Chapter 13

Failed Trades – Causes, Consequences and Resolution

In section 12.2.4 we saw the settlement agent communicating details of settlement instructions that could not be fulfilled to its customer. When a settlement instruction cannot be implemented on value date it is known as a failed trade.

13.1 FAILED TRADES – CAUSES

The causes of failed trades fall into three categories:

• Problems with instructions
• The seller does not have the securities to deliver
• The buyer does not have sufficient cash or credit to make payment.

13.1.1 Unmatched settlement instructions

The settlement agent may be unable to match the buyer’s and seller’s instructions for any one or more of the following reasons:

• One of the parties has failed to send an instruction at all, or has sent it too late for processing on value date.
• The instructions sent by the two parties differ substantially from each other.

Instruction-related problems are almost always due to processing errors by one or other party. The possible causes of such a processing error include:

• Human error at the data entry stage: The order was entered for the wrong stock, wrong quantity of stock, wrong price, buy instead of sell, etc.
• Computation error: If the trade was entered correctly then the part of the process that calculates trade amounts such as principal amount, accrued interest, commission, fees (these elements sum to the trade consideration) may have failed for some reason. This type of problem may be caused by one or more of the following underlying problems:

  – Incorrect instrument-related static data in the system performing the computations

  – Application deficiencies – the business application is not able to perform the calculations for a complex transaction correctly.

• Other data-related problems: Such as incorrect SSI data that may lead the instruction either to be sent to the wrong agent, or quote incorrect nostro and depot accounts for one or other trade party.
• Interfaces that fail: For example, the trade is correctly entered into the front-office system but fails to reach the settlement system so no instruction is generated.

If the trade agreement process is working correctly, and if the different internal systems are reconciled with each other on a daily basis – as discussed in section 23.11 – then these types of problems should be detected and corrected before value date.

13.1.2 The seller has insufficient securities to deliver

This problem is caused by one or more of the following situations:

In the first case, it must be remembered that a settlement instruction is a precise command – the agent will only withdraw the securities from the depot account that was quoted in the instruction. If the firm has the same security in multiple depot accounts with the same agent, then it needs to issue a separate instruction to move them from one account to another.

In the second and third cases, the seller may be able to borrow the securities concerned. Stock borrowing is examined in detail in Chapter 21. In addition, in some markets the settlement agent will automatically arrange a partial delivery. In a partial delivery, the agent will deliver whatever proportion of the quantity instructed it can, against partial settlement of the cash – so if 40% of the stock is available the agent will deliver against 40% of the cash.

In other markets, it is necessary for the two trade parties to come to this type of agreement between themselves, and then cancel the original instruction and replace it with multiple instructions that bear a relationship to the quantities that the selling party estimates that it can deliver.

13.1.3 The buyer has insufficient cash or credit to make payment

Credit in this sense means the availability of an overdraft facility with the settlement agent. It is the buyer’s responsibility to make sure that it is in a position to pay for its purchases.

Chapter 21 examines the need for the firm to be able to produce accurate cash flow projections, and also examines some of the common ways that portfolios are funded.

If a firm does not have sufficient cash or credit to pay for a purchase, then the trade will fail. Settlement agents do not arrange partial deliveries where the buyer has some – but not all – of the cash to pay for a purchase.

13.2 CONSEQUENCES OF FAILED TRADES

13.2.1 Purchases – cash perspective

The inability to pay for purchases creates reputational risk. It may lead to other trading parties reducing any credit limits that they apply to this party, which in turn can lead to liquidity risk. Both of these types of risk are examined in Chapter 24.

Additionally, depending on the rules that apply to the market the trade is executed in, either the seller may be entitled to make an interest claim against the purchaser for the loss of interest on the sale proceeds between contractual value date and actual settlement date, or the CSD may fine the purchaser for its inability to meet its contractual obligations.

13.2.2 Purchases – securities perspective

If a firm has the cash to pay for its purchases, and a purchase fails to settle, then it does not affect other aspects of the trade that are based on value date. It is still entitled to coupons, dividends and other corporate action benefits (examined in Chapter 23) that are based on the value date position.

If the buyer has bought the securities to add to an existing long position, and does not have any unsettled sale transactions that depend upon this receipt, then the failure of this purchase will not have any knock-on effects. However, if the buyer is depending on this receipt in order to make other deliveries, then a failed purchase does present problems. The buyer may be forced to borrow the stock (Chapter 21) in order to deliver its sales. The rules of most securities markets allow for the buyer to issue a buy-in notice to the seller if the seller is unable to deliver for an extended period of time.

Failure to act on the buy-in notice means the trading party that issued the notice may buy the securities from a third party and cancel the transaction with the original party. If the price has risen, then the selling party has to compensate the buying party for its losses.

13.2.3 Sales – cash perspective

The seller will naturally make every effort to ensure that its sales settle in full on value date, because until the trades settle it does not get paid and will not earn interest on the cash proceeds. If a buyer is unable to pay for securities due to lack of cash or credit then the seller may be entitled to make an interest claim against the buyer.

13.2.4 Sales – securities perspective

If the seller is selling out of a long depot position, then there should be no reason why sales fail provided that instructions are matched and purchasers have the cash or credit to pay for them. If the seller has sold short, then it may be able to borrow the securities concerned – this process is explained in Chapter 21.

13.3 THE PREVENTION AND RESOLUTION OF FAILED TRADES AND THE IMPACT ON IT APPLICATIONS

In order to minimise the number of failed trades, operations staff need to be able to monitor the status messages that the settlement agent sends prior to value date so that potential failed trades are handled as exceptions before value date. Settlement systems therefore need to be able to:

• Trading party
• Instrument being traded value date
• Settlement agent/depot account/nostro account
• Current status
• Combinations of the above.

3. Provide a history of status messages, so that the history of events may be used to make or defend interest claims and buy-in notices.

4. Provide operations personnel with the facilities to send and receive messages about actual and potential failed trades to trading parties and settlement agents.

5. Validate that the settlement instructions that the system has sent to settlement agents have in fact been received by those settlement agents. In other words, monitor the quality of the interfaces between systems and external suppliers.