What Is Failure to Deliver, and What Happens With FTDs?
SB
Summary:
Failure to deliver (FTD) is a critical issue in trading contracts, encompassing situations where one party fails to meet their obligation, whether as a buyer unable to provide cash or a seller without the necessary assets. FTDs are especially pertinent in naked short selling, where shares may be sold without ownership. This article delves into the intricacies of FTD, its consequences, and its implications across various trading scenarios.
Understanding failure to deliver (FTD)
Failure to deliver (FTD) is a concept at the heart of financial markets, where traders enter contracts obligating them to transfer either cash or assets before the settlement date. When this obligation isn’t met, an FTD occurs. This can transpire due to various reasons, such as a lack of funds or assets, technical settlement glitches, or in the context of naked short selling.
FTD in naked short selling is particularly noteworthy. In this scenario, a trader agrees to sell shares they don’t possess, without a legitimate means to access them. While this practice is generally illegal for the average individual, proprietary traders or institutions may attempt it, often speculating that the targeted company will fail, allowing them to profit without being held accountable.
This practice can lead to the creation of “phantom shares” in the market, potentially diluting the price of the underlying stock. In essence, buyers may hold shares on paper that don’t actually exist.
Chain reactions of failure to deliver events
Failure to deliver can trigger a series of cascading problems, affecting both equity and derivative markets. In the case of forward contracts, a failure to deliver by the party with a short position can disrupt the business operations of the party with a long position, especially when substantial volumes of pertinent assets are involved.
Real-world analogies can help illustrate the gravity of FTD. Consider a seller who pre-sells an item they don’t yet possess due to a delayed shipment from the supplier. When the time comes to deliver to the buyer, they can’t fulfill the order, leading to a lost sale for the seller, excess inventory, and the need to address the tardy supplier. Meanwhile, the buyer is left without the expected goods, possibly at higher prices in the market.
Similar scenarios apply to financial and commodity instruments. An FTD in one part of the trading chain can have repercussions downstream, affecting multiple participants.
During the 2008 financial crisis, failures to deliver became more prevalent. Analogous to check kiting, where someone writes a check without sufficient funds, sellers delayed the delivery of securities, attempting to buy them at lower prices for subsequent delivery.
Frequently Asked Questions
What is failure to deliver (FTD)?
Failure to deliver (FTD) is a situation in trading contracts where one party fails to fulfill their obligation, whether as a buyer unable to provide cash or a seller without the necessary assets.
Why does failure to deliver occur?
FTD can occur for various reasons, including a lack of funds, technical settlement issues, or in the context of naked short selling.
What is naked short selling, and how does it relate to FTD?
Naked short selling involves selling shares one doesn’t possess. This practice can lead to FTD, as sellers may not have a legitimate means to access the shares they’ve sold.
What are the consequences of failure to deliver?
FTD can lead to the creation of “phantom shares,” potentially diluting the price of the underlying stock. It can also disrupt markets and have legal and ethical implications.
How do failures to deliver affect the market?
Failures to deliver can trigger chain reactions, affecting various market participants and potentially distorting market prices.
Is naked short selling always illegal?
While naked short selling is generally discouraged and often illegal, there are exceptions. Some proprietary traders or institutions may engage in it, but it’s a risky practice.
What measures are in place to prevent or mitigate FTD?
Regulations like Regulation SHO by the U.S. Securities and Exchange Commission aim to address FTD and naked short selling issues. Market surveillance and reporting mechanisms also play a role in monitoring FTD.
What should traders and investors do to protect themselves from FTD-related risks?
Traders and investors should conduct due diligence, stay informed about market regulations, and be cautious when dealing with stocks prone to FTD. Diversifying their portfolios can also help mitigate risks.
Can FTD occur in other types of contracts besides stocks?
Yes, FTD can occur in various types of contracts, including futures, options, and forward contracts, where parties have obligations to transfer assets or cash before settlement.
Are there penalties for individuals or institutions involved in FTD?
Yes, individuals or institutions engaged in FTD, especially in illegal or unethical practices, can face penalties, including legal actions and fines.
How has FTD been addressed in past financial crises?
FTD issues were notable during the 2008 financial crisis. Regulatory authorities and market participants took measures to address these concerns and prevent further disruptions.
Key takeaways
- Failure to deliver (FTD) occurs when trading obligations are not met, whether due to a lack of funds or assets.
- Naked short selling involves selling shares without ownership, potentially leading to “phantom shares” in the market.
- FTD can disrupt markets and have legal and ethical implications.
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