The Introduction of the TMPG Fails Charge for U.S. Treasury Securities
Garbade, Kenneth D., Keane, Frank M., Logan, Lorie, Stokes, Amanda, Wolgemuth, Jennifer, Federal Reserve Bank of New York Economic Policy Review
Securities transactions commonly involve a variety of market conventions--widely accepted ways of doing business that persist through time even though not mandated by law or regulation. Commonplace examples include the quotation of prices for Treasury bonds in increments of 32nds (and fractions of a 32nd) of a percent of principal value (rather than in decimal increments) and the quotation of Treasury bills in terms of discount rates (rather than prices or yields).
In most cases, market conventions are useful or, at worst, innocuous. In some cases, however, a new use for an old instrument can render a convention in need of revision. One particularly notorious example was the convention--observed prior to 1982--of ignoring accrued interest on Treasury bonds sold on repurchase agreements (also known as repos, or RPs). The convention made sense as long as repos were used primarily to borrow money from creditworthy lenders that held the bonds simply to limit their exposure to credit risk. It made less sense when highly leveraged securities dealers began to use repos to borrow bonds to deliver on short sales. The 1982 Drysdale episode illuminated the risks involved in ignoring accrued interest and prompted the Federal Reserve Bank of New York to orchestrate a change in the convention. (1)
A market convention may also require revision following a change in the economic environment. This article discusses a recent example: the convention of postponing--without any explicit penalty and at an unchanged invoice price--a seller's obligation to deliver Treasury securities if the seller fails to deliver the securities on a scheduled settlement date. As discussed in more detail below, as long as short-term interest rates were above about 3 percent, the time value of money usually sufficed to incentivize timely settlement of transactions in Treasury securities. However, when short-term rates fell to near zero following the insolvency of Lehman Brothers Holdings Inc. in September 2008, the time value of money no longer provided adequate incentive and the Treasury market experienced an extraordinary volume of settlement fails. Both the breadth of the fails across a large number of securities and the persistence of the fails were unprecedented and threatened to erode the perception of the Treasury market as a market free of credit risk. (2) In response, the Treasury Market Practices Group (TMPG)--a group of market professionals committed to supporting the integrity and efficiency of the U.S. Treasury market--worked over a period of six months to revise the market convention for settlement fails, developing a "dynamic fails charge" that, when short-term interest rates are below 3 percent, produces an economic incentive to settle trades roughly equivalent to the incentive that exists when rates are at 3 percent. Thus, the TMPG fails charge preserves a significant economic incentive for timely settlement even when interest rates are close to zero.
This article describes the introduction of the TMPG fails charge. The introduction of the fails charge is important for two reasons. First, it mitigated an important dysfunctionality in a market of critical significance both to the Federal Reserve in its execution of monetary policy and to the country as a whole. Second, it exemplified the value of cooperation between the public and private sectors in responding to altered market conditions in a flexible, timely, and innovative fashion.
Our study is divided into three parts. The first part (Sections 2-5) describes settlement processes and settlement fails in the Treasury market, explains why sellers usually try to avoid fails, describes industry and Federal Reserve efforts to mitigate settlement fails prior to 2008, and briefly reviews three episodes of chronic fails in the Treasury market. The second part (Section 6) describes the tsunami of fails that followed Lehman's insolvency. The balance of the study (Sections 7-10) explains the TMPG's response. Section 11 concludes.
2. SETTLEMENTS AND SETTLEMENT FAILS IN U.S. TREASURY SECURITIES
A transaction in Treasury securities is said to "settle" when the seller delivers the securities to, and receives payment from, the buyer. The two most important settlement processes are bilateral settlement and multilateral net settlement. Before describing those processes, we explain how market participants establish and transfer ownership of Treasury securities.
2.1 Establishing and Transferring Ownership of Treasury Securities
For more than three decades, investors have established ownership of Treasury securities through Federal Reserve book-entry securities accounts. (3) Book-entry account holders that own Treasury securities can house their securities directly in their accounts and can transfer the securities to other book-entry accounts by issuing appropriate instructions to the Federal Reserve.
Federal Reserve book-entry accounts are generally available only to depository institutions and certain other organizations, such as government-sponsored enterprises and foreign central banks. All other market participants establish ownership of Treasury securities through commercial book-entry accounts at depository institutions that act as custodians for their customers. Depository institutions that offer commercial book-entry accounts hold their customers' securities in their Federal Reserve book-entry accounts commingled with their own securities.
A market participant with a commercial book-entry account can transfer Treasury securities to another market participant through their respective custodians. For example, participant A can transfer a Treasury security to participant B by instructing its custodian to debit its commercial book-entry account and to transfer the security to B's custodian for credit to B's commercial book-entry account. Upon receipt of instructions, A's custodian will debit A's account and instruct the Federal Reserve to 1) debit its Federal Reserve book-entry account and 2) credit the Federal Reserve book-entry account of B's custodian. Following receipt of the security in its Federal Reserve book-entry account, B's custodian will complete the transfer by crediting B's commercial book-entry account. (If A and B have a common custodian, the transfer can be completed on the books of that common custodian without involving the Federal Reserve.)
2.2 Bilateral Settlement
The simplest type of settlement occurs when a market participant has sold Treasury securities for bilateral settlement on a deliver-versus-payment basis. The sale may be a conventional sale of securities but it may alternatively be the starting leg, or the "off leg, of a repurchase agreement. (We describe repurchase agreements in more detail below.)
Suppose, for example, an investor sells ten Treasury bonds at a price of $100 per bond for settlement on June 2. Following negotiation of the terms of the sale, the seller will instruct its custodian to send ten bonds to the buyer's custodian on June 2 against payment of $1,000. The buyer will concurrently instruct its custodian to receive, on June 2, ten bonds from the seller's custodian and to pay $1,000 upon receipt of the bonds. On June 2, the seller's custodian will instruct the Federal Reserve to 1) debit its Federal Reserve book-entry account for ten bonds, 2) credit the Federal Reserve book-entry account of the buyer's custodian for ten bonds and simultaneously debit the account of the buyer's custodian for the $1,000 due upon delivery, and 3) credit the seller's custodian's account for the $1,000. The resulting transfers of securities and funds are shown in Exhibit 1. (4)
Following notification that ten bonds have come into its Federal Reserve book-entry account and that $1,000 has been withdrawn, the buyer's custodian will verify that the bonds and money are consistent with the buyer's instructions. In most cases, they are and the custodian will credit the buyer's account for the ten bonds and debit that account for $1,000. In some cases, however, the buyer will have provided different instructions--perhaps referencing a different security or a different invoice price--or no instructions. In any of these cases, the buyer's custodian will reverse the settlement, instructing the Federal Reserve to return the ten bonds and recover the $1,000 payment. The buyer and seller and their respective custodians will then have to communicate and come to a common understanding of the terms of the underlying transaction, following which the seller will reinitiate the settlement process.
2.3 Multilateral Net Settlement
Bilateral settlement is a simple process that satisfies the purpose of settlement: moving securities from sellers to buyers and moving funds from buyers to sellers. Alternative settlement structures, however, can sometimes be more efficient.
Consider, for example, the case where:
* participant A sells ten bonds to participant B at a price of $100 per bond for settlement on the following business day,
* B sells ten of the same bonds to participant C at a price of $99 per bond, also for settlement on the following business day, and
* C sells eight of the same bonds to A at a price of $101 per bond, again for settlement on the following business day.
As shown in Exhibit 2, bilateral settlement of the three transactions requires the delivery of twenty-eight bonds against payments of $2,798.
As an alternative, the participants might agree to settle through a central counterparty (CCP). The CCP first marks all of the deliver and receive obligations to a common price--say, $100 per bond. After marking to the common price,
* A is obligated to deliver ten bonds to B against payment
* B is obligated to deliver ten bonds to C against payment of $1,000, and
* C is obligated to deliver eight bonds to A against payment of $800.
Marking to a common price results in gains for some participants and losses for others. In the example, B gains because it will receive more for the bonds sold to C than the original contract price and C loses for the same reason. These gains and losses are exactly offset with further agreements to make small side payments of cash. In particular:
* A agrees to pay $8 to the CCP, reflecting the $8 gain from marking the price of the eight bonds bought from C down from $101 per bond to $100 per bond,
* B agrees to pay $10 to the CCP, reflecting the $10 gain from marking the price of the ten bonds sold to C up from $99 to $100 per bond, and
* the CCP agrees to pay $18 to C, in compensation for the $8 loss from marking the price of the eight bonds sold to A down from $101 per bond, and for the $10 loss from marking the price of the ten bonds bought from B up from $99 per bond.
On the night before the settlement date, the CCP nets out the deliver and receive obligations of A, B, and C and novates (5) their respective contracts, becoming the buyer from every net seller and the seller to every net buyer, all at the common settlement price. After netting and novation:
* A is obligated to deliver two bonds to the CCP against payment of $200,
* B has no deliver or receive obligations, and
* the CCP is obligated to deliver two bonds to C against payment of $200.
On settlement day, the obligations of A to deliver two bonds to the CCP and the CCP to deliver two bonds to C are settled with bilateral deliver-versus-payment settlements. In addition, A, B, and the CCP make the agreed-upon side payments of cash. Exhibit 3 shows that multilateral net settlement requires the delivery of four bonds and payments of $436--about 15 percent of the deliveries and payments shown in Exhibit 2.
2.4 Some Concrete Identities
The foregoing description of settlement processes referred to abstract entities like "participant A" and an unnamed "central counterparty." Before we begin to discuss settlement fails, it may be helpful to identify some of the key participants in the Treasury market.
At the center of the market is a group of dealers that provide liquidity to customers, quoting bid prices at which they are willing to buy and offer prices at which they are prepared to sell. A subset of dealers, called "primary dealers," make markets to the Federal Reserve Bank of New York when the Bank is conducting open market operations on behalf of the Federal Reserve System. (6) Box 1 identifies the primary dealers as of mid 2008.
Dealers sometimes trade directly with each other, but more commonly through specialized interdealer brokers. A dealer that sells securities to another dealer through an interdealer broker agrees to deliver securities (against payment) to the broker. The broker, in turn, agrees to deliver the same securities (also against payment) to the ultimate buyer. This arrangement allows the dealers to trade on a "blind," or undisclosed, basis.
All of the dealers, and all of the interdealer brokers, maintain commercial book-entry accounts at one of two banks: JPMorgan Chase Bank, N.A., and The Bank of New York Mellon. These two "clearing" banks offer custodial services refined over many years to meet the needs of brokers and dealers that deliver and receive large volumes of securities on a daily basis.
The Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust & Clearing Corporation, is the central counterparty in the Treasury market. All of the primary dealers and all of the interdealer brokers, as well as a number of other market participants, are netting members of FICC. FICC maintains commercial book-entry accounts at both JPMorgan Chase and The Bank of New York Mellon and is prepared to receive securities from, and deliver securities to, any of its netting members in a timely and efficient fashion.
Box 1 Primary Dealers in Mid-2008 (a) Banc of America Securities LLC Barclays Capital Inc. Bear, Stearns & Co., Inc. (b) BNP Paribas Securities Corp. Cantor, Fitzgerald & Co. Citigroup Global Markets, Inc. Credit Suisse Securities (USA) LLC Daiwa Securities America Inc. Deutsche Bank Securities Inc. Dresdner Kleinwort Securities LLC Goldman, Sachs & Co. Greenwich Capital Markets, Inc. HSBC Securities (USA) Inc. J. P. Morgan Securities Inc. Lehman Brothers Inc. (c) Merrill Lynch Government Securities Inc. (d) Mizuho Securities USA Inc. Morgan Stanley & Co. Incorporated UBS Securities LLC (a) Federal Reserve Bank of New York, "Primary Dealers List," July 15, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/ an080715.html. (b) Removed October 1, 2008, following its acquisition by J. P. Morgan Securities Inc. (c) Removed September 22, 2008. (d) Removed February 11, 2009, following its acquisition by Bank of America Corporation.
Beyond the dealers, the interdealer brokers, and FICC, the Treasury market consists of a large number of other participants, including "real-money" investors such as mutual funds, pension funds, and corporate treasurers, and "leveraged accounts" such as hedge funds. Some of these participants trade directly with dealers, others trade anonymously in electronic markets. All use custodians that offer more or less complex (and more or less costly) services tailored to their needs.
2.5 Settlement Fails
A settlement fail occurs when the obligation of a seller to deliver securities to a buyer remains outstanding following the close of business on the scheduled settlement date of a transaction. This can occur either because the seller's custodian failed to tender any securities to the buyer's custodian, or because the buyer's custodian rejected whatever securities were tendered by the seller's custodian. In the event of a settlement fail in Treasury securities, the market convention is to postpone settlement to the following business day without any change in the funds due upon delivery and (prior to May 2009) without any explicit penalty or charge. (7) The process of failing (to settle) and deferring settlement to the next business day can take place repeatedly, day after day, until settlement occurs or the trade is canceled.
Settlement fails can occur for any of several reasons. First, a fail can result from miscommunication. A buyer and seller may not have a common understanding of the terms of a trade, or one or the other may have failed to communicate settlement instructions to its custodian, or may have communicated incorrect instructions, or one of the custodians may have misunderstood the instructions that it received. In any of these cases, the buyer's custodian will reject whatever securities are tendered by the seller's …
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Publication information: Article title: The Introduction of the TMPG Fails Charge for U.S. Treasury Securities. Contributors: Garbade, Kenneth D. - Author, Keane, Frank M. - Author, Logan, Lorie - Author, Stokes, Amanda - Author, Wolgemuth, Jennifer - Author. Journal title: Federal Reserve Bank of New York Economic Policy Review. Publication date: October 2010. Page number: 45+. © Not available. COPYRIGHT 2010 Gale Group.
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