An industry working group is consulting on creating a fee to prevent the risk of transaction failures in the overnight market.
While interest rates might be rising now, the ultra-low rate environment created a risk for the overnight market. In a new consultation paper, the Government of Canada Market Functioning Steering Group proposed a new fee for failing to settle government bond and Treasury bill transactions.
The proposed new fee “is necessary to create financial incentives for timely settlement, especially in a low interest rate environment,” the paper suggested.
When rates are extremely low, or even negative, there’s essentially no cost for failing to settle transactions in the market for government securities, the paper noted.
“Participants have no financial incentive to pay more to borrow bonds than the cost of failing to deliver, as the cap compresses the bargaining space for collateral. This compression becomes more pronounced at lower levels of the overnight rate and is not conducive to establishing efficient market-clearing prices in the collateral market,” it said.
“In a negative policy rate environment, the current market structure provides no financial incentives for market participants to avoid failing,” it added.
According to the paper, the market is “not currently experiencing a major fails issue,” but the proposal to introduce a fee to discourage fails is intended to safeguard the sound functioning of the market in general.
Similar efforts in the U.S., Europe, Japan and Australia have also sought to address the risk of fails in government securities markets by creating a financial incentive to deliver, such as a fail fee or a mandatory buy-in for failed settlements.
In this case, the consultation is proposing a fee that would be set at 50 basis points, which would rise to 150 bps if the fails become persistent.
“This consultation paper seeks feedback on the fail fee component of the framework, its calibration, and governance,” it said.
While the proposed framework specifically seeks to create an incentive to avoid settlement failures when rates are low, the paper said that even in a higher-rate environment, “the framework could also improve market discipline and bring more focus on operational inefficiencies through increased monitoring of the actual fail fee, as has been the case in the U.S.”
The consultation runs until Dec. 9, and seeks feedback from players in the government securities market.