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Authors Michael J. Fleming and Kenneth D. Garbade examine the market conditions of last year in which interest rates on certain U.S. Treasury security repurchase agreements (RPs) were sometimes less than zero. The authors conclude that market participants may be willing to pay interest on money they lend if the loan is collateralized with securities that allow them to meet delivery obligations.
The authors investigate the recent episode starting in late June and continuing through mid-November 2003 when there were significant settlement problems in the ten-year Treasury note issued in May of 2003. Extremely low short-term interest rates in 2003, coupled with a sharp increase in intermediate-term yields during the summer, resulted in an extraordinary volume of settlement fails in the note. In a fail, a seller does not deliver the securities it promised to a buyer on the scheduled settlement date and, consequently, does not receive payment for the securities.
The authors contend that while the option of Treasury market participants to fail on, or postpone, delivery obligations with no explicit penalty usually puts a floor of zero on RP rates, this was not the case in 2003 because ancillary costs of failing became significant as settlement problems in the May ten-year note persisted. Thus, from early August to mid-November of 2003, lenders were sometimes willing to pay interest on loans secured with the note. They did so to avoid ancillary costs that included opportunity costs stemming from regulatory capital requirements imposed on “aged” fails (starting at five days overdue), increased labor costs of diverting back-office personnel to reduce the backlog of unsettled trades, and customer dissatisfaction.