealer must now take steps to "close out" this fail. This might involve buying the shares in the open market, regardless of price, to fulfill the obligation, or borrowing shares to complete the delivery, potentially incurring penalties or charges from the clearing house for the delay. This process ensures the buyer eventually receives their shares, albeit delayed.

Practical Applications

Fail to deliver data is a key metric observed by various market participants, particularly those interested in market efficiency and potential regulatory compliance issues.

Regulatory Oversight: Regulatory bodies, notably the SEC, actively monitor FTD data as part of their oversight of market integrity. Regulation SHO was specifically designed to reduce the incidence of FTDs, especially those linked to potentially abusive naked short selling ³⁴. The SEC regularly publishes aggregated FTD data, accessible to the public, which allows for greater transparency regarding settlement efficiency across different securities³², ³³.
Market Analysis: Investors and analysts often review FTD data, particularly for stocks with high short interest, to gauge potential supply/demand imbalances or to identify situations where short positions might not have been properly covered. For example, during the GameStop trading events in early 2021, significant amounts of GameStop shares were reported as failed-to-deliver, drawing considerable attention to the issue²⁹, ³⁰, ³¹.
Clearing and Settlement: Clearing houses, such as the DTCC, play a central role in managing the settlement process and imposing penalties on participants with outstanding FTDs. Their systems track and facilitate the resolution of these failures to ensure that trades are ultimately completed and that market participants receive their entitled dividend or interest payment ²⁷, ²⁸. Daily data on U.S. Treasury trade fails are publicly available from the DTCC, highlighting the continuous monitoring of settlement efficiency in large markets²⁵, ²⁶.
Risk Management: Broker-dealers implement robust risk management practices to minimize their exposure to fails to deliver, which can lead to financial penalties and reputational damage. This includes stringent procedures for "locating" shares before short sales and ensuring timely delivery²⁴.

Limitations and Criticisms

While fail to deliver data provides valuable insights into market dynamics, it comes with certain limitations and has faced criticism.

One primary criticism is that FTD data, as reported, is a cumulative figure and doesn't always reflect new daily fails accurately, making interpretation challenging²², ²³. Additionally, the SEC itself states that FTDs are not necessarily indicative of abusive short selling or naked short selling, as legitimate reasons can account for settlement delays¹⁹, ²⁰, ²¹. This distinction is crucial, as misinterpreting FTD data can lead to unfounded accusations of market manipulation.

Some critics argue that despite regulations like Regulation SHO, loopholes or operational complexities may still allow for persistent FTDs, potentially impacting market integrity and price discovery, especially in thinly traded or heavily shorted securities. Concerns have also been raised regarding the effectiveness of penalties in deterring FTDs in all market conditions. However, studies have also provided a more nuanced view; for example, a 2014 study published in the Journal of Financial Economics found no evidence that FTDs caused price distortions or the failure of financial firms during the 2008 financial crisis, suggesting that "greater FTDs lead to higher liquidity and pricing efficiency". This highlights the complexity of attributing direct negative impacts solely to FTDs. The debate around FTDs often touches on the broader challenges of regulation and enforcement in fast-moving financial markets¹⁸.

Fail to Deliver vs. Naked Short Selling

While closely related and often discussed together, "fail to deliver" and "naked short selling" are distinct concepts within securities settlement.

A fail to deliver is a neutral term describing the operational outcome when a party does not fulfill its delivery obligation by the settlement date¹⁵, ¹⁶, ¹⁷. It can occur for various reasons, including simple human error, technical glitches, or even if the original owner of the shares doesn't deliver them on time. It can happen in a "long" sale (where the seller owns the shares) or a "short" sale¹³, ¹⁴.

Naked short selling, on the other hand, is a specific, generally illegal practice that can lead to a fail to deliver¹². In naked short selling, a seller sells shares without first borrowing them or even confirming that they can be borrowed. This means the seller does not have the shares in hand nor a firm arrangement to obtain them by the settlement date¹¹. If the seller cannot acquire the shares to cover their position, it results in a fail to deliver. While not all FTDs are due to naked short selling, and not all naked short sales immediately result in an FTD (if the shares are eventually secured), the practice of naked short selling significantly increases the likelihood of FTDs and is heavily regulated due to its potential for market manipulation and distorting genuine supply and demand⁹, ¹⁰.

FAQs

What causes a fail to deliver?

A fail to deliver can be caused by various factors, including administrative errors, technical issues, insufficient shares available for delivery, or a seller engaging in short selling without successfully borrowing the shares by the settlement date ⁷, ⁸.

Is fail to deliver illegal?

A fail to deliver itself is an operational issue, not inherently illegal. However, certain practices that lead to a fail to deliver, such as naked short selling, are generally prohibited by regulatory bodies like the SEC due to their potential for market manipulation ⁶.

How are fails to deliver resolved?

When a fail to deliver occurs, the responsible broker-dealer is typically required to "close out" the position. This usually involves purchasing the outstanding shares in the open market or borrowing them to complete the delivery obligation, often within a specified timeframe, as mandated by Regulation SHO⁵. Penalties or charges may also be incurred for delayed settlement⁴.

Where can I find fail to deliver data?

The U.S. Securities and Exchange Commission (SEC) publicly releases aggregated fail to deliver data twice a month on its website², ³. The Depository Trust & Clearing Corporation (DTCC) also publishes daily data on U.S. Treasury trade fails¹.