What Are Failures to Deliver?
Failures to deliver (FTDs) represent situations in securities trading where one party to a transaction does not fulfill their obligation to deliver the required cash or securities by the agreed-upon settlement date. This can occur when a buyer lacks the necessary funds to pay for the securities or when a seller does not possess the securities they are obligated to deliver. FTDs are a component of market microstructure, reflecting issues within the post-trade process. These occurrences are tracked by regulatory bodies to monitor market activity and ensure market integrity.
History and Origin
The concept of failures to deliver is as old as organized securities markets themselves, arising whenever a buyer or seller cannot complete their side of a trade. Historically, settlement periods were much longer, increasing the window for potential FTDs. Over time, efforts to reduce counterparty risk and improve efficiency have led to shorter settlement cycles.
A significant development in addressing FTDs in the U.S. markets was the implementation of Regulation SHO by the Securities and Exchange Commission (SEC) in 2005. This regulation was adopted to update existing short sale rules and specifically tackle concerns regarding persistent failures to deliver and potentially abusive "naked" short selling practices5. Regulation SHO introduced "locate" and "close-out" requirements, aiming to ensure that sellers have a reasonable belief they can deliver shares at settlement, thereby curtailing instances of fails to deliver.
Key Takeaways
- Failures to deliver occur when one party in a securities trade does not meet their obligation to deliver cash or shares by the settlement date.
- FTDs can result from a buyer not having sufficient funds or a seller not possessing the securities to deliver.
- Regulatory measures, such as Regulation SHO, aim to reduce FTDs, especially those stemming from short selling.
- While FTDs can indicate operational issues, persistent high levels in specific securities may signal more significant underlying market concerns.
- Recent moves to faster settlement cycles (like T+1) are expected to temporarily increase FTDs as market participants adjust.
Interpreting Failures to Deliver
Failures to deliver data provides insight into the efficiency and health of the securities settlement process. High or persistent failures to deliver in a particular security can indicate several issues. For instance, they might point to operational glitches within broker-dealers or clearinghouse systems. In some cases, a significant volume of FTDs, particularly those related to short selling, can suggest difficulty in borrowing shares for delivery, potentially impacting market dynamics and liquidity. Regulators monitor FTD data closely to identify trends that may warrant further investigation.
Hypothetical Example
Consider an investor, Alice, who sells 1,000 shares of XYZ equity securities on Monday. The current standard settlement cycle in the U.S. is T+1, meaning the trade is expected to settle one business day after the trade date. So, the shares should be delivered by Tuesday.
However, if Alice's brokerage firm encounters an unforeseen technical issue, or if Alice herself somehow does not have the shares in her account by the required delivery date, a failure to deliver occurs. The brokerage firm is then obligated to buy or borrow the shares to complete the transaction, but until that happens, an FTD for those 1,000 shares of XYZ remains open on the system.
Practical Applications
Failures to deliver data is a crucial metric for regulators and market participants. The SEC, for example, publishes aggregate FTD data for all equity securities and corporate and municipal bonds, which can be accessed by the public4. This data is used for regulatory oversight to identify patterns that might suggest market inefficiencies or potential misconduct.
For broker-dealers, managing and minimizing fails to deliver is a key aspect of their compliance and operational risk management. Effective internal controls and robust settlement processes are essential to prevent FTDs and the associated penalties and costs.
Furthermore, recent shifts in settlement cycles, such as the move from T+2 to T+1 in the U.S. in May 2024, directly impact FTDs. Regulators and market participants anticipated a temporary uptick in FTDs immediately following this transition as firms adjusted to the compressed timeline for processing trades3. The aim of these shorter cycles is to reduce systemic risk by decreasing the time between a trade and its final settlement.
Limitations and Criticisms
While failures to deliver can be indicators of market issues, it is important to interpret the data with caution. The SEC explicitly states that fails to deliver can occur for various reasons on both long and short sales and are "not necessarily the result of short selling, and are not evidence of abusive short selling or 'naked' short selling"2. Operational inefficiencies, such as incorrect paperwork or technical glitches, can also contribute to FTDs1.
A primary criticism revolves around the transparency and timeliness of FTD data. While the SEC publishes this data, there is a delay between the occurrence of FTDs and their public release, which some critics argue limits its utility for real-time market analysis. Additionally, instances of significant increases in FTDs, particularly in relation to alleged naked short selling, have sometimes fueled concerns about potential manipulation and the effectiveness of current regulations, even though these links are often complex and not easily proven.
Failures to Deliver vs. Settlement Risk
Failures to deliver and Settlement Risk are closely related but distinct concepts.
| Feature | Failures to Deliver | Settlement Risk |
|---|---|---|
| Definition | The specific event where a party fails to meet its obligation (deliver cash or securities) by the settlement date. | The risk that a trade will not settle as expected, exposing one or both parties to potential loss. This risk exists from the trade date until settlement is complete. |
| Nature | An observable outcome or symptom of a problem in the settlement process. | A broader concept encompassing the potential for an FTD, as well as the financial losses or operational disruptions that could arise from it. It's the exposure to non-settlement. |
| Timing | Identified on or after the settlement date when the obligation is not met. | Exists from the moment a trade is executed until it is successfully settled. |
| Relationship | An FTD is a realization or manifestation of settlement risk. If settlement risk materializes, it can result in an FTD. | Settlement risk is the underlying exposure that could lead to a failure to deliver. Efforts to reduce settlement risk (e.g., shorter settlement cycles) aim to reduce the likelihood and impact of FTDs. |
In essence, a failure to deliver is a concrete event that proves settlement risk was present and materialized.
FAQs
What causes a failure to deliver?
Failures to deliver can result from a buyer not having sufficient funds to pay for securities, a seller not having the securities to deliver (including in cases of short selling), or technical and operational issues within brokerage firms or clearinghouse systems.
Are failures to deliver illegal?
Not inherently. FTDs are an operational issue within the settlement system. However, certain practices that deliberately lead to FTDs, such as "naked" short selling without a reasonable expectation of delivery, can be illegal under regulations like Regulation SHO.
How long does an FTD last?
A failure to deliver generally persists until the obligation is fulfilled, meaning the securities are delivered or the cash is provided. Regulatory rules, particularly Regulation SHO's "close-out" requirement, mandate that persistent FTDs in certain "threshold securities" must be resolved within a specific timeframe to prevent prolonged unsettled positions.
Does a failure to deliver affect the stock price?
The impact of failures to deliver on stock prices is a subject of ongoing debate. While a single FTD is unlikely to move a stock's price, persistent and significant levels of FTDs in a particular security could theoretically affect supply and demand dynamics, especially if they are perceived to be related to manipulative short selling. However, definitive causation is often difficult to establish.