Bond Dealers, Hedge Funds Will Face Penalty for Failed Trades
By Rebecca Christie and Liz Capo McCormick
Dec. 31 (Bloomberg) -- Bond dealers and hedge funds that fail to complete trades in Treasury securities face a penalty of as much as 3 percent on the proceeds of transactions, according to a Federal Reserve-backed industry code to be implemented in the next six months.
The plan, which strengthens official oversight of trading, will be unveiled as soon as Jan. 5, said Thomas Wipf, chairman of the Treasury Market Practices Group and the head of institutional securities group financing at Morgan Stanley in New York.
“It seems quite obvious that the Fed and Treasury cannot and will not accept the status quo for much longer,” Wipf said in an interview.
Demand for Treasuries is so great that investors are lending cash for next to nothing to obtain the securities as collateral through repurchase agreements, or so-called repos. The problem is market participants haven’t always delivered the bonds, causing “fails” to exceed $5 trillion at their peak, according to the New York Fed.
Because the penalties will be imposed across the government debt market, unregulated investors like hedge funds will be held to the same standard as banks and bond dealers. Failures impair trading in a range of debt markets, exacerbating the worst credit crisis in 70 years. The Treasury Department needs to keep the bond market working smoothly to meet the government’s financing needs, which may reach $2 trillion next year, according to Goldman Sachs Group Inc. economists.
Rates Near Zero
The Fed this month lowered its target rate for overnight loans between banks to between zero and 0.25 percent. Rates on repos in the market for borrowing and lending government debt opened at 0.15 percent today for general collateral. Securities that can be borrowed at interest rates close to the Fed’s target rate are called general collateral.
“The fact that participants can choose to fail when low rates distort the incentives is unacceptable,” Wipf said.
The Treasury Market Practices Group, which the New York Fed helped assemble in 2007, includes managers, lawyers and compliance officers from bond dealers, banks and institutional investors.
Treasury Department and Fed officials take part in its discussions. The Fixed-Income Clearing Corp., a unit of the New York-based Depository Trust & Clearing Corp. that nets and settles government securities trades among bond dealers, will help enforce the penalties.
Impact of Low Rates
With interest rates so low, bond market participants have less incentive to solve settlement problems because they’re forgoing less return than usual on a failed trade.
The Practices Group, which released a draft of the guidelines in November, will also address margin requirements and conditions that would require cash settlement of failed trades. The recommendations also deal with trade netting, a method of consolidating trades that is an important part of untangling unsettled transactions.
“We appreciate the new policies and guidelines,” Treasury Assistant Secretary Karthik Ramanathan said in an e-mail to Bloomberg News on Dec. 29. When failed trades surged to a record in October, he put bond markets on notice that the Treasury would step in unless the industry took quick action.
“We clearly stated that private sector participants should take additional steps from a monitoring, compliance and supervisory perspective to ensure that settlement fails do not reach levels that impact financing markets,” Ramanathan said.
Lehman Aftermath
Treasury officials have voiced concern about failed trades since at least 2003. Fails climbed in the weeks following the Sept. 15 collapse of Lehman Brothers Holdings Inc. as demand for the relative safety of Treasuries increased.
Failures to deliver or receive securities rose to a record $5.311 trillion in the week ended Oct. 22. While the amount fell to $891 billion by Dec. 17, that’s still above the average of $165 billion before credit markets seized up in August of last year, according to Fed data dating to 1990.
“This is one of those issues that festered a while,” said Dino Kos, managing director at Portales Partners LLC, New York, and the former manager of open market operations at the New York Fed. “It’s time to stop dithering and get on with it.”
“Interest rates are essentially zero, and they’re going to stay here for a really long time,” Kos said. “Market efficiency will degrade with time if this situation is not addressed.”
Volumes Decline
Primary dealers’ average daily trading volume fell to $356.4 billion in the week ended Dec. 17, the smallest amount of government securities changing hands in about a year, according to Bloomberg data.
The Fixed-Income Clearing Corp. told customers last week that it expects to adopt the new policies in the second quarter of next year. Such a move would require approval by its regulator, the Securities and Exchange Commission.
FICC’s step puts dealers on the hook for all failed trades, giving them an incentive to pass the charges through to investors. In October, when fails peaked, members would have received net penalties of $110 million, with $14.8 million the biggest charge to a single firm, FICC said.
“A member will be responsible for the fails charge regardless of whether the fail to deliver was ultimately caused by the member’s non-FICC member counterparty,” the clearing group said in a note to members.
Hedge funds say they’re already affected by failed trades, noting fewer opportunities to trade with foreign investors reluctant to lend securities while fails are high.
“It’s a counterparty risk they just don’t want to take,” said Mark Spindel, chief portfolio manager at Potomac River Capital LLC, a Washington-based hedge fund that trades and invests in Treasuries.
Hedge funds doubled their share of U.S. bond trading to 30 percent in the 12 months through April 2007, according to the most recent data from Greenwich, Connecticut-based research firm Greenwich Associates.
To contact the reporters on this story: Rebecca Christie in Washington at rchristie4@bloomberg.net; Liz Capo McCormick in New York at emccormick7@bloomberg.net
Last Updated: December 31, 2008 11:45 EST |
