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In some jurisdictions, derivatives are taxed differently to equities (as regards [[stamp duty reserve tax]] for example, and in the US, under [[871(m)]]) so it is important that your synthetic position doesn’t look like a play to avoid tax. [[Tax attorney|Tax attorneys]] — especially American ones — will fret mightily if it does. One of the key indicators here will be the degree to which the contract permits you to influence or control your [[prime broker]]’s hedge. A derivative counterparty should care not one whit about its broker’s hedge — other than its cost. If it does takes an unhealthy interest, the [[fear]] will be that the swap position is [[recharacterised|really no more than]] a disguised custody arrangement of shares that you have actually bought, and on which you should have paid tax, [[stamp duty]] and so on. Depending on which tax specialist you ask, this might extend even to your interest in the [[PB]]’s the hedge execution price. Thus, you will see much chatter about the termination price being the one a “[[hypothetical broker-dealer]]” might achieve selling [[fungible]] securities, and [[volume-weighted average price]]s and so on.
In some jurisdictions, derivatives are taxed differently — more favourably — than [[Cash equity|cash equities]] (for example [[stamp duty reserve tax]], and in the US, for certain types of underlier, under [[871(m)]]) so it is important that your synthetic position doesn’t look like a tax play. [[Tax attorney|Tax attorneys]] — especially American ones — fret mightily that high-delta [[equity derivatives]] do.


So who, why, which or what is this '''[[hypothetical broker-dealer]]'''? Well, he’s a fellow just like the ''actual'' [[broker-dealer]] — in the same jurisdiction, having the same taxation status, earning the same income, executing the same hedge transactions, eating at the same restaurants, having the same GSOH and watching the same stuff on Netflix — but ''not'' the actual [[broker-dealer]]. He’s like actual [[broker-dealer]]’s “sober me”, only ''he gets drunk too''. Now this might strike you, as it strikes the [[JC]], as just too cute – too much of a playground argument to hold water. (“I didn’t break the window, sir, honest, sir, it was a boy who looked exactly like me who arrived from out of nowhere and is gone now”). But [[US tax attorney]]s seem to be taken in by it even, if they won’t buy arguments on actual economic substance.
One of the key indicators, they intuit, is the degree to which the contract permits a swap counterparty influence or control its [[prime broker]]’s hedge. A swap counterparty should care not one whit about its broker’s hedge — other than its [[cost]]. If it does takes an unhealthy interest, the swap position may be — dramatic look gopher — [[recharacterised]] as a ''disguised [[custody]] arrangement'' of shares the swap counterparty has in reality bought, and on which it should pay tax, [[stamp duty]] and so on. Depending on which tax specialist you ask, an “unhealthy interest” might extend even to the execution price the [[broker-dealer]] achieves on its hedge. (This seems potty to us, by the way, but such is the interior world of the US tax attorney). [[US tax attorney]]s are greatly calmed by the suggestion that a hedge execution price is imaginary, and not real, even though it happens to be identical to the real one. Thus, you will see much chatter about prices a “[[hypothetical broker-dealer]]might achieve selling [[fungible]] securities, and [[volume-weighted average price]]s and so on.


About the economic substance: synthetic equity derivatives don’t resemble disguised custody arrangements at all:  
===What is a hypothetical broker-dealer anyway?===
:(i) a synthetic prime broker will hedge delta-one across its whole client portfolio — some of which will be [[short]], and some [[long]] — so there is no one-to-one relationship between each client’s long position and the [[prime broker]]’s net [[physical hedge]] in the first place; and
So who, why, which or what is this much-talked-about, seldom-seen “[[hypothetical broker-dealer]]”?
:(ii) even if there were, the [[prime broker]] will almost certainly finance the [[net]] [[long]] portion of its [[delta]] anyway, to reduce its [[funding cost]]s, lending it out for [[cash]], so again the [[prime broker]] won’t be holding a physical [[hedge]] ''at all''m, let alone one it is covertly custodying for its swap clients.  
 
Well, it’s an investment banker’s imaginary friend. A fellow just like the ''actual'' [[broker-dealer]] — in the same jurisdiction, having the same taxation status, earning the same income, executing the same hedge transactions, eating at the same restaurants, having the same GSOH and watching the same stuff on Netflix — but ''not'' the actual [[broker-dealer]]. He’s like actual [[broker-dealer]]’s “sober me”, only ''he gets drunk too''. Now this might strike you, as it strikes the [[JC]], as just too cute – too much of a playground argument to hold water. (“I didn’t break the window, sir, honest, sir, it was a boy who looked exactly like me who arrived from out of nowhere and is gone now”). But [[US tax attorney]]s seem to be taken in by it, even if they won’t buy arguments on actual economic substance.
 
===But ''do'' synthetic equity swaps resemble disguised custody arrangements?===
Um — ''no''. About the economic substance: [[synthetic equity swap]]s don’t resemble disguised custody arrangements at all:  
:(i) a [[prime broker]] will hedge [[delta-one]] across its whole client portfolio — some of which will be [[short]], and some [[long]] — so there is no one-to-one relationship between each client’s long position and the [[prime broker]]’s net physical [[hedge]] in the first place — that is to say, there is no assurance that the prime broker is holding ''anything'' in custody at any time; and
:(ii) even if there were, the [[prime broker]] will almost certainly finance the [[net]] [[long]] portion of its [[delta]] anyway, to reduce its [[funding cost]]s, by lending it out, [[title transfer]], for [[cash]], so even if the [[prime broker]] has a corresponding exposure, it won’t be hedging it with holding a physical [[hedge]] ''at all'', let alone one it is covertly holding on custody for its clients.  


But US [[tax attorney]]s wilfully ignore all this dispiriting logical talk and insist the only thing that can save you are some [[magic words]] about you [[hedge]] costs being incurred by a [[hypothetical broker dealer]] exactly ''like'' you, but who ''isn’t'' you.
But US [[tax attorney]]s wilfully ignore all this dispiriting logical talk and insist the only thing that can save you are some [[magic words]] about you [[hedge]] costs being incurred by a [[hypothetical broker dealer]] exactly ''like'' you, but who ''isn’t'' you.

Latest revision as of 11:09, 20 July 2022

In some jurisdictions, derivatives are taxed differently — more favourably — than cash equities (for example stamp duty reserve tax, and in the US, for certain types of underlier, under 871(m)) so it is important that your synthetic position doesn’t look like a tax play. Tax attorneys — especially American ones — fret mightily that high-delta equity derivatives do.

One of the key indicators, they intuit, is the degree to which the contract permits a swap counterparty influence or control its prime broker’s hedge. A swap counterparty should care not one whit about its broker’s hedge — other than its cost. If it does takes an unhealthy interest, the swap position may be — dramatic look gopher — recharacterised as a disguised custody arrangement of shares the swap counterparty has in reality bought, and on which it should pay tax, stamp duty and so on. Depending on which tax specialist you ask, an “unhealthy interest” might extend even to the execution price the broker-dealer achieves on its hedge. (This seems potty to us, by the way, but such is the interior world of the US tax attorney). US tax attorneys are greatly calmed by the suggestion that a hedge execution price is imaginary, and not real, even though it happens to be identical to the real one. Thus, you will see much chatter about prices a “hypothetical broker-dealer” might achieve selling fungible securities, and volume-weighted average prices and so on.

What is a hypothetical broker-dealer anyway?

So who, why, which or what is this much-talked-about, seldom-seen “hypothetical broker-dealer”?

Well, it’s an investment banker’s imaginary friend. A fellow just like the actual broker-dealer — in the same jurisdiction, having the same taxation status, earning the same income, executing the same hedge transactions, eating at the same restaurants, having the same GSOH and watching the same stuff on Netflix — but not the actual broker-dealer. He’s like actual broker-dealer’s “sober me”, only he gets drunk too. Now this might strike you, as it strikes the JC, as just too cute – too much of a playground argument to hold water. (“I didn’t break the window, sir, honest, sir, it was a boy who looked exactly like me who arrived from out of nowhere and is gone now”). But US tax attorneys seem to be taken in by it, even if they won’t buy arguments on actual economic substance.

But do synthetic equity swaps resemble disguised custody arrangements?

Um — no. About the economic substance: synthetic equity swaps don’t resemble disguised custody arrangements at all:

(i) a prime broker will hedge delta-one across its whole client portfolio — some of which will be short, and some long — so there is no one-to-one relationship between each client’s long position and the prime broker’s net physical hedge in the first place — that is to say, there is no assurance that the prime broker is holding anything in custody at any time; and
(ii) even if there were, the prime broker will almost certainly finance the net long portion of its delta anyway, to reduce its funding costs, by lending it out, title transfer, for cash, so even if the prime broker has a corresponding exposure, it won’t be hedging it with holding a physical hedge at all, let alone one it is covertly holding on custody for its clients.

But US tax attorneys wilfully ignore all this dispiriting logical talk and insist the only thing that can save you are some magic words about you hedge costs being incurred by a hypothetical broker dealer exactly like you, but who isn’t you.