The post-trade part of bond trading may not excite everyone’s imagination, but it’s where an important and perhaps unappreciated practice provides substantial economic benefits to market participants.
Many may not be aware, and perhaps it seems counter-intuitive, but securities transactions do not always settle on the agreed date. And generally, when they don’t, it is not regarded as grounds for a non-failing party to simply tear up and cancel the trade. Unlike in other markets, for example sales of goods, in the securities markets it has long been market practice generally that “a deal is a deal” notwithstanding a settlement failure, and the buyer and seller under most regulatory frameworks normally mark to market their positions on the date the trade was agreed - whether or not the trade later settles on time.
So what do you do about a seller’s failure to deliver the bonds on time?
It works a bit differently than when your Amazon order doesn’t turn up.ICMA’s Secondary Market Rules and Recommendations (“ICMA Rules”) provide a very useful framework to resolve bond settlement failures quickly and avoid potentially costly litigation, arbitration or other forms of dispute resolution that also can consume substantial management time. ICMA Rules, and specifically what market participants refer as the “Buy-in rules,” are frequently used by counterparties to resolve unsettled bond trades. How does it work? Suppose a seller of bonds on Monday agrees to sell ABC bonds at 99 for settlement Wednesday but fails to deliver on time. Under ICMA Rules, where both parties to the trade are members, the buyer can issue a “buy in notice” to the seller and then buy bonds of the same description elsewhere in the market and use these other bonds to “cover” its missing delivery.
But what if the price in the market is higher than 99? If the market price at the time of the buy in price is, say, 100, then under ICMA Rules the seller pays the difference to the buyer. However, if on the other hand the price has dropped to 98, the buyer would pay the difference to the seller. Why? Because the Rules are designed to place the parties into the same economic position they would have been in had the trade settled as originally agreed. In the second example, where the price has fallen, if the buyer did not pay this difference back to the seller, the buyer would be unjustly enriched. The Rules have this symmetry in order to reflect the “no fault” treatment by the market for settlement failures as well as to ensure fair and equal treatment of the parties. It is also necessary to reflect correct position valuation and accounting in accordance with best practice and regulatory capital requirements.