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Capital Markets

Strategic failures

Academic research into delivery failures in the US cash equity and options market support the idea that prior to Reg SHO, market makers deliberately failed to deliver securities in a strategic way.

Leslie Boni, an economist at the University of New Mexico, wrote a paper entitled "Strategic delivery failures in US equity markets" while a visiting financial economist at the SEC last autumn. Boni found that most US equity issues experience at least a small percentage of failures-to-deliver every day. On average failed shares account for just 0.15% of the outstanding shares of listed companies and 0.91% of unlisted shares. Some 42% of listed stock issues and 47% of unlisted stock issues, have persistent fails of five days or more.

Any clearing member with a failure to receive position has the option of asking the NSCC to force a "buy in" on its position. Buy-ins, however are rarely requested. In a 2003 paper, Wharton and University of North Carolina economists found that options market makers with cash equity failures-to-deliver were only bought-in in 86 of the 69,063 transactions examine, or just 0.12% of cases.

Academics argue that persistent fails are primarily due to market makers strategically failing to deliver because the data show that the likelihood of persistent fails in a stock increases with its borrowing cost. Persistent fails, they note, are also more likely when a stock is illiquid. The likelihood of persistent fails in a security also increases if it has options listed because option market makers can hold short stock positions for longer than equity market makers.

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