- Prior to May 2009, market convention enabled 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.
- As long as short-term interest rates were above 3 percent or so, the time value of money usually sufficed to encourage timely settlement.
- The September 2008 insolvency of Lehman Brothers challenged the existing market convention.
- When short-term rates fell to near zero following the Lehman insolvency, the time value of money no longer provided adequate incentive to settle on time, and the Treasury market experienced an extraordinary volume of fails that threatened to erode the perception of the market as being free of credit risk.
- In response, the Treasury Market Practices Group (TMPG) worked over a period of six months to revise the market convention for settlement fails.
- Effective May 2009, the TMPG—comprising market professionals committed to supporting the integrity and efficiency of the U.S. Treasury market—introduced a “dynamic fails charge” to incentivize timely settlement of Treasury securities and reduce fails.
- When short-term interest rates fall 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, in the form of monetary compensation from a seller of Treasury securities to a buyer if the seller fails to deliver on time.
- The fails charge thus preserves a significant economic incentive for timely settlement even when interest rates are close to zero.
- The introduction of the fails charge corrected a dysfunctionality in the U.S. Treasury market while illustrating the value of public and private sector cooperation in responding to altered market conditions in an innovative way.
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.