What is non-compliance (FTD)?
Non-delivery (FTD) refers to a situation where one of the parties to a commercial contract (be it stocks, futures, options, or forward contracts) fails to meet its obligation. Such failures occur when a buyer (the party with a long position) does not have enough money to take delivery and pay for the transaction at settlement.
Failure can also occur when the seller (the party with a short position) does not own all or none of the underlying assets required in liquidation and is therefore unable to deliver.
- Non-delivery (FTD) refers to failing to meet one’s business obligations.
- For buyers, it means not having cash; in the case of sellers, it means not having the merchandise.
- The recognition of these obligations occurs in the commercial liquidation.
- Failure to deliver can occur in derivative contracts or when you go short.
Understand failure to deliver
Whenever a transaction takes place, both parties to the transaction are contractually obligated to transfer cash or assets prior to the settlement date. Subsequently, if the transaction is not settled, a part of the transaction has not been fulfilled. Non-delivery can also occur if there is a technical problem in the settlement process carried out by the respective clearinghouse.
Lack of compliance is critical when it comes to short selling. When a short sale occurs, an individual agrees to sell a share that neither he nor his associated broker own, and the individual has no way of justifying his access to those shares. The average individual is incapable of conducting this type of trade. However, a person who works as a self-employed trader for a trading company and risks his own capital can do so. Although it would be considered illegal to do so, some of these individuals or institutions may believe that the company they are short selling to will close and therefore in a short sale they may be able to make a profit without liability.
Subsequently, the non-delivery pending creates what are called “ghost shares” in the market, which can dilute the price of the underlying shares. In other words, the buyer on the other side of such operations may own shares, on paper, that do not really exist.
Chain reactions of event delivery failures
Several potential problems occur when trades are not settled properly due to non-delivery. Both equity and derivatives markets can have a delivery failure.
With forward contracts, a party with a short position that defaults can cause significant problems for the party with a long position. This difficulty occurs because these contracts often involve substantial volumes of assets that are relevant to trading the long position.
In business, a seller can pre-sell an item that he does not yet have in his possession. This is often due to a delay in supplier shipping. When it comes time for the seller to deliver to the buyer, he cannot fulfill the order because the supplier was late. The buyer can cancel the order leaving the seller with a lost sale, wasted inventory, and the need to deal with the backlogged supplier. Meanwhile, the buyer will not have what he needs. The remedies include the seller going to the market to buy the desired goods at prices that may be higher.
The same scenario applies to financial and commodity instruments. Non-compliance in one part of the chain can affect participants much further down that chain.
During the 2008 financial crisis, defaults increased. Like the check game, where someone writes a check but has not yet secured the funds to cover it, sellers did not deliver the sold securities on time. They delayed the process to buy securities at a lower price for delivery. Regulators have yet to address this practice.