April 13, 2018 / 8:47 PM / a year ago

U.S. bond trade group tweaks penalty for 'fails' as interest rates rise

NEW YORK (Reuters) - A U.S. bond industry group that advises the New York Federal Reserve is set to impose a permanent penalty for busted trades in the U.S. Treasury and mortgage bond markets to ensure “operational continuity” of existing practices.

The Treasury Market Practice Group, a panel of Wall Street dealers and investment houses, this week backed a minimum 1.0 percent “fails charge” for not delivering the Treasury, agency and MBS securities pledged in a trade.

The penalty serves as a disincentive for dealers or investors to horde these safe-haven securities during periods of market stress, which can impede the smooth operation of important money markets like the $4 trillion repurchase agreement (repo) sector, as happened during the 2007-2009 financial crisis.

“It’s something to ensure a smooth functioning of the repo market,” said Gennadiy Goldberg, an interest rate strategist at TD Securities in New York. “It prevents a scenario that would be cost-free to fail.”

The existing penalty, in place since May 2009, is derived from a formula tied to the Federal Reserve’s benchmark overnight lending rate, but it had no floor rate and as a result the penalty has shrunk substantially since December 2015 when the Fed started raising its policy interest rates.

When the bottom end of the range for the fed funds rate was zero, as it was for the seven years after the Fed cut rates in the financial crisis, the penalty amounted to 2.0 percent for failed agency and MBS trades and 3.0 percent for failed Treasury trades.

But the Fed has now raised its fed funds rate six times and the lower end of the federal funds range is 1.50 percent, so the charge on a defunct agency or MBS trade is just 0.50 percent and is 1.50 percent on a failed Treasury trade.

With the Fed expected to raise rates at least twice more this year, and another three or more in 2019, the penalties would effectively dissolve. That would raise the risk that dealers or investors could horde bonds, which are prized as collateral in money markets, with no risk of being penalized for doing so.

Some analysts questioned the effectiveness of the penalty to curb failed trades, while other argued its absence would have resulted in fails to be even higher.

Fails “would be even higher without it,” said Mark Cabana, head of short rates strategy at Bank of America Merrill Lynch in New York. He called the 1.0-percent floor, which will take effect on July 1, “quite reasonable.”

The level of fails has been on the rise in the last year or so compared with the first several years after the financial crisis receded in 2009. Over the last year it has averaged about $145 billion per week, more than twice the level in 2014, New York Fed data shows.

But the current level of fails is still a fraction of the huge spike seen at the peak of the financial crisis in the fall of 2008, when the volume of failed trades reached nearly $2.7 trillion.

(GRAPHIC: Failed U.S. Treasury Trades - reut.rs/2GVsSaU)

Reporting by Richard Leong; Editing by Dan Burns

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