Failure to deliver

What Is Failure to Deliver?

A failure to deliver (FTD) occurs in the financial markets when a party to a trade, typically a seller, fails to deliver the promised securities to the buyer within the stipulated settlement period. This issue falls under the broader category of securities settlement, which encompasses the processes of exchanging securities for cash after a trade is executed. FTDs are a critical concern because they can impact market efficiency, introduce counterparty risk, and potentially undermine market integrity. While a failure to deliver can arise from various operational issues, it can also be associated with more complex situations, such as a seller not possessing the shares at the time of the sale, commonly known as a "naked" short sale.

History and Origin

The concept of a failure to deliver is as old as the practice of trading itself. Historically, when financial transactions involved physical certificates, settlement times were considerably longer, often spanning weeks or even months due to the logistics of physically moving paper. For instance, in earlier centuries, the standard settlement period could be as long as 14 days, reflecting the time it took for couriers to transport physical documents. The shift from paper-based to electronic settlement in the late 20th century, particularly with the establishment of central securities depositories like the Depository Trust Company (DTC) in the U.S., significantly reduced these times.¹⁷

Despite technological advancements, failures to deliver persisted. The 1987 stock market crash, known as Black Monday, highlighted the vulnerabilities of extended settlement periods, prompting a global move to shorten the time between trade execution and settlement. In response to ongoing concerns about market efficiency and the potential for manipulative practices, particularly related to short selling, the U.S. Securities and Exchange Commission (SEC) adopted Regulation SHO in 2004. This regulation was specifically designed to reduce persistent failures to deliver and address issues like "naked" short selling by implementing "locate" and delivery requirements for broker-dealers.¹⁵, ¹⁶

Key Takeaways

• A failure to deliver occurs when a seller does not provide the agreed-upon securities or a buyer does not provide the funds by the settlement date.
• FTDs can result from operational errors, illiquidity, or, in some cases, aggressive short-selling strategies.
• The U.S. Securities and Exchange Commission (SEC) actively monitors fails-to-deliver data and enforces regulations, such as Regulation SHO, to mitigate their impact.
• Persistent failures to deliver can lead to increased market volatility, reduced investor confidence, and potential financial losses for market participants.
• While FTDs are a measure of unfulfilled settlement obligations, they do not inherently indicate fraudulent activity.

Interpreting the Failure to Deliver

Failures to deliver represent unfulfilled obligations in the securities settlement process. When an FTD occurs, it means that the party due to deliver the asset (or cash) has not done so by the agreed-upon settlement date. These figures are generally aggregated and reported by regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), which provides public data on fails-to-deliver in equity securities.¹⁴

Interpreting the data requires understanding that the reported figures are cumulative balances of outstanding fails, not daily new fails.¹³ A high number of fails to deliver for a particular security can indicate several underlying issues, including operational inefficiencies within clearing systems, a lack of liquidity in the market for that security, or significant short selling activity where the short seller has difficulty locating shares to borrow. While FTDs are a routine part of market operations to some extent, consistently high or rising FTDs for a specific security can sometimes flag potential issues that warrant closer scrutiny by regulators and market participants.

Hypothetical Example

Consider a hypothetical scenario involving shares of "Tech Innovations Inc." (TII). On Monday, an investor, Sarah, sells 1,000 shares of TII at $50 per share. The standard settlement period for most U.S. equities is T+1, meaning the trade should settle one business day after the transaction date. So, the shares should be delivered by Tuesday.

However, due to an unexpected delay—perhaps a technical glitch at Sarah's broker-dealer or an issue with the transfer agent—the 1,000 shares of TII are not delivered to the buyer by Tuesday's settlement deadline. This event would be recorded as a failure to deliver for 1,000 shares of TII. The clearing house and the respective broker-dealers involved would then work to resolve this FTD. This might involve Sarah's broker borrowing shares to complete the delivery, or a buy-in process where the shares are purchased on the open market to fulfill the obligation, often at the defaulting party's expense. Until the shares are delivered, the transaction remains unsettled, creating an open obligation.

Practical Applications

Failures to deliver manifest in various aspects of financial markets, impacting operations, regulation, and risk management. In market operations, FTDs are a constant consideration for clearing houses and broker-dealers responsible for ensuring timely settlement. They monitor FTD data to identify potential bottlenecks or unusual activity. The U.S. Securities and Exchange Commission (SEC) publicly releases data on fails-to-deliver, providing transparency into settlement efficiency across the market.

Fr¹¹, ¹²om a regulatory standpoint, FTDs are a key area of oversight. The SEC's Regulation SHO, for example, sets forth rules specifically aimed at preventing and addressing persistent failures to deliver, including a "locate" requirement for short sales and mandates for clearing firms to close out FTDs within specified timeframes. The¹⁰ SEC also takes enforcement actions against firms that fail to comply with these regulations.

In⁹ terms of risk management, FTDs contribute to settlement risk within the capital markets. If a party fails to deliver, it can create a "daisy chain" effect, where one firm's failure to receive shares or cash prevents it from settling its own subsequent obligations. This interconnectedness can potentially lead to systemic risk if a significant number of FTDs accumulate. Fin⁷, ⁸ancial institutions, therefore, employ robust systems to track and resolve FTDs quickly, often engaging in securities lending to cover shortfalls and avoid penalties.

Limitations and Criticisms

While failures to deliver are a valuable metric for understanding settlement efficiency and potential market issues, their interpretation comes with limitations and has faced criticisms. One common critique is that FTD data, while indicative of unsettled trades, does not inherently distinguish between benign operational delays and potentially abusive practices. The SEC explicitly states that fails-to-deliver can occur for various reasons on both long and short sales and are not necessarily evidence of abusive short selling or "naked" short selling.

Cr⁶itics also point out that the publicly available FTD data represents an aggregate net balance, which might not fully capture the daily dynamics or the gross volume of underlying failed transactions. Thi⁵s aggregation can make it challenging to discern the specific causes of FTDs or to precisely quantify their daily impact.

Furthermore, some research has suggested that FTDs may not have the severe negative consequences often attributed to them. For example, a 2014 study published in the Journal of Financial Economics found no evidence that fails to deliver "caused price distortions or the failure of financial firms during the 2008 financial crisis." The researchers concluded that "greater FTDs lead to higher liquidity and pricing efficiency, and their impact is similar to our estimate of delivered short sales." This perspective suggests that while FTDs represent an operational break, their broader market impact, especially in well-regulated markets, might be less detrimental than often assumed. However, the potential for FTDs to propagate systemic risk remains a concern, prompting continuous efforts by regulation bodies to minimize them.

##⁴ Failure to Deliver vs. Naked Short Selling

Failure to deliver and naked short selling are related but distinct concepts in finance. A failure to deliver is a broad term that describes the inability of a seller to deliver securities to a buyer by the settlement date, regardless of the reason. This can stem from various causes, including administrative errors, technical glitches, or even a simple oversight where shares are not transferred on time. It is an operational outcome of a trade.

Naked short selling, on the other hand, is a specific type of short selling where an investor sells shares they do not own and have not borrowed or located for borrowing. This practice is largely prohibited in regulated markets unless certain exemptions apply. When a naked short sale occurs, it inherently leads to a failure to deliver because the seller has no shares to deliver at settlement. Therefore, while all naked short sales result in a failure to deliver, not all failures to deliver are the result of naked short selling. An FTD is the symptom, whereas naked short selling is a particular cause of that symptom.

FAQs

What causes a failure to deliver?

A failure to deliver can be caused by various factors, including administrative errors, technical issues in the settlement system, insufficient collateral or liquidity, or, in some cases, a seller not possessing the shares at the time of sale (naked short selling).

How long does a failure to deliver last?

In the U.S. equities market, firms are generally required to close out failures to deliver resulting from short sales by the beginning of regular trading hours on the settlement day following the trade date (T+1). For long sales or bona fide market making activities, they must be closed out by no later than the beginning of regular trading hours on the third settlement day following the settlement date (T+3).

##³# Is failure to deliver illegal?
The failure to deliver itself is an operational issue that may or may not violate specific rules, depending on the circumstances. However, certain actions that lead to persistent failures to deliver, such as engaging in naked short selling without legitimate exceptions, can be illegal and subject to regulatory penalties under rules like Regulation SHO.

Who monitors fails to deliver?

In the United States, the U.S. Securities and Exchange Commission (SEC) monitors and collects data on fails to deliver. This data is publicly available and helps the SEC oversee market activity and enforce regulation to ensure fair and efficient markets.¹, ²