Stock Borrowing and Settlement Fails

A fundamental feature of modern capital markets is that participants regularly sell securities they do not currently own. A market maker sells a bond to a client before buying it from another source. A hedge fund shorts a stock it expects to fall in price. A dealer sells government bonds on behalf of a central bank. In each case, the seller needs to deliver the security on the settlement date — but does not yet possess it. The securities lending and repo markets exist to solve this problem.

Securities are borrowed for three primary reasons:

Short selling. To sell a security short, a firm must borrow it first. The borrower receives the securities, delivers them to the buyer, and later purchases the securities in the market to return them to the lender. If the price has fallen in the interim, the short seller profits from the difference. Stock borrowing is the legal and operational mechanism that makes short selling possible.

Market making. Market makers continuously quote bid and offer prices and may sell securities to clients before they have sourced those securities from the market. A bond market maker who sells a benchmark government bond to a client and then needs time to source it in the secondary market will borrow the bond to cover the settlement obligation in the meantime.

Covering settlement fails. When a firm has a settlement fail — a trade that is due to settle but the securities are not in the account — it can borrow the securities to cover the delivery obligation and avoid the fail continuing to accumulate CSDR penalty charges. This is known as a "borrow to cover."

There are two main mechanisms for borrowing securities: repurchase agreements (repos) and securities lending transactions. Though they serve similar economic purposes, they differ in legal structure and operational treatment.

Repo (repurchase agreement). In a repo, the seller of securities agrees to repurchase them at a specified future date and price. Economically, this is a collateralised loan of cash: the party that needs cash sells securities and agrees to buy them back at a slightly higher price (the difference representing the repo rate). The party lending cash receives the securities as collateral. From the cash borrower's perspective, it is a repo; from the cash lender's perspective, it is a reverse repo.

Repos are documented under GMRA (Global Master Repurchase Agreement) — the standard legal agreement for repo transactions. Under repo, legal title to the securities transfers to the cash provider during the term. This is an important distinction for regulatory capital and accounting treatment.

Securities lending. In a securities lending transaction, the lender transfers securities to the borrower in exchange for collateral (either cash or other securities). The borrower pays a fee — the securities lending fee — to the lender for the use of the securities. The lender retains the economic benefits of ownership (e.g., any dividends or coupon payments are "manufactured" back to the lender), but legal title passes to the borrower for the term of the loan. Securities lending is documented under GMSLA (Global Master Securities Lending Agreement).

The key practical differences:

• Repo is primarily a funding instrument (cash vs securities); securities lending is primarily a securities availability instrument
• Repo rates are typically quoted as interest rates; securities lending fees are quoted in basis points per annum of the market value of the lent securities
• Cash collateral in securities lending is typically reinvested by the lender, generating additional return
• Securities lending is most common in equities; repo dominates in government bonds

A settlement fail occurs when a trade is not settled on its contractual settlement date. In liquid markets, settlement fails are usually resolved within one to two days. But in some circumstances — particularly when a security is in short supply across the market — a fail can trigger a cascade.

Consider a simplified example. Firm A sells shares to Firm B. Firm A is itself waiting to receive those shares from Firm C (which it bought earlier). Firm C in turn is waiting to receive the shares from Firm D. This is a settlement chain: each party's delivery depends on receiving securities from the party above it in the chain. If Firm D fails to deliver to Firm C, then Firm C fails to deliver to Firm A, which fails to deliver to Firm B. A single fail at the top of the chain propagates all the way through it.

Settlement chains are particularly common in government bond markets during periods of scarcity — for example, when a specific bond is on special in the repo market (meaning it is in high demand and available to borrow only at very low or even negative rates). In extreme cases, the same security can fail to settle repeatedly over many days, with the same securities cycling through multiple failed deliveries.

High levels of settlement fails signal stress in the securities lending market and are monitored by regulators as a systemic risk indicator. Persistently high fails in a specific security may indicate a short squeeze — a situation where short sellers are struggling to borrow the security to cover their positions.

The EU's Central Securities Depositories Regulation (CSDR) introduced a mandatory buy-in regime and a cash penalty system for settlement fails in EEA securities. The cash penalty mechanism has been fully operational since February 2022.

Cash penalties. For each day that a settlement fail persists beyond the intended settlement date, the failing party is charged a penalty by the CSD (Euroclear, Clearstream, or another CSD). The penalty rate depends on the instrument type:

• Liquid equities: 1.0 basis point per day of the market value
• Illiquid equities: 0.5 basis points per day
• Sovereign bonds: 0.1 basis points per day
• Corporate bonds: 0.2 basis points per day

Penalties are automatically calculated by the CSD and passed to the non-failing counterparty as compensation. They are reported monthly.

Mandatory buy-in. The mandatory buy-in provisions of CSDR — which would have required the non-failing party to compulsorily purchase the securities in the market at the failing party's expense after a defined extension period — were suspended by European regulators before implementation following significant industry pushback. The concern was that mandatory buy-ins would reduce market liquidity, increase volatility, and create perverse incentives for market participants. The regime remains under review, with a more targeted approach expected.

Central banks and regulators monitor settlement fail rates as indicators of market stress. A sudden spike in fails in a particular instrument or market segment can signal:

• A shortage of a specific security in the lending market (potential short squeeze)
• Operational problems at a major market participant
• A system outage at a CSD or custodian
• Market stress — during the March 2020 COVID volatility, settlement fail rates spiked significantly as participants struggled to manage simultaneous large positions across multiple markets

The Federal Reserve Bank of New York publishes weekly data on settlement fails in US Treasury markets. The ECB monitors fail rates in European securities. These public datasets allow analysts and regulators to identify emerging stress before it becomes systemic.