Fails‐to‐Deliver before and after the Implementation of Rule 203 and Rule 204

Date01 November 2015
Published date01 November 2015
The Financial Review 50 (2015) 611–636
Fails-to-Deliver before and after the
Implementation of Rule 203 and Rule 204
Archana Jain
Rochester Institute of Technology
Chinmay Jain*
University of Ontario Institute of Technology
Westudy the determinants of fails-to-deliver in the period before and after the implemen-
tation of Rule 203 (elimination of option market maker exception from the locate and close-out
requirement) and Rule 204 (t+3 close-out rule) in September 2008. Wefind a positive relation
between short selling and fails-to-deliver that weakens after the implementation of these rules.
Fails-to-deliver are higher for stocks with low institutional ownership, low book-to-market,
small market capitalization, high turnover, and put option availability. The relation between
short selling and these measures of borrowing costs is also weaker after the implementation of
these rules.
Keywords: fails-to-deliver, short selling, borrowing costs
JEL Classifications: G10, G18
Correspondingauthor: Faculty of Business and IT, University of Ontario Institute of Technology,Oshawa,
Ontario, Canada L1H 7K4; Phone: (901) 652-9319; E-mail:
Wethank two anonymous referees and financial support from University of Ontario Institute of Technology
research grant.
C2015 The Eastern Finance Association 611
612 A. Jain and C. Jain/The Financial Review 50 (2015) 611–636
1. Introduction
In the U.S. equity markets, sellers are required to deliver shares on a three-day
cycle. For a trade that occurs on day t, the shares are required to be delivered on
day t+3, else the position becomes “fails-to-deliver” (FTD). FTDs usually occur
for trades where the seller does not own the stock and is short selling the stock
without borrowing or arranging to borrow to deliver the stock in time (termed as
naked short selling as per the Securities and Exchange Commission [SEC]). As per
the SEC’s release 34–58775, the SEC has been concerned about the negative effects
of FTDs as they deprive shareholders of the ownership benefits (for, e.g., voting and
lending). Issuers and investors have also shown concerns about FTDs in relation to
manipulative naked short selling, which can undermine the confidence of investors.
These investors, in turn, may be reluctant to commit capital to an issuer they believe
to be subject to manipulative conduct. The SEC implemented Rules 203 and 204,
discussed in detail in the following paragraphs, to curb naked short selling and reduce
FTDs. We aim to examine the effect of these rules on the FTDs.
There is a significant literature examining the effect of FTDs on marketliquidity,
price, and volatility.Stokes (2009) studies the litigations based on naked short selling
and the failures of naked short-selling lawsuits and finds that naked short selling
has not been proved to be linked to market manipulation. In fact, Fotak, Raman and
Yadav (2014) compare FTD trades with short sales that result in timely delivery and
find that they both lead to the same beneficial effect on liquidity and price efficiency.
They do not find evidence that FTD trades are related to subsequent price declines
or to the price decline in financial stocks during 2008. On the other hand, Lecce,
Lepone, McKenzie and Segara (2012) find that allowing naked short sales impairs
market liquidity and increases market volatility. Autore, Boulton and Braga-Alves
(2015) find that stocks reaching threshold levels of failures become significantly
overvalued and Stratmann and Welborn (2014) find that stocks with high FTDs
experience abnormal negative returns, both in present and future periods. In spite of
existence of any clear evidence of market manipulation using naked short selling, the
SEC implemented locate and close-out requirement for short selling to reduce FTDs.
Fotak, Raman and Yadav (2014) report that almost all delivery failures originate
exclusively as a result of short trades. In the presence of short-sale constraints, stocks
become overpriced (Asquith, Pathak and Ritter, 2005; Chang, Cheng and Yu, 2007).
Option of failing to deliver allows short sellers to short stocks with high short-sale
constraints. Many market participants were concerned that naked short selling can
manipulate stock prices in the downward direction (SEC’s release no. 34–58775).
Rule 203 and Rule 204 were aimed at curbing naked short selling; thus, it is interesting
to study the delivery failures after the SEC implemented these rules.
The SEC issued emergency rule to ban naked short selling for 19 financial stocks
on July 15, 2008. This rule required the short sellers to borrow the stocks before
initiating short selling in these stocks. This emergency rule expired on August 12,
2008. On September 17, 2008, the SEC approved a final rule (Rule 203) to eliminate

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