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

• Date: 01 November 2015
• Published date: 01 November 2015
• DOI: http://doi.org/10.1111/fire.12093

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

Abstract

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: chinmay.jain@uoit.ca.

Wethank two anonymous referees and financial support from University of Ontario Institute of Technology

research grant.

C2015 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