Apr. 10, 2023
Until you've got a real settlement discipline regime, those failing to deliver, FTD's are just scamming the market. Off exchange data, tick size, dark pool transparency and (insert any other rule here) is worthless if the shares aren't actually getting delivered.
SEC needs to get it’s priorities right and FTD’s are number 1 on that list.
We need a Settlement Discipline Regime (SDR) in the USA. An SDR would prevent the value of those failed positions from overwhelming the system. It would also ensure that every retail investor who pays for a stock receives a real share – and not just a phantom entitlement on the brokers’ books. SDR requires just 4 steps.
1 Fines for Settlement Failures: This is the only one we have – or at least thought we had until the House "Game Stopped" report revealed that NSCC waives margin calls willy-nilly, without written procedures. NSCC charges a very small fee for a member’s daily settlement failures. What they are waiving is the additional requirement for contributions to the Clearing Fund that come from the rising value of settlement failures. The Federal Reserve’s Regulation T sets the maintenance margin to at least 25% of the investment. However, some brokers may set their maintenance margin to 30% or 40%. Brokerages implement margin rules to protect themselves against the risk of customer defaults. At NSCC, the ratio of brokers’ margin deposits to open positions is around 5%! Small fines alone won't stop FTDs in equities; they need to be raised to the point of being a penalty rather than a cost of doing business. Margin requirements must be enforced without exception; it is the periods of exceptionally high FTDs that put the system at greatest risk.
2 Mandatory Buy-Ins: Under this protocol, if a broker fails to deliver shares for settlement on T+2, the system will automatically attempt to buy those shares on the open market at whatever price is available. The failing broker is then charged for any difference between the price of the share on the original trade date and the price paid during the buy-in. Right now, we only have voluntary buy-ins, which must be initiated by the broker that fails to receive shares at settlement. Very few brokers issue buy-in orders for two main reasons: A) they don’t want to be bought in the next time they fail-to-deliver; and B) more often than not (especially when there are high FTDs in a particular stock) the buy-in trade will also fail to settle. That’s why the system must prepare to take the next step simultaneously with this one.
3 Reverse Failed Trades: In a reversal, the money goes back to the buyer and the IOU for the seller is erased. This would happen no further out than maybe T+5 (2 days for each settlement period and 1 day to issue the buy-in). At the broker level, a retail customer would be entitled to compensation for loss of use of funds during the time between when they were charged for the purchase and when their money is returned. This is a very standard industry practice among broker-dealers that needs to be extended to retail investors. They are taking extra risk and must be compensated for it. DTCC is starting to use a Unique Transaction Identifier, which is the missing piece to make trade reversals possible. For now, NSCC becomes the buyer to every seller and the seller to every buyer during trade netting in a process known as “novation.” What that means is that until there is a way to identify which original sale (using the Identifier) resulted in the failure to deliver, NSCC has no way to identify which broker did what to whom. If a seller fails to deliver securities for settlement, the failure to receive is randomly assigned to brokers who were expecting shares/bonds for the investor accountholders that already paid for them.
4 Kick out repeat offenders: Finally, if an NSCC member fails to deliver securities for settlement on, let’s say, 3 days in one month, they should be immediately suspended from doing business at NSCC and their accounts closed. The final step is one that NSCC is already authorized by Congress to do:
“A registered clearing agency may summarily suspend and close the accounts of a participant who …, (ii) is in default of any delivery of funds or securities to the clearing agency …” Securities and Exchange Act of 1934, Section 17A.a.5.(C).
All credit goes to esteemed Dr Susan Trimbath, a champion for fair markets, please read her book; Naked, Short and Greedy if you get the chance.
Kind regards, Ashley King