What Is Failure to Deliver (FTD) in Trading? Key Facts and Impacts

What Is Failure To Deliver (FTD)?

Failure to deliver (FTD) occurs when one party in a trading contract, like shares or futures, or forward contracts, fails to meet their obligation. These failures happen when a buyer, with a long position, lacks the funds to pay at settlement or when a seller, with a short position, lacks the underlying assets needed for delivery. Technical issues with the settlement process can be another cause.

One of the impacts of FTDs can be the creation of phantom shares, which dilute the price of the underlying assets.

How Failure to Deliver Affects Trading

In a trade, both parties must transfer cash or assets before the settlement date. If not settled, one party has failed to deliver. Technical issues during the clearinghouse settlement process can also cause delivery failures.

Failure to deliver is critical when discussing naked short selling. When naked short selling occurs, an individual agrees to sell a stock that neither they nor their associated broker possess, and the individual has no way to substantiate their access to such shares. The average individual is incapable of doing this kind of trade. However, an individual working as a proprietary trader for a trading firm and risking their own capital may be able. Though it would be considered illegal to do so, some such individuals or institutions may believe the company they short will go out of business, and thus in a naked short sale they may be able to make a profit with no accountability.

Subsequently, the pending failure to deliver creates what are called "phantom shares" in the marketplace, which may dilute the price of the underlying stock. In other words, the buyer on the other side of such trades may own shares, on paper, which do not actually exist.

The Ripple Effects of Failure to Deliver

Several potential problems occur when trades don't settle appropriately due to failure to deliver. Both equity and derivative markets can have a failure to deliver occurrence.

With forward contracts, a party with a short position's failure to deliver can cause significant problems for the party with the long position. This difficulty happens because these contracts often involve substantial volumes of assets that are pertinent to the long position's business operations.

In business, a seller may pre-sell an item that they do not yet have in their possession. Often this will be due to a delayed shipment from the supplier. When it comes time for the seller to deliver to the buyer, they can't fulfill the order because the supplier was late. The buyer may cancel the order leaving the seller with a lost sale, useless inventory, and the need to deal with the tardy supplier. Meanwhile, the buyer will not have what they need. Remedies include the seller going into the market to buy the desired goods at what may be higher prices.

The same scenario applies to financial and commodity instruments. Failure to deliver in one part of the chain can impact participants much further down that chain.

During the financial crisis of 2008, failures to deliver increased. Much the same as check kiting, where someone writes a check but has not yet secured the funds to cover it, sellers did not surrender securities sold on time. They delayed the process to buy securities at a lower price for delivery.