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. …