Rise in Securities Settlement Failures Shows Some Traders Game System, but Failed Settlements Also Can Signal Systemic Risk, According to Kauffman Report

Contact:
Ben Branham, 646-246-6147, benjamin.branham@edelman.com, Edelman
Barbara Pruitt, 816-932-1288, bpruitt@kauffman.org, Kauffman Foundation
Fred Sommers, 617-733-8291, fred.sommers@basispointgroup.com, Basis Point Group

New paper urges regulatory crackdown on traders who boost profits by failing to honor legal obligations

(KANSAS CITY, Mo.) March 1, 2011 - A large and growing number of securities transactions that fail to settle indicates a possible lapse in regulatory oversight and poses a potential liquidity risk that can lead to a future systemic crisis, according to a new report issued today by the Ewing Marion Kauffman Foundation. The report urges a tough regulatory crackdown, including substantial financial penalties for settlement fails.

According to the report, every fail introduces a cumulative and potentially compounding liquidity risk into the orderly process of settling the $7.5 trillion of security transactions completed each day. It goes on to say that the failures are at least partly attributable to gaming of the system by traders who use delay to generate additional profit. 

"There is a lopsided risk-reward dynamic embedded in the structure of current fails regulations. Capital markets firms can increase profits while laying off the risk associated with these profits to investors, the Treasury, and ultimately the taxpayers," the report observes.

Harold Bradley, Kauffman's chief investment officer, and Robert Litan, Kauffman's vice president of research and policy, co-authored the paper with Robert A. Fawls and Fred E. Sommers, partners at Basis Point Group, a leading financial markets research firm based in Massachusetts.

"Settlement failures are a canary in the coal mine of the financial markets," Bradley warns. "If we write a check without money in the bank, we end up in jail. When securities transactions don't settle, the same thing happens on a larger scale. Too many settlement fails can put the financial system on edge."

The report points to an uptrend in settlement failures for Mortgage-backed Securities (MBS) and Exchange Traded Funds as particularly troublesome. It says MBS fails averaged $115 billion per day in 2010, an increase of more than tenfold since 2008.  

"Failures now are at a level that presents significant systemic risk to all investors in the event of another market shock," Fawls said. "Though the Fed has the detailed fails data for each primary dealer, we could find no indication that it is using available tools to mitigate this risk to U.S. capital markets."

Basis Point Group estimates that settlement failures and other accounting recognition delays impose hidden costs to asset owners of about 27 basis points every day—or about $300 billion in assets that cannot be reinvested. At that level, and assuming a conservative annual interest rate of 3 percent, settlement failures cost underfunded pension funds and other institutional investors at least $9 billion a year in lost earnings.

"These preventable losses are particularly intolerable at a time when both public and private pension funds are asking employees to accept benefit cuts, increase their own contributions, or both," Litan said. "Regulators can fix this. Every day of delay raises the risk to the financial system as a whole and to every investor, large or small."

The paper notes that the Federal Reserve and the Securities and Exchange Commission have previously and successfully intervened to reduce fails in the market for U.S. Treasury paper and in the equities market. It says they should take similar action now in the broader securities market. 

"The regulatory establishment must gain control over Wall Street's hyperkinetic trading interests and stiffly fine traders who do not meet their contractual and legal obligations to settle trades on time," Sommers said.

Specifically, the report urges regulators to:

  • Impose penalties or fees for all transaction fails on all securities types that will offset financial gains derived from late settlement of trades, usually at investor expense;
  • Broaden the reporting of transactions where counterparties fail to deliver on time, and include all transaction activity for all major organizations; and
  • Improve the analytic framework required to understand how markets are operationally connected and the potential failure points in today's tightly coupled systems.

The report also points to the events of 2008 and observes that the settlement system depends "on a daisy chain of intermediaries doing the right thing at the right time. This does not often happen during market crisis."

About Basis Point Group
Basis Point Group is a research and management consulting firm that specializes in operational and systemic risk management for global financial services firms with partners located in Boston, New York, London and Toronto. BPG's partners have developed a deep understanding of the financial operational processes that support the world's markets and how market operational behavior affects investors. The company's operations and systemic risk indexes cover U.S. $42 trillion of issued securities in the U.S. Treasury, Agency, Mortgage-back, corporate bond, equity and ETF markets. BPG has developed a comprehensive, patented framework for simultaneously measuring the quality of processing and real-time operational risk in any financial transaction process stream. The company also conducts research on the impact that operational efficiency and risk have on institutional and private investor performance. For more information, visit www.basispointgroup.com.

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