There’s a lot of discussion about fails in the Treasury market, including a variety of armageddon theories about why fails have increased, but rest assured, fails are a normal part of the market. That’s not to say I take the increased fails lightly, but it’s not a threat to humanity. The recent spike in fails might seem significant, but it isn’t.
What’s A Fail?
Fails come in two forms: A fail-to-deliver and a fail-to-receive. They’re both the same in a way, one person’s fail-to-deliver is another person’s fail-to-receive. Here’s how it happens: When someone sells a security to someone else, the buyer expects the security to be delivered. Now, suppose the seller didn’t actually own the security and they must go into the Repo market and borrow it. But now, suppose they can’t borrow it. Without the security, they’re unable to deliver anything and it becomes a fail-to-deliver. Naturally, for the buyer, it’s a fail-to-receive. Market participants can fail for a variety of reasons, recently, it’s because there’s more demand.
The Cost of Fails
Without the Fail Charge, the cost of a fail is the equivalent of investing cash at a 0% rate, which is the same as not covering (borrowing) the security at all. Here’s how it works: Someone who’s short borrows the security via a reverse-repo trade to cover their short. They borrow the security and simultaneously lend cash at the same time (delivery versus payment). A “Special” is when someone is willing to accept below market interest rates on their cash in order to receive a specific security. The larger the premium (spread) below general collateral (GC), the more that security is in demand. For example, if GC is trading at 0.25% and a specific Treasury is trading at 0.0%, that issue is trading 25 basis points below GC. Thus, the borrower is willing to invest their cash at 0.0% instead of 0.25% in order to receive that specific security.
Before there was a fail charge, some market participants wouldn’t even cover their shorts when rates got close to zero. Perhaps they didn’t want to show the market the size of their short, or pay brokerage, or maybe even pay the ticket charge and processing fees. In any event, those costs exceeded the cost of not covering the security at all.
Not covering shorts was actually quite common in the past for periods of time when there were protracted shortages. It all came to a head in October 2008 when securities were pulled from the market, the Fed dropped overnight rates down to near 0.0%, and counterparties stopped trading with each other. It was the perfect storm in the repo market and fails shot up to an all-time record high of $5.06 trillion on October 15, 2008. People realized there needed to be a cost of failing in the Fed’s new 0.0% interest rate environment. About 7 months later, the Fail charge was introduced. At 0.0% rates, the Fail Charge is 300 basis points which makes the break-even cost for not covering a short the equivalent of -3.00%. These days, when repo rates get near or below -3.00%, dealers will not cover their shorts. It’s also why you rarely see repo rates below -3.00%
Supply And Demand
Think of the repo market like any market, it’s the meeting place between supply and demand. Demand in the specials market comes from the shorts. Traders might be outright short the market, they might feel the short-end of the curve will back-up more than the long-end, and traders are just more likely to hedge when they expect rising rates. Basically, when there are more shorts in the market, the demand for securities increases.
Supply comes from the available supply in the market – dealer inventories, securities lenders, prime brokerage accounts, and in general, any portfolio which lends it’s securities into the market. Supply leaves the market when securities are sold to “retail accounts” and portfolios which do not lend their securities. Supply is also a function of which securities the Fed is holding. Currently, the Fed owns about 20 percent of all U.S. Treasuries, a total of $2.39 trillion. The more the Fed owns of specific Treasurys, the more supply can get channeled back into the repo market via the Fed’s securities lending program.
Let’s put the current situation in perspective. A Fail Charge of -3.00% basis points is expensive by post 2008 standards, but not by historical standards. In 2007 overnight rates were set around 5.00%. Back then if someone failed, there was a 500 basis point cost. It’s a matter of mindset. The Fail Charge was never guaranteed to eliminate fails, it set up to make them more expensive when overnight rates were at 0.0%.
2013 Vs. 2014
Last year, around this time, there was concern about 10 Year Note fails. Beginning in 2013, there was a large short-base in 10 Year Note which culminated in June 2013 and led to a spike in fail volume. The shorts were on target, Bernanke’s “tapering” hint in May 2013 backed-up the Treasury market considerably.
This year, as it turns out, other Treasury issues are special, including the 2 Year Note, 5 Year Note, and 10 Year Note, plus a little bit in the 3 Year Note. Just like last year, there’s an imbalance between supply and demand and that imbalance will be corrected as new securities are issued. More supply in the 2 year and 5 year sectors arrived on June 30 and supply arrived in the 10 Year Note on June 15.
That brings us to the doomsday theories about the spike in fails. Some say the fails are an indication of “stress in the financial system.” That the increased fails are a reflection of the lack of high quality collateral. There won’t be sufficient short-term paper to handle the amount of shorts generated from a round of Fed tightening. That won’t be the case. In June, the fails were concentrated in on-the-run issues: the 2 Year Note, 5 Year Note and 10 Year Note. When on-the-run issues become too expensive in the repo market, shorts move into other issues or instruments, like old issues, double-old issues, futures, swaps, etc.
Another outlet blamed the increase in fails on QE. I can assure you, QE is not causing the fails, and let’s be clear, I’d be one of the first to criticize QE if it did. Remember, the Fed has a securities lending program, so the securities it purchases in the market are still available in the repo market. However, I did read one interesting point. Under Operation Twist, the Fed sold their short-term securities and purchased long-term securities and the Fed does not own any securities that mature until 2016. Operation Twist skewed the Fed’s holdings away from the short-end. Thus, potentially less supply in the short-end of the market.
Then, someone even suggested that the increase in fails was a result of quarter-end. Now, quarter-end does contribute to increased fails, but this fail discussion appeared well before June 30.
Natural Market Mechanism
All in all, the existence of fails is an indication of an imbalance between supply and demand in the repo market. Normally, there’s an abundance of securities (supply) in the market – plenty of securities to fill all of the shorts. When demand increases considerably (more shorts) and that demand exceeds supply, fails are the result. But don’t worry, it’s a normal part of the repo market. Once there’s a shortage, securities become more expensive in both the outright and repo markets. Then, many of the shorts roll out of the expensive issues, portfolios sell their long positions and it brings securities back into the market. Fails were a pretty common occurrence just several years ago. These days, people are a little panicky because they haven’t see as many shortages since the end of the financial crisis.
For more discussion on fails, see my commentary from June 11, 2013