Fails to deliver

What Is Fails to Deliver?

A "fails to deliver" (FTD) occurs in securities trading when one party in a transaction is unable to deliver the securities or cash to the counterparty by the agreed-upon settlement date. This failure means that the transfer of ownership of a security, or the corresponding payment, does not happen on time. FTDs are a component of the broader financial category of securities trading and settlement, representing a disruption in the normal, timely completion of a trade. The Securities and Exchange Commission (SEC) collects and publishes "fails-to-deliver" data in the United States, providing transparency into these market events¹⁹. While often associated with certain trading strategies, fails to deliver can stem from various operational or liquidity issues within the complex system of financial markets.

History and Origin

The concept of fails to deliver is inherent to any trading system where transactions are not settled instantaneously. Historically, securities settlement involved physical certificates, which naturally led to delays and potential failures. As markets modernized, moving from manual processes to electronic systems, the primary objective remained ensuring that buyers receive their securities and sellers receive their funds in a timely manner. The standardization of settlement periods, such as the T+3 (trade date plus three business days) and more recently T+2, and the transition to T+1 in the U.S. and other markets, has continuously aimed to reduce settlement risk and the incidence of fails.

However, even with advancements, FTDs persist. The SEC introduced Regulation SHO in 2005 to address concerns about persistent fails to deliver, particularly those linked to abusive short selling practices. Despite regulatory efforts, FTDs can still occur for various legitimate reasons, ranging from technical glitches to administrative errors. Concerns regarding the costs of failed settlements have been highlighted, with estimates suggesting billions of dollars are spent resolving failures in global equities markets annually. A report in early 2024 estimated that over $96 billion was spent resolving failures in 2023, with a potential increase to $157 billion in 2025¹⁸. This underscores the ongoing challenge of achieving seamless settlement in high-volume, complex financial environments.

Key Takeaways

• A fail to deliver (FTD) indicates that a party in a securities trade did not fulfill its obligation to deliver the security or cash by the settlement date.
• FTDs can result from various factors, including operational issues, liquidity problems, or, less commonly, strategic behaviors.
• The Securities and Exchange Commission (SEC) provides public data on fails-to-deliver for equity securities in the U.S. market.
• While FTDs are a normal part of market operations to some extent, persistent or significant levels can indicate underlying market inefficiencies or issues.
• Regulatory efforts, such as Regulation SHO, aim to mitigate the impact of FTDs and prevent abusive practices.

Interpreting Fails to Deliver

Understanding fails to deliver involves recognizing that they are a symptom, not necessarily a cause, of market conditions. FTD data published by regulatory bodies like the SEC reflects the cumulative net balance of shares that failed to be delivered as of a specific settlement date¹⁷. It is crucial to note that this figure includes both new fails that occurred on that day and existing fails that have not yet been resolved. Therefore, the data reflects a snapshot of outstanding failures, not a daily volume of new fails¹⁶.

A high level of fails to deliver for a particular security can sometimes signal unusual trading activity or market stress. For example, during periods of extreme volatility or significant short interest, FTDs might rise as market participants struggle to locate or deliver shares. However, the SEC clarifies that FTDs can result from both long and short sales and are not inherently indicative of abusive trading or "naked" short selling¹⁵. Analysts may examine FTD data in conjunction with other metrics, such as trading volume and short interest, to gain a more complete picture of market dynamics.

Hypothetical Example

Consider a hypothetical scenario involving shares of "Tech Innovations Inc." (TII).

1. Trade Execution: On Monday, an investor places an order to sell 1,000 shares of TII. A buyer simultaneously places an order to purchase 1,000 shares. The trade is executed on Monday, with a T+2 settlement cycle, meaning settlement is expected by Wednesday.
2. Operational Glitch: On Wednesday morning, the seller's broker-dealer's internal system experiences a technical issue, preventing the electronic transfer of the TII shares to the clearing house by the settlement deadline.
3. Fail to Deliver: As a result, the seller's broker-dealer records a "fail to deliver" for 1,000 shares of TII. The buyer does not receive the shares on Wednesday as expected.
4. Resolution: The broker-dealer works to resolve the operational issue. By Thursday morning, the technical problem is fixed, and the 1,000 shares are successfully delivered and settled. The FTD is then cleared from the system. During the period of the fail, the clearing house may require the defaulting broker-dealer to post additional collateral to mitigate risk.

This example illustrates how an FTD can occur due to an unforeseen operational issue, even in a routine transaction.

Practical Applications

Fails to deliver are a crucial metric within financial market oversight and risk management, particularly in the realm of market microstructure. Regulators, exchanges, and clearing houses closely monitor FTD data to ensure market integrity and stability.

• Regulatory Oversight: The SEC publishes FTD data to enhance transparency in the equity markets and to aid in the enforcement of rules like Regulation SHO, which imposes requirements on broker-dealers for facilitating the delivery of securities. The data, aggregated through the National Securities Clearing Corporation's (NSCC) Continuous Net Settlement (CNS) system, provides insights into settlement efficiency¹⁴,¹³.
• Risk Management: Financial institutions use FTD data as part of their internal risk management frameworks. Persistent fails by a counterparty could signal potential operational weaknesses or liquidity issues, prompting a review of credit exposures. The cost of settlement failures can be significant, including interest claims and potential ripple effects across multiple counterparties¹².
• Market Analysis: While not a direct indicator of abusive behavior, analysts and researchers may examine FTD patterns for specific securities, particularly those experiencing high volatility or significant short interest. For example, during the GameStop short squeeze in early 2021, significant amounts of GameStop shares were reported as failed-to-deliver, with buyers lacking cash or sellers not having shares to settle trades¹¹. This highlights how FTDs can become pronounced during periods of intense market activity.

Limitations and Criticisms

While fails to deliver data provides valuable insights, it comes with certain limitations and has faced criticisms regarding its interpretation. A key point is that an FTD does not automatically imply illicit activity like "naked" short selling. The SEC explicitly states that fails-to-deliver can occur for various legitimate reasons in both long and short sales and are not evidence of abusive short selling¹⁰. Operational issues, technical glitches, and administrative errors within the complex web of market participants can all lead to FTDs.

One criticism is that FTD data reflects a cumulative balance rather than new daily fails, which can make it challenging to ascertain the true "age" or origin of a particular fail⁹. This aggregation can obscure the underlying dynamics of how and why fails are occurring. Furthermore, academic research on the market impact of FTDs has yielded mixed results. 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 could even lead to higher liquidity and market efficiency in some contexts,⁸. However, other studies have pointed to potential market distortions from sustained fails, especially for certain types of securities like Exchange Traded Funds (ETFs)⁷.

The move to shorter settlement cycles, such as T+1, also presents new challenges and potential for increased initial FTDs, as market participants have less time to resolve issues before the settlement deadline⁶,⁵. This highlights the ongoing complexity and the need for robust operational processes to minimize settlement failures.

Fails to Deliver vs. Naked Short Selling

Fails to deliver and naked short selling are often discussed together and can be a source of confusion, but they are distinct concepts.

Fails to Deliver refers to the failure of a seller to deliver the securities or a buyer to deliver the cash by the designated settlement date. This is an operational outcome, meaning the trade did not complete as planned on time. FTDs can occur for many reasons, including legitimate issues like administrative errors, technical problems, or delays in receiving shares from another party.

Naked Short Selling is a specific type of short selling where the seller does not borrow or arrange to borrow the securities before selling them, nor does the seller deliver the securities by the settlement date. In essence, it is selling shares that have not been confirmed to exist or be available for borrowing. Naked short selling can contribute to fails to deliver, as the seller, lacking the shares, cannot fulfill their delivery obligation. However, an FTD is not always the result of naked short selling. A broker-dealer might have intended to deliver shares from a long position, but an unforeseen issue prevented it.

The key difference lies in intent and origin: an FTD is the result of a failed settlement, which may or may not be due to a lack of shares available to borrow (as in naked short selling). Regulatory frameworks, such as Regulation SHO, specifically target naked short selling by requiring broker-dealers to have reasonable grounds to believe the securities can be delivered before executing a short sale.

FAQs

What causes a fail to deliver?

Fails to deliver can be caused by various factors. These include operational problems within a firm's back office, such as technical glitches or incorrect booking of trades; liquidity problems, where a firm cannot obtain the security due to high demand or reliance on a delayed delivery from another party; or, less commonly, strategic behavior by a firm to delay delivery⁴.

Are fails to deliver illegal?

No, fails to deliver are not inherently illegal. While persistent FTDs for extended periods can draw regulatory scrutiny, and some may arise from practices like illegal naked short selling, FTDs themselves are an operational event in the settlement process. They are reported by the SEC to provide transparency and are part of the broader system of securities trading.

How are fails to deliver resolved?

When a fail to deliver occurs, the parties involved and their clearing brokers work to resolve it. This typically involves the seller eventually delivering the securities, often by borrowing shares or acquiring them in the open market. The clearing house may impose penalties, such as interest claims, on the defaulting party to incentivize timely settlement and to compensate the non-defaulting party³. In some cases, a buy-in procedure may be initiated where the defaulted shares are purchased in the market to fulfill the obligation².

Does a fail to deliver impact the stock price?

The direct impact of fails to deliver on stock prices is a subject of ongoing debate among academics and market participants. Some studies suggest that FTDs have little or no discernible impact on returns or market manipulation¹. Others argue that sustained delivery failures can lead to pricing abnormalities and affect market integrity. During significant market events, such as a large gamma squeeze or short squeeze, high FTD levels may coincide with extreme price movements, but a direct causal link is complex and often debated.

What is the T+1 settlement cycle and how does it relate to FTDs?

The T+1 settlement cycle means that trades are settled one business day after the trade date. This shorter timeframe is designed to reduce market risk and improve capital efficiency. However, the transition to T+1 can initially lead to an increase in fails to deliver because market participants have less time to resolve any operational or logistical issues that arise between trade execution and settlement. This requires firms to have more robust and efficient post-trade processing systems.