What Is Failure To Deliver?
Failure to deliver refers to a situation where one party in a trading contract (whether it's shares, futures, options, or forward contracts) does not deliver on their obligation. Such failures occur when a buyer (the party with a long position) does not have enough money to take delivery and pay for the transaction at settlement. A failure can also occur when the seller (the party with a short position) does not own all or any of the underlying assets required at settlement, and so cannot make the delivery.
- Failure to Deliver refers to not being able to meet trading obligations.
- In the case of buyers it means not having the cash, in the case of sellers in means not having the goods.
- The reckoning of these obligations occurs at trade settlement.
Understanding 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 neither they nor their associated broker possess, and the individual has no way to substantiate their access to such shares. The average individual is incapable of doing this kind of trade, but an individual working as a proprietary trader for a trading firm and risking their own capital, may have the ability to carry out such an order. Though it would be considered illegal for them to do so, some such individuals or institutions may believe the company they short will go out of business, and thus in a naked short sale they may be able to make a profit with no accountability.
Subsequently, the pending 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 on the other side of such trades may own shares, on paper, which do not actually exist.
Chain Reactions of Failure to Deliver Events
Several potential problems occur when trades do not settle appropriately due to failure to deliver. Both equity and derivative markets can have a failure to deliver occurrence.
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.