Canaries in the Coal Mine: How the Rise in Settlement 'Fails' Creates Systemic Risk for Financial Firms and Investors

Abstract

Financial plumbing is taken for granted, except when things go wrong. It was only a few years ago, for example, that the Federal Reserve Bank of New York saw the mess in the derivatives market, where transactions were recorded on slips of paper and sometimes misplaced before the Fed forced the major banks that were part of that market to clean up their act.In this essay, we focus on other parts of the financial plumbing that now must be fixed, sooner rather than later. In particular, we address:• extremely high and rising number and frequency of “fails to deliver” in mortgage-backed securities transactions (MBS) and in exchange traded Funds (ETFs);• the sheer size of the outstanding trades agreed to by counterparties that do not settle on time in relation to the liquidity and capitalization of banks and intermediary firms; and• the scale of the systemic risk posed by securities that fail to deliver, and how this activity steals value from investor portfolios.Our central conclusion is this: Every fail introduces a cumulative and potentially compounding liquidity risk into the orderly process of settling the $7.5 trillion of security transactions completed each day, which could be especially dangerous during times when financial institutions are short of liquidity (as was true during the financial crisis of 2008).The settlement fails problem is readily resolvable. Both the Federal Reserve and the Securities and Exchange Commission (SEC) have penalized fails in the U.S. Treasury and equities markets with successful outcomes. The appropriate federal regulators therefore should:• Impose penalties or fees for all transaction fails on all securities types that will offset financial gains derived from late settlement of trades, usually at investor expense;• Broaden the reporting of transactions where counterparties fail to deliver on time, and include all transaction activity for all major organizations; and• Improve the analytic framework required to understand how markets are operationally connected and the potential failure points in today’s tightly coupled systems.