Close-Out Requirements and Fails-to-Deliver: A Trader's Guide

The Close-Out Requirement: The Final Backstop

Rule 204 of Regulation SHO requires broker-dealers to close out any failure to deliver positions in a timely manner. A failure to deliver occurs when a seller does not deliver the securities to the buyer on the settlement date. While there can be legitimate reasons for a failure to deliver, such as administrative errors, persistent fails can be a sign of naked short selling.

The Mechanics of the Close-Out Requirement

The close-out requirement is a important component of Regulation SHO, as it provides a backstop to prevent the indefinite rolling of fails-to-deliver. The rule specifies different close-out timeframes depending on the reason for the fail:

• Short Sale Fails: A failure to deliver resulting from a short sale must be closed out by the beginning of regular trading hours on the settlement day following the settlement date (T+2).
• Long Sale Fails and Bona Fide Market Making Fails: A failure to deliver resulting from a long sale or bona fide market making activities must be closed out by the beginning of regular trading hours on the third consecutive settlement day following the settlement date (T+4).

If a broker-dealer fails to close out a fail-to-deliver position within the required timeframe, they are subject to a 'pre-borrow' requirement. This means that they cannot effect any further short sales in that security without first borrowing or arranging to borrow the shares.

The Impact on Trading Strategies

The close-out requirement can have a significant impact on trading strategies, particularly for those that involve shorting hard-to-borrow securities. The potential for a forced buy-in can create a significant risk for short sellers, as they may be forced to cover their positions at an unfavorable price.

On the other hand, the close-out requirement can also create opportunities for long-biased traders. The prospect of a forced buy-in can create upward pressure on the price of a security, especially if there is a large and persistent fail-to-deliver position.

Monitoring Fails-to-Deliver Data

The SEC publishes monthly fails-to-deliver data that can be used to track the number of delivery failures in a particular security over time. This data can be a valuable tool for traders who are looking to identify potential trading opportunities or to manage the risks associated with their short positions. When analyzing fails-to-deliver data, it is important to look for:

• Persistent Fails: A security with a large and persistent fail-to-deliver position is more likely to be subject to a forced buy-in.
• Spikes in Fails: A sudden spike in fails-to-deliver can be a sign that a security is becoming more difficult to borrow, which could be a precursor to a short squeeze.