Kauffman: Settlement Fails Pose Risk
March 01, 2011
A growing number of securities transactions that fail to settle could pose a risk to the financial system, and regulators ought to police the issue by imposing stiff fines on parties that don’t meet their obligations, according to a new report by the Kauffman Foundation.
The study specifically pointed to failed transactions involving mortgage-backed securities and exchange-traded funds, saying an uptrend in both was troublesome. The study said MBS fails averaged $115 billion per day in 2010, an increase of more than tenfold since 2008. For their part, ETFs now make up about a third of all U.S. equity trades.
The new study marks the second time in about four months that Kansas City, Mo.-based Kauffman has weighed in on what it sees as systemic risks posed by ETFs. In November, it published a study arguing, among other points, that ETFs may have been one of the main factors behind the “flash crash” last year, and that, without market reforms, market instability and another flash crash were almost inevitable.
“Settlement failures are a canary in the coal mine of the financial markets,” Harold Bradley, Kauffman’s chief investment officer and one of the study’s authors, said in a press release. “If we write a check without money in the bank, we end up in jail. When securities transactions don’t settle, the same thing happens on a larger scale. Too many settlement fails can put the financial system on edge.”
The new report, titled “Canaries in the Coal Mine: How the Rise in Settlement ‘Fails’ Creates Systemic Risk for Financial Firms and Investors,” argues that every fail introduces a cumulative and potentially compounding liquidity risk into the orderly process of settling the $7.5 trillion of security transactions completed each day. In a blog on March 1, IndexUniverse Director of Research analyzed Kauffman's warning, concluding that the foundation doesn't seem to be accounting for how ETF settlement fails are measured.
It also says that the failures are at least partly attributable to a gaming of the system by traders who use delays to generate additional profit.
Basis Point Group, a financial markets research firm that contributed to the report, estimates that settlement failures and other accounting recognition delays impose hidden costs to asset owners, of about 27 basis points every day—or about $300 billion in assets that cannot be reinvested.
At that level, and assuming a conservative annual interest rate of 3 percent, settlement failures cost underfunded pension funds and other institutional investors at least $9 billion a year in lost earnings.
“Failures now are at a level that presents significant systemic risk to all investors in the event of another market shock,” Robert Fawls, a partner at Basis Point, said in the press release. “Though the Fed has the detailed fails data for each primary dealer, we could find no indication that it is using available tools to mitigate this risk to U.S. capital markets.”
The study was written by Bradley, Kauffman’s chief investment officer, as well as Robert Litan, Kauffman’s vice president of research and policy. The co-authors at Basis Point were Fawls and Fred Sommers.
The Ewing Marion Kauffman Foundation is a private nonpartisan organization that says it works to harness the power of entrepreneurship and innovation to grow economies and improve human welfare. Basis Point Group is based in Massachusetts.
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