May 1 (Bloomberg) -- Rates in the $7 trillion-a-day market to borrow and lend government debt dipped below zero as a 3 percentage point penalty for failing to meet delivery obligations went into effect for the first time.

The old five-year note, the 1.75 percent security maturing in March 2014, traded today at the lowest repurchase, or repo, rate, dipping as low as negative 1 percentage point. The rate closed at negative 0.05 percent, according to GovPX Inc., a unit of ICAP Plc, the world’s largest inter-dealer broker.

A negative repo rate means that investors who lend cash in exchange for obtaining Treasuries as collateral actually pay interest instead of receiving it on the money they loan.

“Repo rates went negative because we have the new fails fees,” said Joseph Abate, a money-market strategist in New York at Barclays Capital Inc., one of the 16 primary dealers that trade directly with the Federal Reserve. “In order to get people to deliver the security, the fails charge is meant to encourage negative repo-rate trading.”

The Treasury Market Practices Group, which the New York Federal Reserve Bank helped establish in 2007, began implementing the penalty today. The measure’s intent is to reduce uncompleted trades. It adds an incremental cost of $833.33 per day on a delivery failure of $10 million worth of bonds, according to data compiled by Bloomberg.

Delivery Failure

In a repurchase agreement, one party provides securities as collateral to another in exchange for cash; in a reverse repurchase agreement, the opposite takes place. When a security is not delivered as promised, the uncompleted trade is called a fail.

The so-called general-collateral repo rate opened today on the bid side of the market, the price quoted for immediate sale, at 0.35 percent, according to GovPX. The federal funds rate opened at 0.21875 percent. The Fed’s official target rate for overnight loans between banks has been at a range of zero to 0.25 percent since December.

Securities that can be borrowed in the repo market at interest rates close to the Fed’s target rate are called general collateral. Notes and bonds that are in the highest demand, such as the previously issued five-year note today, are called “special” by traders because rates on loans secured by these securities are lower than the general collateral rate.

More Attractive

The cost of incurring a negative repo rate to get securities needed to meet delivery obligations is more attractive than paying the 3 percentage point failure penalty, according to Scott Skyrm, head of repo trading at NewEdge USA LLC in New York.

With interest rates close to zero, there was little incentive to make good on delivery commitments because the main cost for failing to deliver a borrowed security was the loss of interest that would have been received on the money lent to obtain it.

The threat of the penalty caused repo rates to drop below zero on several Treasuries in addition to the old five-year note, Skyrm said. The old five-year note’s overnight repo rate averaged about negative 33 basis points today, or 0.33 percentage point, according to NewEdge.

“There has never been a formalized negative repo rate market in the U.S. before now,” said Skyrm. “We’ve had negative repo rates before only in one-off, extreme circumstances. The fails charge can be viewed as moving the effective trading range of the repo market 300 basis points lower.”

Record Failures

The penalty rate is equal to either 3 percent minus the base of the target zone for the Fed’s benchmark rate, or zero, whichever is greater.

The Treasury Market Practices Group first recommended the penalty last year, among other trading-practice guidelines, after a record $5.3 trillion in trades failed in the week ended Oct. 22 amid interest rates near all-time lows and surging demand for the safety of Treasuries. Trading failures declined to $64.776 billion in the week ended April 22.

The New York Fed, which has adopted the new trading practice in its own market operations, welcomed the implementation of the penalty, according to a statement posted on its Web site today. The penalty will work as a “targeted solution to the settlement-fails problem,” William Dudley, the bank’s president, said in the statement.

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net;

Last Updated: May 1, 2009 14:47 EDT