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Effect of Regulatory Reform on Trade Settlement Failures in US Equity Markets

Analyzing the economic inefficiencies of settlement failures in US equity markets, examining causes, effects, and regulatory influence on market efficiency.

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Effect of Regulatory Reform on Trade Settlement Failures in US Equity Markets

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  1. Effect of Regulatory Reform on Trade Settlement Failures in US Equity Markets Muath Asmar, An-Najah National University Susanne Trimbath, Cochise College

  2. A note on terminology… • Settlement Failure: Fail to Deliver and/or Fail to Receive • Naked Short Sell: could, but did not always, result in a settlement failure • DTC was Lender of Last Resort before 2014 • Any Fail to Deliver covered by Stock Borrow Program did not result in a Fail to Receive • Fails in study are only those reported by NSCC

  3. Summary: Economic Inefficiency When securities transactions fail to settle (due to failure to deliver): • Supply exceeds issued & outstanding while one share entitlement is sold multiple times • No incentive to reduce transaction costs (not required to complete transaction) • Temporal distortion of profit incentive (buyer pays today’s price while seller pays later)

  4. Summary: concept Settlement Failures: • Artificially inflate supply of shares • Impair access to capital and shareholder rights • Create uncompensated risk • Increase opportunity costs • Tax consequences not discussed

  5. Summary: results • FTDs increased (efficiency decreased): with changes in operations. • FTDs decreased (efficiency increased): with regulatory changes. • Market Returns increased: slightly more with regulatory changes, especially with Reg SHO “short sale-related circuit breaker.”

  6. Limited Existing Literature FTDs are OK: • Investment Strategy • Temporary, based on interest rates and borrowing fees • “Virtually” all trades settle on time • ETFs: Complexity requires more time to settle

  7. Limited Existing Literature FTDs are NOT-OK: • Time is money – opportunity cost • Time is risk – uncompensated • Suppressed asset value reduces issuer’s access to capital • Compromised corporate governance

  8. Susanne Trimbath Settlement Failure Research: • Lessons Not Learned (2015), • Systemic Failures in US Capital Markets (2015), • FTDs in US Treasury Markets (2010), • No Accounting for Corporate Governance (2009), • FTDs in Bond Markets (2009) , • FTDs in Equity Markets (2007)

  9. Muath Asmar Market Microstructure research: • Market Microstructure & The Black-Box (2011), • Market Microstructure & Liquidity (2012), • Market Microstructure & Investor Behavior (2010)

  10. Limited Existing Literature Here, impact on capital market microstructures: • Harmonizing rules • Standardizing protocols • Liberalizing service provision • Regulatory schemes • Internal governance

  11. Data Post-trade microstructure rule-changes • 109 Rule Changes, 13 years • Operational: comparison and settlement processes, fees/fines, changes to procedures/services • Regulatory: settlement timing, membership requirements, risk mitigation

  12. Data • FTDs == proxy for trade settlement inefficiencies • 58,392 unique securities (by CUSIP identification) • 3,337 settlement days • Decline in maximum equity fails (at NSCC) since 2012, but mean remains steady

  13. Average Daily Max per year

  14. Daily Average per Security per year

  15. Daily Average per Security per year

  16. VAR Model Qft Quantity of fails Rmt Market returns c Constant term Ɛt Error term

  17. Extended VAR(4) Qft Quantity of fails Rmt Market returns dk Dummy variable for rule changes δk(Li) Lag operator

  18. Results (p ≤ 0.01)

  19. Reg SHO Results

  20. Comments Welcome! • Please do not cite or quote: Relatively early stage – second public discussion/sharing • Suggestions for additional literature search terms? E.g., “naked short sale” versus “fail to deliver”; are there alternative terms for “microstructure”?

  21. Effect of Regulatory Reform on Trade Settlement Failures in US Equity MarketsSusanne Trimbath, Cochise Collegetrimbaths@cochise.edu

  22. TRIMBATH, SUSANNE Naked, Short and Greedy: the Failure to Deliver (forthcoming), Spiramus Press, Ltd., London. Lessons Not Learned: 10 Steps to Financial Stability (2015), Spiramus Press, Ltd., London. The Savings and Loan Crisis: Lessons from a Regulatory Failure (2004), (eds., with J. Barth and G. Yago), The Milken Institute Series on Financial Innovation and Economic Growth, Kluwer Academic Press, Boston. Beyond Junk Bonds: Expanding High Yield Markets (2003), with G. Yago, Oxford University Press, New York. Chinese edition 2013. Mergers and Efficiency: Changes Across Time (2002), Kluwer Academic Press (Springer), Boston. Previewed in Case Folio, September 2002, p. 63-68. Featured at Research Roundtable on Mergers and Efficiency, Federal Trade Commission (with Department of Justice), Washington, D.C., December 2002.

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