The Treasury Direct makes available essential government securities regulatory information about the Aged Fails Treatment.
(emphasis mine) [my comment]
Aged Fails Treatment
November 22, 1989
Jeffrey F. Ingber
Associate General Counsel
Government Securities Clearing Corporation
55 Water Street
New York, New York 10041
Dear Mr. Ingber:
[This is a very technical letter, but it explains the interpretations/exemptions which made naked short selling so widespread and profitable]
This is in response to your letter of June 20, 1989, in which you request interpretations of three provisions of the Treasury regulations implementing the Government Securities Act of 1986 (GSA regulations, 17 CFR 400, et seq.). Specifically, you request that, for purposes of sections 402.2, 403.4, and 403.5 (capital and customer protection rules), government securities brokers or dealers that participate in the Government Securities Clearing Corporation (GSCC) system for netting compared trades (Netting System) be allowed to consider the settlement date for a fail to receive or deliver to be the most recent business day for which such fail has been marked to market and repriced through GSCC's Netting System.
[TRANSLATION: government securities brokers or dealers]
We understand the facts to be as follows. GSCC is registered as a clearing agency with the Securities and Exchange Commission (SEC) pursuant to Sections 17A(b)(2) and 19(a) of the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. 78q-1(b)(2) and 78s(a)). Registration was granted on May 24, 1988, for a period not to exceed 36 months. In this role, GSCC has filed various proposed rule changes with the SEC in order to establish a legal framework for its Netting System (rule filings 89-4, 89-5, 89-6, and 89-7). Upon receiving SEC approval, GSCC began its netting operation on July 7, 1989.
Each business day, GSCC calculates and reports to participants in the Netting System (Netting Members) each net settlement position, including fails, that Netting Members have in an eligible netting security. When GSCC releases its report detailing netted positions, all deliver and receive obligations (together with related payment obligations) that were created by the Netting Members' trades submitted for netting are terminated and replaced by deliver, receive, and payment obligations to or from GSCC. For each net position, the Netting Member is either obligated to deliver securities to GSCC or to receive securities from GSCC; the Netting Member could also have a flat position. Every delivery and receipt by a Netting Member to and from GSCC is done against simultaneous payment, through Fedwire, at a uniform system price established by GSCC each business day for each eligible netting security. The uniform system price represents an approximation of the market value of a security for a day's trades. Fails are not netted with other fails or with new trades. Instead, they are maintained on an independent basis until settled.
On each business day, Netting Members pay to, or collect from, GSCC a funds-only settlement amount, which is separate from the settlement of delivery obligations described above. Included in the funds-only settlement are: (1) an adjustment consisting of the difference between the contract value and the uniform system price for settling trades, and (2) a mark-to-market adjustment for every fail net settlement position, including accrued interest.
You represent that capital charges related to "aged" fails (defined below) and mark-to-market requirements for aged fails are designed to take into account situations where market prices move significantly away from contract prices as the original settlement date becomes more remote. For purposes of the GSA regulations, a fail occurs when a security is not delivered or received on settlement date. Settlement date is the date on which delivery and receipt of a security and payment are contracted to occur. A fail becomes aged when it remains unsettled for more than a specifically prescribed period of time beyond settlement date.
You also represent that GSCC requires Netting Members to confirm their trading obligations and make daily mark-to-market adjustments, which consist of payments to, and collections from, Netting Members who are parties to a fail in order to update the price of the fail position to the current market value of the underlying securities. Based on these representations, you assert that for purposes of the capital and customer protection rules, Netting Members should be allowed to consider the settlement date for a fail to be the most recent business day for which the fail has been marked to market. In effect, you request that Netting Members be allowed to treat fails as unaged (i.e., only one business day old) for purposes of the capital and customer protection rules.
The GSA regulations address the treatment of aged fails in the liquid capital computation. The definition of liquid capital, set out at section 402.2(d), incorporates the SEC's definition of net capital (17 CFR 240.15c3-1(c)(2)), with certain modifications that are not material to your interpretation request. Paragraph (ix) of the incorporated definition of net capital provides that fail to deliver contracts outstanding for five business days or longer require deductions from net worth based on the appropriate haircut for the underlying security and deductions from, or additions to, net worth depending on the difference between the contract price and the market value of a trade. Moreover, paragraph (iv)(E) of the incorporated net capital rule requires deductions from net worth if the market value of securities failed to receive outstanding longer than 30 days exceeds the contract value of such fails.
The customer protection rules also impose requirements on government securities broker-dealers regarding aged fails. Section 403.4 of the GSA regulations adopts the SEC's customer protection requirements (17 CFR 240.15c3-3 and 240.15c3-3a), with certain modifications that are not relevant to your request. Paragraph (d)(2) of the adopted customer protection rule provides that buy-ins must be conducted when securities failed to receive are outstanding more than 30 days [Key point: fails aged more than 30 days trigger forced "buy-ins"]. In addition, the adopted customer protection rule requires that broker-dealers maintain a special reserve bank account for the exclusive benefit of customers. The amount required to be deposited into the account is de rived from a formula set out at section 240.15c3-3a (Exhibit A) of the adopted rule. Exhibit A, Note D of Item 4 requires that broker-dealers credit to the reserve formula the amount by which the market value of securities failed to receive and outstanding more than 30 days exceeds their contract value. Exhibit A, Item 12 provides that when fail to deliver contracts become older than 30 calendar days, broker-dealers must remove debits that were recorded in the reserve formula for such fails. Finally, section 403.5(c)(1)(iii) of the GSA regulations establishes buy-in requirements for financial institution government securities brokers or dealers when failed to receive securities are outstanding for over 30 days.
Although, as discussed below, GSCC has taken steps to reduce the risks to Netting Members with respect to fails, fails that continue to be unsettled after a specified time, regardless of whether they are marked to market, remain within the definition of aged fails as applied in the capital and customer protection rules. We believe that a wider definition would be inconsistent with the application of the GSA rules. Accordingly, we are unable to provide you with the particular interpretations you request since they would conflict with the definition of aged fails. [to say the least]
However, our analysis indicates that GSCC's daily mark-to-market procedure, which includes payments through GSCC from one Netting Member to another, provides financial safeguards to Netting Members for credit and market risk that parallel the capitalization required of such members under the capital rule. Additionally, the protection provided to customers through the mark-to-market mechanism is comparable to that provided under the customer protection requirements [it isn't]. Like the customer protection requirements, the mark-to-market procedure provides brokers and dealers with sufficient funds to satisfy contractual obligations to customers. Moreover, mark-to-market payments constitute incentives for brokers and dealers to complete deliver and receive obligations [Flawed reasoning. Without the safeguard designed to prevent abuse of settlement failures (an automatic forced buy-in after 30 days), it ALSO provides incentive to keep selling hundreds of thousands of shares, reducing a stocks value to zero.]. Similar conclusions were reached by the SEC staff in two no-action letters (dated June 11, 1987 and December 22, 1987) addressed to the National Securities Clearing Corporation (NSCC) regarding its Reconfirmation and Price Service (RECAPS) and as evidenced by the NSCC's treatment of fails in its Continuous Net Settlement (CNS) system as unaged under the SEC net capital rule. [In other words, stock buy-ins were eliminated in 1987]
Based on these factors and your representations of the structure and operation of the Netting System and the daily mark-to-market process, we believe that exemptions from certain capital and customer protection requirements regarding aged fails are warranted. We have consulted with the staff of the SEC in arriving at our decisions, and we have determined that such exemptions are consistent with the public interest, the protection of investors, and the purposes of the Government Securities Act given GSCC's current operating structure.
Accordingly, pursuant to 15 U.S.C. 78o-5(a)(4), we hereby grant exemptions, only for trades processed through GSCC's Netting System, to GSCC Netting Members that are government securities brokers and dealers from the following GSA rules: (i) as incorporated in 17 CFR 402.2(d), paragraphs 17 CFR 240.15c3-1(c)(2)(iv)(E) and (c)(2)(ix); (ii) as incorporated in 17 CFR 403.4, paragraph 240.15c3-3(d)(2) and Exhibit A (Note D of Item 4 and Item 12); and (iii) 17 CFR 403.5(c)(1)(iii).
These exemptions apply solely to GSCC Netting Members' trades that are processed through GSCC's Netting System and are conditioned upon the following: (i) in lieu of adhering to the Treasury customer protection (section 403.4) rule's adopted requirement at 17 CFR 240.15c3-3a (Exhibit A) Note D of Item 4, GSCC Netting Members that are government securities broker-dealers required by section 403.4 to maintain a special reserve bank account for the exclusive benefit of customers will at all times maintain a credit balance in Item 4 of the reserve requirement in an amount representing the current market price of the underlying fail to receive security, regardless of the age of such fail; and (ii) the system price will continue to be established by GSCC each business day, as represented by you, based on current market prices of government securities. Any change in the facts or circumstances of your request would require further analysis and could lead to a termination of the exemptions.
Pursuant to 17 CFR 400.2(c)(7)(i), your incoming letter and this response will be immediately available to the public.
Richard L. Gregg
My reaction: This letter shows that mandatory buy-ins for stocks were eliminated in 1987 and the mandatory buy-ins for government securities buy-ins were eliminated in 1989. Without the forced buy-in of failure to delivers older than 30 days, broker dealers were freed to keep these trades open indefinitely, which opens the door to horrible abuse of the settlement system.
A broker-dealer can now short sells hundreds of thousands of shares, reducing a stock's value to zero without ever worrying about needing to make delivery. Even better (for the broker), since the current market price of the underlying fail to deliver security is now zero, there is little need to maintain reserves ( "hundreds of thousands of shares" * zero = zero).