The Trade That Did Not Settle on the Day It Should Have
A meaningful share of securities transactions fail to settle on time, because somebody does not have the securities or the cash. The consequences were mild for decades, and regulators decided that was the problem.
What a Fail Is
A securities trade agrees a price today and settles on a defined date afterward, when securities move one way and cash the other.
A settlement fail occurs when that exchange does not happen on the scheduled date. Most commonly the seller does not have the securities to deliver, because they were lent out, because the seller was itself waiting on an incoming delivery, or because of an operational error.
The trade does not cancel. It remains open and settles later, and in the interim the buyer has paid nothing and holds nothing while the seller retains securities it has sold.
Why They Happen
| Cause | Mechanism |
|---|---|
| Securities on loan | Recall takes time to complete |
| Chain of dependent settlements | One fail cascades to several |
| Operational error | Wrong account, mismatched instructions |
| Deliberate | Cheaper to fail than to borrow |
The second row explains why fails cluster. If a firm is selling securities it is simultaneously buying, a failure to receive produces a failure to deliver, propagating through a chain of counterparties who each did nothing wrong.
The fourth row is the one regulators focused on. Where the cost of failing is lower than the cost of borrowing the security to deliver, a rational participant fails.
For an extended period the penalty for failing to deliver was, in effect, forgoing interest on cash you had not received. When interest rates were near zero, that penalty was approximately nothing, and fails rose accordingly.
The Zero Rate Problem
The traditional discipline in government securities markets was economic rather than regulatory. A seller that fails does not receive the cash, and therefore loses the return on it.
When short term rates collapsed to near zero, that cost disappeared. Failing became nearly free, and fails in government securities markets rose to very high levels during stressed periods.
The market response was a fails charge, adopted by industry convention, imposing a penalty calculated as a floor rate minus the prevailing rate. That restored a cost to failing even when rates were zero, and observed fail rates fell substantially.
It is a rare example of a market solving a collective problem through voluntary convention rather than regulation.
The Regulatory Regime in Europe
European authorities took the mandatory route through a settlement discipline regime, imposing cash penalties on failing participants, calculated daily against the value of the failed trade at defined rates by instrument type.
The regime also contemplated mandatory buy ins, requiring the failing party to be bought in after a defined period, meaning a third party purchases the securities in the market and the failing party pays any price difference.
The penalties were implemented. The buy in requirement was repeatedly deferred and substantially reconsidered after sustained industry objection.
Why Mandatory Buy Ins Were Controversial
The argument against is worth understanding because it concerns market structure rather than convenience.
A mandatory buy in creates a known future purchase requirement in a specific security at a specific time, which is information a counterparty can trade against. In an illiquid instrument, the buy in itself moves the price against the failing party.
The predicted consequence was that market makers would widen quotes or decline to quote in less liquid instruments, since the cost of a fail became unbounded rather than a calculable penalty.
Since market makers frequently sell securities they must then source, and sourcing is precisely what is difficult in an illiquid instrument, the regime risked reducing liquidity in exactly the securities where it was scarcest.
That argument prevailed sufficiently for the requirement to be treated as a last resort measure rather than an automatic one.
The Shorter Cycle Interaction
Moving settlement from two days to one compressed the time available to resolve problems, which was expected to raise fail rates.
The mechanisms most affected are securities lending recalls, which must now happen faster; foreign exchange funding for cross border purchases, where time zones leave a narrow window; and affirmation of trade details, which must be completed on trade date rather than the following morning.
Observed fail rates following the transition did not deteriorate as much as feared, largely because the industry invested substantially in automating affirmation ahead of the change, which was the point of setting a deadline.
Why It Matters Beyond Operations
Persistent fails are a symptom rather than a problem in themselves, and what they indicate is useful.
Elevated fails in a specific security frequently indicate it is hard to borrow, meaning heavy short interest against limited lendable supply, which is informative about positioning.
Elevated fails across a market indicate funding stress or operational strain, and fail rates rose sharply during periods of market dislocation, which is why supervisors track them as a stress indicator.
The Bottom Line
Settlement fails happen because somebody cannot deliver, and they persisted at high rates for years because failing cost almost nothing when interest rates were near zero. The American response was a voluntary fails charge that restored an economic cost, and the European response was mandatory cash penalties with a buy in requirement that was deferred because it threatened liquidity in exactly the instruments it targeted. As a market signal, fails are a reasonable indicator of borrowing scarcity in a specific name and of funding stress across a system.