FTDs
Failure to deliver / fails-to-deliver: a structural loophole that enables market participants to exploit the financial system for profit
- FTDs occur when a party in a stock transaction fails to deliver the security to the buyer by the settlement date
- While FTDs can be caused by administrative errors or system issues, they most frequently occur in conjunction with short selling and naked short selling
In the age before there were computers and electronic networks, trading stocks involved hand-delivering stock certificates.
The settlement period for many years was five business days after the transaction date, providing adequate time for the delivery of physical stock certificates. Once the seller received the money and the buyer received the stock, the transaction was settled.
As the volume of stock transactions increased over the years, this eventually led to a paperwork crisis in the 1960s, and eventually the formation of the Depository Trust Company (DTC), a centralized security depository.
As technology progressed, paper stock certificates were mostly replaced by electronic record-keeping, centrally maintained by the DTC. This transition greatly improved efficiency and allowed for the settlement period to be reduced from five days (T+5), to three days in the 1990s (T+3), to two days in 2017 (T+2), and then finally to one day as of May 2024 (T+1).
In the current system, when a transaction takes place, the seller must deliver the securities by the end of the following business day (T+1).
The trade information is sent to a clearinghouse, normally the NSCC, who acts as a middleman for the transaction. The buyer sends their money to the clearinghouse, and the seller sends the shares to the clearinghouse, exchanging the money for shares for each party, settling the transaction.
If the seller of a stock transaction does not deliver the shares by the end of the following business day (T+1), a fail-to-deliver occurs.
The trade is not cancelled, but it is incomplete. The buyer paid for shares but never received them. The FTD remains open until the seller finally provides the shares or buys them on the open market to settle the trade.
When this happens, the seller is expected to resolve the FTD by the next trading day. However, the rules and clauses are complicated and they provide for a variety of exceptions under different circumstantces that allow for additional delays.
If the FTD is still unresolved by the latest allowable date, the participant is required to purchase shares from the market in order to resolve the FTD.
Failing to resolve the FTD can result in fines, disciplinary action, investigations, or lawsuits. However, enforcement of this remains weak, and sometimes the fines are smaller than the profit made from doing it.
How can a market participant sell something that they do not have?
Due to the history of how the market system formed, there exists the window of time that is the normal settlement period, currently T+1, where an institutional seller in a transaction does not immediately have to deliver the shares that they promised to sell.
This is a systemic vulnerability that can be exploited by large institutions such as hedge funds, market makers, and proprietary trading desks, in the pursuit of profit. These institutions have relationships with prime brokerages, direct access to clearing firms, as well as high-frequency trading systems. This enables them to execute a sale, even if they haven't confirmed that they possess the shares or can borrow the shares to do so, under the assumption based on trust that they'll be able to obtain possession of those shares to deliver them before settlement.
- Indicators of market manipulation: Persistent FTDs may result from practices like naked short selling, where traders sell shares they haven't borrowed, artificially increasing supply and pressuring the stock price downward.
- Liquidity and pricing issues: Ongoing FTDs can distort the true value of a security, creating supply and demand imbalances that harm market stability and investor confidence.
The T+35 settlement cycle: SEC Rule 204 gives market participants, such as market makers or authorized participants a special exemption up to 35 calendar days to deliver securities after a sale. Various observations corroborate that this cycle can impact the price of a stock.
