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Failure is not an Option

Note: This feature length story by Chris McMahon originally appeared in the February 2009 issue of Futures Magazine.
Link to original @ Futures Magazine

With the global equity and commodity markets in turmoil, U.S. government securities have offered a safe haven for capital, drawing in more and more domestic and non-U.S. buyers, who have pushed prices for Treasury bills, notes and bonds to all-time highs and their yields to all-time lows.

It's an indication of just how panic stricken the markets have been that yields on some short-term Treasuries have gone negative, meaning that buyers are locking in an assured loss rather than facing the uncertainty of other markets.

"In a panic market, the flight to quality is fierce," says independent floor broker and trader Robert J. Griffin. "Companies who have cash balances and are afraid to keep it in a bank buy T-bills for 0% [yield] just because they want that money back."

Traders who want exposure to U.S. government securities can access several different markets to satisfy their demand: the over-the-counter cash market, the repurchase (repo) markets and the futures market.

But there's a problem. With all of that new demand for Treasuries has come a spike in the number of failures to deliver them.

The number of fails has increased so substantially that the Treasury Market Practices Group (TPMG) has endorsed a series of changes to bond market best practices to lower the number of fails and thus lower their negative market effects.

Foremost is a financial penalty of 3% minus the Fed funds rate for failure to deliver starting on May 1. Market participants who fail to receive their securities could then file a claim against the seller and the penalty for failing to deliver would accrue for the duration of the dispute. Details are available in "Claiming a Fails Charge for Settlement Fail in U.S. Treasury Securities," which is available on the New York Fed's Web site,

Other suggested changes include: margining of settlement fails, which could be implemented midyear; bilateral cash settlement after five business days, which could be fleshed out in consultation with the Securities Industry and Financial Market Association; and broader multilateral netting solutions to reduce the incidence of round robins while maintaining the confidentiality of market participants. The TPMG is working with The Depository Trust and Clearing Corporation on the issue and a progress report is expected midyear.


In the cash market, primary government securities dealers (prime dealers) purchase U.S. government securities, including Treasury bills, notes and bonds, from the New York Federal Reserve Bank. The prime dealers then make markets, buying and selling those government securities. Bond market participants are typically institutions, such as pension funds, hedge funds, financial institutions and other governments.

In outright transactions, purchasers negotiate terms with a dealer and on the settlement date wire the funds to a clearing bank via the cash securities system. All Treasury securities are issued as entries in a central electronic ledger in one of three systems: TreasuryDirect, Legacy Treasury Direct or the Commercial Book-Entry System. The seller wires the Treasury to the clearing bank and upon settlement the buyer gets the bond. Except when they don't.

In the September 2005 issue of "Current Issues in Economics and Finance," a publication by the New York Federal Reserve Bank, Michael J. Fleming and Kenneth D. Garbade explained that failures to deliver occur for a variety of reasons, including miscommunication between the buyers and sellers, operational problems and simply not having possession of the Treasury at the delivery time.

Short selling of Treasuries is completely legitimate, but the seller remains on the hook to deliver the Treasury as agreed. He could purchase the same bond elsewhere to make delivery, or deliver the next cheapest issue to fulfill that obligation. Another solution is to deliver a bond borrowed from a third party, which is known as a reverse repo.

However, given the current tightness of credit markets and with short-term interest rates near zero, some are finding that it makes more sense economically to stay 'failed.' The shorts have "insufficient incentive to borrow it to make delivery," Fleming and Garbade explain, because buyers pay only when the seller delivers and currently his only penalty is the time value of the transaction, which is based either on the overnight Fed funds rate or the rate for general collateral repurchase agreements, until the transaction is cleared.

While not costly to an individual seller, fails have a cascading effect, with one person failing to the next, who fails to the next, creating a "daisy chain." If the last buyer finds himself failing to deliver to the first seller, the phenomenon is called a "round robin," which apparently happens frequently enough for the Fed to have given it a cute name.


Bond market participants who find themselves short can lend and borrow Treasuries through repos. When you execute a repo, you are agreeing to sell a Treasury and repurchase it at a later date at a higher price.

"The transaction is tantamount to lending securities and borrowing money, with the excess of the repurchase price over the sale price being the interest paid on the money borrowed," explain Fleming and Garbade. The buyer in that same transaction is said to be entering a reverse repo, or to be 'reversing in.'

From a mechanical standpoint, the transaction looks like a collateralized loan and there are two flavors available: general and special collateral repos.

In a general collateral repo, the funds lender accepts a Treasury as collateral and is primarily interested in earning interest on the loan and owning a highly-liquid Treasury that could be sold in the event of a default.

In a special collateral repo, the funds lender wants to borrow a specific Treasury rather than borrowing or lending money. The owner of the security is motivated to loan it by the 'specials rate,' which would be below the rate at which he could relend the same funds on a general collateral reverse repo and pocket the spread between the two rates.

The difference between the general collateral rate and the special collateral rate is called the "specialness spread." If demand for a specific Treasury is strong, or it's otherwise scarce, the specials rate may be significantly below the general collateral rate and the specialness spread would be large. The Treasury would then be referred to as 'on special.'

"The whole repo market is 'on special,' because people are holding onto Treasuries," says Kim A. Rupert, managing director of global fixed income analysis for Action Economics LLC. "The problem now is that the Fed funds rate is practically zero, so there is no spread between the repo rate and the funds rate." Rupert explains that many of the new Treasuries being issued are being bought up by non-U.S. buyers, who are more interested in keeping the Treasuries as a safe haven than they are in loaning the securities out in the repo market, which is creating further dislocations in the market.


Treasury futures trade on exchange, and as a result are subject to more regulatory oversight and have the exchange clearinghouse as their counterparty. All market participants post margin based on their risk, are subject to position limits and all trades are cleared by a central counterparty, virtually eliminating that risk.

"On the exchange side, we have never had a failure to deliver," says Dean Payton, managing director and chief regulatory officer at the CME Group. All expirations are monitored closely and the recently expiring Treasury futures are no exception, Payton says, adding that the market surveillance team routinely monitors all elements of the market, knows who all the position holders are and monitors open interest on a daily basis. "What's unique is the market environment that we are dealing with," Payton says. "It's less an issue of people lacking clarity about the rules than it is just managing in a unique market environment."

Included in the advisory were the delivery dates and the multi-step timeline for announcing and arranging your intention to make or take delivery as well as a list of the opportunities before first notice day for the expiration to liquidate positions or roll them over to the next delivery month. "These contracts have been around for a long time and I think people are pretty clear. What futures traders need to know is that it is not an option to fail," Payton says.

Note: This feature length story by Chris McMahon originally appeared in the February 2009 issue of Futures Magazine.

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