Settlement Failure

A settlement failure, often called a "fail", happens when a transaction does not settle on its intended settlement date because one of the parties does not deliver what it owes: cash, securities, currency or another asset. Most failures are temporary and are resolved within days, but they create costs, operational work and, in severe cases, losses or wider disruption. The term is used in securities and derivatives markets, foreign exchange and payment systems.

Settlement failure is the event at the heart of settlement risk. It differs from a routine settlement exception, which may be only a mismatch in records, because a failure means that value did not move as agreed. When the cause is a party's insolvency rather than a temporary problem, the failure becomes a default and is handled under insolvency law and the default rules of the clearing or settlement system.

Failures usually stem from operational or liquidity problems rather than outright default:

• Lack of securities. A seller does not have the securities in its account, perhaps because it has lent them out, is waiting for another trade to settle or sold short without borrowing.
• Lack of cash. A buyer or payer does not have enough funds or credit in its settlement account by the deadline.
• Instruction mismatches. The two sides' settlement instructions disagree on details such as quantity, price, date or account, so the settlement system cannot match them.
• Static data errors. Incorrect standing settlement instructions, account numbers or identifiers send assets to the wrong place.
• Chains of fails. When one trade fails, a firm that relied on receiving the securities may in turn fail to deliver to another counterparty, spreading the problem.
• Technical outages. System failures at a party, a custodian or the infrastructure itself prevent processing before the cut-off.

Securities settle through a central securities depository on a delivery versus payment basis, so a fail usually means that neither side has lost its asset: the buyer keeps its cash and the seller keeps its securities. The cost lies in the delay, the replacement risk if prices move, and the funding and operational work involved. Markets therefore impose discipline. In the European Union, the Central Securities Depositories Regulation introduced daily cash penalties on failing participants, and markets provide for a buy-in procedure under which the receiving party can buy the securities elsewhere at the failing party's expense. In the US Treasury market, a fails charge was introduced after a period of persistent fails, to give sellers an incentive to deliver even when interest rates are very low.

Shortening settlement cycles, such as the move to T+1, raises the importance of avoiding fails because there is less time to correct errors before the settlement date.

In payment systems, a failure occurs when a participant cannot fund its obligations in time. In a deferred net settlement system, one participant's failure to pay its net debit could prevent the system from settling for everyone, so system rules specify what happens: unwinding the failed participant's payments, drawing on collateral or using a settlement guarantee arrangement. Real-time gross settlement systems avoid this by settling each payment individually only when funds are available, at the price of higher liquidity needs.

In foreign exchange, the classic danger is principal risk, where one party pays the currency it sold but never receives the currency it bought. The 1974 failure of Bankhaus Herstatt, which was closed after receiving payments in one currency but before paying out in the other, gave its name to Herstatt risk and led eventually to Continuous Linked Settlement, which settles both legs together.

Firms reduce fails by matching and confirming trades early, maintaining accurate standing instructions, monitoring securities and cash positions throughout the day, and using securities lending to cover shortfalls. Infrastructures use mechanisms such as partial settlement, automatic recycling of failed instructions, collateral requirements and default management procedures. A central counterparty stands between buyers and sellers in cleared markets, guaranteeing performance so that a single participant's failure does not pass directly to others.

Large or widespread settlement failures can turn a firm-specific problem into a market-wide one, because participants depend on receiving assets to meet their own obligations. Regulators therefore set standards, such as the international Principles for Financial Market Infrastructures, requiring systems to settle reliably and to have clear rules for handling a participant's failure. Statistics on fail rates are monitored by supervisors as an indicator of market stress and operational weakness, and of potential systemic risk.