Failure to deliver: Explained | TIOmarkets
BY TIO Staff
|July 8, 2024In the world of trading, the term 'Failure to Deliver' (FTD) is a critical concept that every trader should understand. It refers to a situation where one party in a trading contract fails to deliver on their obligations, either the delivery of securities or cash. This article aims to provide a comprehensive understanding of the term 'Failure to Deliver' in the context of trading.
The term is commonly used in both securities trading and commodities trading. While the specifics may vary between these two types of trading, the underlying principle remains the same: a failure to deliver occurs when a party does not fulfill their part of a trading agreement. This can have significant implications for both parties involved and can affect the overall stability of the market.
Understanding Failure to Deliver
At its core, a failure to deliver is a breach of contract. In a trading agreement, both parties have specific obligations. One party agrees to deliver a certain quantity of a security or commodity, and the other party agrees to deliver a certain amount of cash. If either party fails to deliver on these obligations, it is considered a failure to deliver.
Failure to deliver can occur for a variety of reasons. For example, a seller may not have the securities they promised to deliver, or a buyer may not have the funds they promised to pay. Regardless of the reason, a failure to deliver can have serious consequences for both parties involved.
Implications of Failure to Deliver
When a failure to deliver occurs, it can cause significant disruption to the trading process. The party that was expecting to receive either the securities or the cash is left in a difficult position. They may have made plans based on the expectation that they would receive these assets, and a failure to deliver can throw these plans into disarray.
Furthermore, a failure to deliver can also have legal implications. As mentioned earlier, a trading agreement is a contract, and a failure to deliver is a breach of this contract. This can lead to legal action, with the party that failed to deliver potentially being liable for damages.
Preventing Failure to Deliver
Given the potential consequences of a failure to deliver, it is in the best interest of all parties involved in a trade to take steps to prevent this from happening. This can involve thoroughly vetting trading partners, ensuring that all parties have the necessary assets to fulfill their obligations, and using trusted intermediaries to facilitate the trade.
Additionally, many trading platforms have mechanisms in place to prevent failures to deliver. For example, they may require parties to provide proof of their ability to fulfill their obligations before a trade can be executed. These measures can help to reduce the risk of a failure to deliver occurring.
The Role of Clearing Houses
In many markets, clearing houses play a crucial role in preventing failures to deliver. A clearing house is an intermediary that ensures that trades are executed as agreed. They do this by taking on the risk of the trade themselves.
When a trade is agreed, the clearing house steps in and acts as the buyer to every seller and the seller to every buyer. This means that if one party fails to deliver, the clearing house will fulfill their obligations, preventing a failure to deliver from affecting the other party.
Clearing Houses and Margin Requirements
One of the ways that clearing houses manage the risk of failures to deliver is through the use of margin requirements. When a trade is agreed, the clearing house will require both parties to deposit a certain amount of money, known as a margin. This acts as a form of insurance against a failure to deliver.
If one party fails to deliver, the clearing house can use the margin to fulfill their obligations. This helps to ensure that the other party is not left out of pocket. Margin requirements are a crucial tool in managing the risk of failures to deliver.
Clearing Houses and Settlement Periods
Another important aspect of how clearing houses prevent failures to deliver is through the use of settlement periods. A settlement period is the time between when a trade is agreed and when it is executed.
During this time, the clearing house will verify that both parties have the necessary assets to fulfill their obligations. If one party does not, the clearing house can step in and fulfill their obligations, preventing a failure to deliver. Settlement periods are another key tool in managing the risk of failures to deliver.
Failure to Deliver in Different Markets
While the basic principle of a failure to deliver is the same in all markets, the specifics can vary depending on the type of market. In this section, we will look at how failures to deliver can occur in different types of markets, and how they are managed.
It's important to note that while the mechanisms for managing failures to deliver may vary between markets, the underlying principle is the same: to ensure that trades are executed as agreed, and to protect all parties involved in the trade.
Failure to Deliver in Securities Trading
In securities trading, a failure to deliver can occur when a seller does not have the securities they promised to deliver. This can happen if the seller was short selling - selling securities they do not currently own, with the expectation of buying them back at a lower price before the trade is executed.
If the price of the securities rises instead of falling, the seller may be unable to buy them back at a price that allows them to fulfill their obligations. In this case, the clearing house would step in and fulfill the seller's obligations, using the margin that the seller deposited as part of the trade.
Failure to Deliver in Commodities Trading
In commodities trading, a failure to deliver can occur when a seller does not have the commodity they promised to deliver. This can happen if the seller was speculating on the price of the commodity, and the price moves against them.
In this case, the clearing house would step in and fulfill the seller's obligations, using the margin that the seller deposited as part of the trade. This helps to ensure that the buyer receives the commodity they were expecting, and that the stability of the market is maintained.
Conclusion
Failure to deliver is a critical concept in trading, with significant implications for both parties involved in a trade and for the overall stability of the market. Understanding what a failure to deliver is, why it occurs, and how it is managed is crucial for anyone involved in trading.
While the specifics can vary between different types of markets, the underlying principle remains the same: a failure to deliver occurs when one party does not fulfill their obligations in a trade, and measures are in place to manage the risk of this happening and to protect all parties involved in the trade.
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