In the US, a fail penalty is applied on the failure to deliver securities in a US Treasury or Agency transaction. This applies to any trade in these securities , including a simple cash trade , or the opening leg of a repo, or the closing leg of a repo.
The intent of the system , first introduced in 2012, was to clean up fails in the Marketplace by providing an incentive to settle. The convention in the marketplace is that if there is a settlement failure, then further daily attempts to settle are made until the trade clears. When this happens , the cash amount instructed doesn’t change over time. Therefore, a counterparty that fails to deliver securities is effectively making a decision to lend money at zero interest. But in the absence of a fails penalty, this may be logical if interest rates are close to zero and/or the securities are scarce.
In addition, In the absence of a fails penalty, repo cannot trade below zero. Why? There’s no point in lending money via repo at a negative rate in order to borrow securities that you have sold short. It is better economically just to fail on the cash trade.