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The latest edition of the Federal Reserve Bank of New York’s Current Issues in Economics and Finance, Explaining Settlement Fails, is available.
Authors Michael J. Fleming and Kenneth D. Garbade analyze the current and historical data on trades in U.S. Treasury securities that fail to settle as scheduled. They find that surges in fails sometimes result from operational disruptions, but often reflect market participants’ insufficient incentive to avoid failing.
The authors observe that since 1990, the period for which fails data are available, there is substantial variation in the frequency of fails. They determine that settlement fails are not unusual and occur for a variety of reasons.
According to Garbade and Fleming, the evidence suggests that episodes of persistent settlement fails are often related to market participants’ lack of incentive to avoid failing. When a fail occurs, the seller is allowed to make delivery the next day at an unchanged invoice price. Because the transaction is not complete, the seller does not have the proceeds to invest, thus forgoing the interest that could have been earned in the overnight federal funds market or in the closely related market for general collateral (GC) repurchase agreements.
Garbade and Fleming note that market participants also have the option of borrowing to avoid a fail and in doing so, they balance the cost of borrowing against the cost of failing. According to the authors, it follows that market participants should be willing to borrow securities to avoid failing as long as the cost of borrowing is less than the GC rate. At times, however, borrowing costs approach and reach the GC rate. The authors conclude that as the cost of borrowing securities rises, the incentive to borrow securities to avoid failing declines, which contributes to the problem of persistent fails.
Michael J. Fleming is an assistant vice president and Kenneth D. Garbade a vice president in the Capital Markets Function of the Research and Statistics Group.