10 October 2008

Stand and Deliver - Significant Fails in the US Treasury Market

This is the worst 'failure to deliver' Treasuries that we've seen since we started tracking this on a weekly basis in 2003.

An explanation of the Settlement Failures from the Federal Reserve is listed below.

There was no corresponding spike in Agencies, MBS, or Corporates in the data.

Fails data reflect cumulative "fails to receive" and "fails to deliver" over the course of a week for the primary dealer community only. The cumulative weekly totals are calculated by summing the fails outstanding on each business day of the reporting week.1 These totals include both fails that started during the reporting week as well as fails that started in prior weeks and have not yet been resolved. The aggregate fails data include fails associated with both outright transactions and financing transactions.

Fails data are reported for four distinct categories: Treasury Securities, Agency Securities, Mortgage-Backed Securities and Corporate Securities. Mortgage-backed securities include those issued and insured by government sponsored enterprises. Privately issued mortgage-backed securities are categorized as corporate securities. The FRBNY has collected aggregated fails data in this form since July 1990 for Treasury, Agency and Mortgage-Backed securities, and since July 2001 for Corporate securities.

Reported fails numbers sometimes can reach elevated levels due to so-called "daisy chains" and "round robins" in which an initial delivery failure causes a chain of subsequent fails as the party expecting to receive the security in the initial transaction fails to deliver to its counterpart in the second transaction, and so on. Daisy chains and round robins are ultimately not the cause of fails. Fails, at root, are caused by the core short positions of cash and repo market participants.

As described in the primer below, there are many factors that can create an initial delivery failure. Once a significant volume of fails occurs, lenders of collateral sometimes also withhold collateral because they are concerned that existing fails diminish the likelihood of that collateral being returned to them. Such withholding can be self-fulfilling because withholding scarce collateral can increase the incidence of fails in and of itself.

The importance of delivery chains and the potential for feedback effects from changes in the withholding behavior of collateral lenders also imply that relatively small amounts of collateral can settle a larger volume of failed transactions: an increase in collateral can be delivered from one party to the next to clear up a chain of failed trades and the resolution of failed trades may, in turn, make collateral lenders more willing to lend securities that had been in short supply.

Reasons for Settlement Fails

Fails occur for a variety of reasons. One source of fails is miscommunication. Despite their best efforts to agree on terms, a buyer and seller may sometimes not identify to their respective operations departments the same details for a given transaction. On the settlement date the seller may deliver what it believes is the correct quantity of the correct security and claim what it believes is the correct payment, but the buyer will reject the delivery if it has a different understanding of the transaction. If the rejection occurs late in the day there may not be enough time for the parties to resolve the misunderstanding.

In some cases a seller or a seller’s custodian may be unable to deliver securities because of operational problems. An extreme example is the September 11 catastrophe that destroyed broker offices and records, impaired telecommunications links between market participants, and damaged other critical infrastructure. Less extreme operational problems can also precipitate settlement fails, and are not uncommon.

Finally, a seller may be unable to deliver a security because of a failure to receive the same security in settlement of an unrelated purchase. This can lead to a “daisy chain” of fails; where A’s failure to deliver bonds to B causes B to fail on a sale of the same bonds to C, causing C to fail on a similar sale to D, and so on. A daisy chain becomes a “round robin” if the last participant in the chain is itself failing to the first participant.

Fails also occur “naturally” when special collateral repo rates approach or reach zero. In general, a market participant would be better off borrowing securities to avoid a fail even if the interest on the money lent in the specials market is below the general collateral repo rate, because (as explained below) the alternative is forgoing interest altogether.3 However, this incentive becomes less compelling as a specials rate approaches zero. A specials rate will approach zero if there is unusually strong demand to borrow a security, e.g. following heavy short selling by hedgers, or if holders are unusually reluctant to lend the security.

Source: Federal Reserve Bank