This study estimates the total value of trade settlement failures in the US bond markets. Analyzing data from multiple sources, it shows that the value of settlement failures is rising. Regulatory and market efforts to reduce the problem have been largely unsuccessful. In April 2008, fails to deliver in bond markets reached a peak value of $600 bn, a fail rate of nearly 9%. The resulting loss of tax revenue on payments in lieu of interest (on tax-exempt municipal and Treasury securities) is found to be $42 mn per year to the federal government and $271 mn per year to the states. The loss of use of funds to investors as a result of securities paid for but not received is found to be $7 bn per year.

At a conference held in New York in October 2006, we expressed concern about settlement failures in the US equity markets (Trimbath, 2006a). Our emphasis was on the extent of trade settlement failures, a subject that had begun to receive attention from the Securities and Exchange Commission (SEC) with the implementation of Regulation SHO in 2005 and subsequent revisions in 2007 and 2008. At the New York meeting, staff members from the Federal Reserve Bank (FRB) who were in attendance described similar concerns about activity in the bond markets. According to data and staff research available from the FRB, settlement failures are prevalent in the market for the US Treasury bonds (including bills and notes). Transactions to which the FRB is a party are settled directly with them and not through any other clearing corporation. Therefore, the FRB could have a great deal of control over that bond market activity. For example, they might hold cash overnight without interest and assess penalty fees directly to the primary dealers, although they do not take this step. Trades in Treasury bonds that do not involve the FRB may be settled at a privately run clearing corporation, such as the Depository Trust and Clearing Corporation (DTCC). A subsequent review of FRB data and research reports showed that the actual size of the problem in the bond markets was many times the size of known equity market settlement failures.

Economists at the FRB (Fleming and Garbade, 2002 and 2005) suggest that settlement failures in Treasuries could be the result of operational (paperwork) problems, fluctuating interest rates, changes in supply and demand resulting from quarterly Treasury financing needs, and/or lack of incentive to deliver sold bonds on time. The FRB economists suggested that "episodes [of high settlement failures] can be traced to market participants' insufficient incentive to avoid failing." They suggest that implementing fines for settlement failures could curb the practice, although that suggestion was not implemented.

Financial Economics Journal, Trade Settlement Failures, US Bond Markets, Equity Market, Multiple Datasets, Financial Instruments, Government Securities Division, Financial Markets, Netting Ttrade Obligations, Cash Settlement Obligations, US Government Securities, Corporate Bonds, Equity Securities, Risk Management Practices, Foreign Exchange Trades, Unit Investment Trusts, Mortgage-Backed Securities.