What is Failure To Deliver
Failure to deliver refers to a situation where one or both of the counterparties in a transaction does not meet their obligation. The failure can be when the party with a long position does not have enough money to pay for the transaction. It can also be when a party with a short position does not own the underlying assets and so cannot make the delivery. Both equity and derivative markets can have a failure to deliver occurrence.
BREAKING DOWN Failure To Deliver
Whenever a trade is made, both parties in the transaction are contractually obligated to transfer either cash or assets before the settlement date. Subsequently, if the transaction is not settled, one side of the transaction has failed to deliver. Failure to deliver can also occur if there is a technical problem in the settlement process carried out by the respective clearing house.
Failure to deliver is critical when discussing naked short selling. When naked short selling occurs, an individual agrees to sell a stock that they borrow from their broker because they do not own it. Subsequently, the failure to deliver creates what are called "phantom shares" in the marketplace, which may dilute the price of the underlying stock. In other words, the buyer may own shares on paper which do not, in fact, exist.
Chain Reactions of Failure to Deliver Events
Several potential problems occur when trades do not settle appropriately due to failure to deliver.
With forward contracts, a party with a short position's failure to deliver can cause significant problems for the party with the long position. This difficulty happens because these contracts often involve substantial volumes of assets that are pertinent to the long position's business operations.
In business, a seller may pre-sell an item that they do not yet have in their possession. Often this will be due to a delayed shipment from the supplier. When it comes time for the seller to deliver to the buyer, they cannot fulfill the order because the supplier was late. The buyer may cancel the order leaving the seller with a lost sale, useless inventory, and the need to deal with the tardy supplier. Meanwhile, the buyer will not have what they need. Remedies include the seller going into the market to buy the desired goods at what may be higher prices.
The same scenario applies to financial and commodity instruments. Failure to deliver in one part of the chain can impact participants much further down that chain.
During the financial crisis of 2008, failures to deliver increased. Much the same as check kiting, where someone writes a check but has not yet secured the funds to cover it, sellers did not surrender securities sold on time. They delayed the process to buy securities at a lower price for delivery. Regulators still need to address this practice.