Until recently, market convention allowed a seller of U.S. Treasury securities to postpone—without an explicit penalty and at an unchanged invoice price—its obligation to deliver the securities on a scheduled settlement date. The September 2008 insolvency of Lehman Brothers challenged this convention, when a decline in short-term interest rates led to a proliferation of settlement fails in the Treasury market. In response, the Treasury Market Practices Group (TMPG) introduced a “dynamic fails charge” for Treasury securities, mitigating a critical dysfunctionality in the market and illustrating the value of cooperation between the public and private sectors.
In this paper, authors Kenneth D. Garbade, Frank M. Keane, Lorie Logan, Amanda Stokes and Jennifer Wolgemuth provide an overview of settlement processes and settlement fails in the Treasury market, and describe how the TMPG worked over a period of six months to revise the market convention in the wake of the significant volume of fails that followed Lehman Brothers’ insolvency.
In May 2009, the TMPG—a Federal Reserve Bank of New York-sponsored group of market professionals from a variety of institutions—developed a dynamic fails charge to incentivize timely settlement and reduce fails when market conditions no longer provide adequate incentive, as was the case when short-term interest rates fell to near zero after the Lehman Brothers failure. When short-term interest rates drop below 3 percent, the fails charge produces an economic motivation to settle trades roughly equivalent to the incentive that exists when rates are at 3 percent. Thus, the fails charge preserves a significant economic incentive for timely settlement even when interest rates are close to zero.
The introduction of the TMPG fails charge relieved 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, and exemplified the benefit of public and private sector cooperation in responding to altered market conditions in a flexible, timely and innovative fashion.
Kenneth D. Garbade is a senior vice president, Frank M. Keane an assistant vice president, Lorie Logan a vice president, Amanda Stokes a trader/analyst and Jennifer Wolgemuth a counsel and assistant vice president at the Federal Reserve Bank of New York.