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Synthetic prime brokerage and the risk of tax recharacterisation: Difference between revisions

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Synthetic prime brokerage and the risk of tax recharacterisation (view source)

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{{a|spb|[[File:Dramatic Look Gopher.gif|thumb|center|450px|DID SOMEONE SAY [[recharacterisation|RECHARACTERISATION]]??]]}}Controversial view, perhaps, but the tax disposition which led to someone inventing the “[[hypothetical broker dealer]]” — a creature as beloved of the [[equity swap]] market as the [[reasonable man]] is of the [[common law]] — is, in [[this commentator]]’s view, predicated on a fundamental misapprehension as to how a [[synthetic equity swap]], and the [[hedging]] and financing behind it, works.
===Why there is no real risk of a [[synthetic equity]] position being a secret custody position doing the tax man out of his money===


Controversial view, perhaps, but the tax disposition which led to someone inventing the [[hypothetical broker dealer]] — a creature as beloved of the [[equity swap]] market as the [[reasonable man]] is of the [[common law]] — is, in this commentator’s untutored view, predicated on a fundamental misapprehension as to how a [[synthetic equity swap]], and the [[hedging]] and financing thereof, works. This fear of [[recharacterisation]] also disregards the [[IRS]]’s known acknowledgment that [[synthetic equity swap]]s are a thing; a bona fide class of transactions of genuine utility and wide use in the market.  
This fear of “[[recharacterisation]]” — obligatory nod to our [[dramatic look gopher]] — also disregards the [[IRS]]’s known acknowledgment that [[synthetic equity swap]]s are a thing; a bona fide class of transactions of genuine utility and wide use in the market.  
====So what is the problem?====
===So what is the problem?===
The putative concern is that, should there be too close a connection between an equity swap and the means by which the swap [[dealer]] hedges it, thew dealer could be judged to be “acting as nominee owner” of the hedge for its client — a sort of undisclosed [[custodian]] — meaning the client becomes liable to that universe of stamp taxes and withholdings that apply to actual transactions in equity securities, but do not apply to swaps.
The putative concern is that, should there be too close a connection between an equity swap and the means by which the swap [[dealer]] hedges it, thew dealer could be judged to be “acting as nominee owner” of the hedge for its client — a sort of undisclosed [[custodian]] — meaning the client becomes liable to that universe of stamp taxes and withholdings that apply to actual transactions in equity securities, but do not apply to swaps.


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Thus:
Thus:
==== There is no delta-one hedge at the ''client'' level, even economically ====
====There is no delta-one hedge at the ''client'' level, even economically ====
The [[dealer]]’s existing hedge inventory is (a) constantly churning, (b) does not translate 1:1 with each individual long client position.  At any time, the [[dealer]]’s long exposure to a given cash security will equal its net long exposure across ''all'' clients, long and short, in the [[dealer]]’s whole book. The [[dealer]]’s  total holding is a function of its total client portfolio shape, not that of any individual client.  
The [[dealer]]’s existing hedge inventory is (a) constantly churning, (b) does not translate 1:1 with each individual long client position.  At any time, the [[dealer]]’s long exposure to a given cash security will equal its net long exposure across ''all'' clients, long and short, in the [[dealer]]’s whole book. The [[dealer]]’s  total holding is a function of its total client portfolio shape, not that of any individual client.  


Therefore, if the book is 500 long and 300 short, the [[dealer]] will hold just 200 positions. If the 500 long clients want the [[dealer]] to vote their shares they’re — out of luck..  
Therefore, if the book is 500 long and 300 short, the [[dealer]] will hold just 200 positions. If the 500 long clients want the [[dealer]] to vote their shares they’re — ''out of luck''.


Nor does the [[dealer]] hold continuous positions in shares for the life of any transaction: It buys and sells every day to reflect changes in its net aggregate exposure caused by all client activity. It churns. Therefore:
Nor does the [[dealer]] hold continuous positions in shares for the life of any transaction: It buys and sells every day to reflect changes in its net aggregate exposure caused by all client activity. It churns. Therefore:
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*All swap clients are at risk of hedging disruption ''every day'' whether or not any particular one has adjust its own position.  
*All swap clients are at risk of hedging disruption ''every day'' whether or not any particular one has adjust its own position.  


====The [[dealer]] lends out its aggregate long position by [[title transfer]] and usually doesn’t have a physical hedge at all====
===Financing===
====The [[dealer]] lends out its aggregate long position (mostly) by [[title transfer]]====
And then we consider the financing operation of the [[dealer]]’s swap book into account. the [[dealer]] generally lend most, if not all, of the [[dealer]]’s net aggregate long position out into the market every day. It does this by [[title transfer]]. Where it can, it will lend the ''whole'' book out. It doesn’t, generally, hold any more physical securities hedges, as legal owner, at all.  
And then we consider the financing operation of the [[dealer]]’s swap book into account. the [[dealer]] generally lend most, if not all, of the [[dealer]]’s net aggregate long position out into the market every day. It does this by [[title transfer]]. Where it can, it will lend the ''whole'' book out. It doesn’t, generally, hold any more physical securities hedges, as legal owner, at all.  
                                                                                                                                                                                                                                                          
                                                                                                                                                                                                                                                          
None of these things are consistent with a physical, enduring holding that could resemble a nominee ownership. It is clearly, categorically, an economic exposure only. The point is it is not that the [[dealer]] isn’t a nominee owner for a given client according to the legal theory, but that it isn’t a nominee, or any kind of owner, ''at all''. Generally speaking the [[dealer]] won’t hold shares at all. the [[dealer]]’ll hold economic exposures to shares. Even where the [[dealer]] do there is no 1:1 mapping between hedge position and share position.
None of these things are consistent with a physical, enduring holding that could resemble a “nominee ownership”. It is clearly, categorically, a purely ''economic'' [[exposure]]. The point is it is not that the [[dealer]] isn’t a nominee owner for a given client according to the legal theory, but that it isn’t a nominee, or ''any'' kind of owner, ''at all''. This would also be the case under a US law [[MSLA]], even though the collateral is pledged, as generally the Lender has a right of rehypothecation.


3. The IRS position on the product generally
====But what about the [[pledge GMSLA]]?====
I am pretty sure the IRS understands this and is comfortable with it. This is why it introduced 871(m).
It is true that the [[agent lending]] world — an enthusiastic part of the synthetic equity financing business — has recently moved towards collateralising [[stock loan]]s by way of [[pledge]], not [[title transfer]], and with no right of [[reuse]]. To the exent you lend out your hedge book by pledge, the clever argument above is somewhat diluted as the nexus between {{eqderivprov|Hedging Party}} and physical hedge is not quite so conclusively broken. But, really not much. The pledge initiative is entirely due to changes to how [[LRD]] is charged these book financing arrangements<ref>Because these are [[collateral upgrade]] trades, the [[broker]]s tend borrow ''high'' credit-quality assets ([[treasuries]]) and collateralise them with ''lower'' credit-quality assets ([[equities]], right?) and as such there tends to be a handsome [[haircut]] on the collateral, meaning the brokers are significantly ''over-collateralising'' the lenders. If collateral is posted by [[title transfer]], as it would be under a regular {{gmlsa}}, counter-intuitively, the lender is net borrowing from the borrower and, across a portfolio of lenders, in ''big'' size. Thus the borrower generates a huge net credit risk exposure to the lenders for which it gets punitive LRD charges.  By converting its collateral arrangement into a [[pledge]] (with no right of [[reuse]]) it eliminates that credit exposure, and avoids the [[LRD]] charge. We don’t think this changes the force of the argument: the [[broker-dealer]] will commingle its swap hedges with rehypothecated client custody long assets, and there is no guarantee all or any are lent out on pledge, and certainly no commitment made in the swap confirmation.</ref>, and has nothing at all to do with the swap counterparty’s wish to maintain beneficial or legal ownership of the shares.
- High delta equity derivatives are a very big, liquid, and standardised product; the IRS understands it, accepts it, and has already taken direct measures to ensure they are taxed appropriately (ie 871(m)).
 
- The IRS’s goal is to stop brokers disguising effective nominee ownership arrangements, not to stop brokers paying exact delta one value of securities through genuine swap contracts.  
===The IRS position on the product generally===
o If it were to stop genuine swaps, then the “hypothetical broker dealer” language wouldn’t work anyway; the [[dealer]] would actually have to adjust the delta away from 1 by a meaningful amount.  
As far as we know the [[IRS]] labours under no illusions about the synthetic equity swap product, understands it and is comfortable with how it trades. This is why it introduced [[871(m)]]. “High delta” equity derivatives are a widely traded, liquid, and standardised product; the [[IRS]] understands it, accepts it, and has already taken direct measures to ensure they are taxed appropriately (ie 871(m)). The [[IRS]]’s goal is to stop [[dealer]]s disguising nominee ownership arrangements, not to stop them paying the [[delta one]] value of securities to clients under genuine swap contracts. If that were their aim, the “[[hypothetical broker dealer]]” language wouldn’t work anyway; the [[dealer]] would have to adjust the [[delta]] ''away'' from 1 by a meaningful amount. In turn, that would significantly transform the product:  the point of the synthetic equity swaps is to exactly replicate the performance of a stock through derivatives. It is hard to see the IRS’s interest in targeting legal “[[verbiage]]” to see if they catch [[dealer]]s out by extracting tax from those who have forgotten to use the word “hypothetical” here or there in a master confirm. If that were a genuine risk, the [[dealer]] should not be doing this business at all.
o That would significantly transform the product:  the very point of the synthetic equity product is to exactly replicate the performance of a stock through derivatives.
{{ref}}
- I can’t see what interest the IRS would have in, or to gain by, targeting legal “verbiage” of contracts to see if they catch brokers out by extracting an even more favourable tax treatment because one or other has forgotten to use the word “hypothetical” here or there. If that were a real risk, it would be far too high and the [[dealer]] should not be doing this business at all.
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