Synthetic prime brokerage
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Prime Brokerage Anatomy™
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A topic of great, sudden, interest in the wake of the Archegos scandal.
Also called portfolio swaps, synthetic equity swaps, contracts for difference[1] or high-delta equity derivatives. Cryptic crossword fans — JC has become addicted over lockdown — may also be thrilled to know how good “synthetic equity swap” is for generating anagrams. A twisty spy technique, for example. Or witty, peachy inquests. If you wanted to know why typist quit seance, or have ever been dismayed by quite whiny typecasts, this may be your inner equity derivative structurer banging on your cranium and trying to get out.
Why are all these things called “synthetic prime brokerage”, then? Well, because economically this is physical prime brokerage — that is, equity brokerage done on margin only done with swaps on shares, and not actual shares. The client never actually owns the share: instead, his swap dealer buys it, and passes on the economic return under an equity derivative.
You may like our longer-form essay — it’s a contrarian piece, be warned — “synthetic prime brokerage and the risk of tax recharacterisation”.
Anyway.
Why synthetic and not physical?
- Going long: instead of buying shares on margin and asking your prime broker to hold them for you, you just trade a total return swap with your prime broker where the PB pays the return of the share price and you pay a floating rate. The PB will (cough, in all probability) buy the physical shares and hold them in its own inventory as a delta-one hedge. But it will do this across its whole book, not client-by-client, much less position-by-position, and it will finance those shares in the market to offset its funding costs, so you shouldn’t imagine your prime broker keeps a little bucket with your name on it containing all the shares it has bought to hedge your swaps[2]. You will be exposed to the price of the assets, but do not control or own the prime broker’s hedge. This can sometimes lead to disappointment when it comes to voting and corporate actions, but it’s all for the best.
- Going short: instead of borrowing shares from your PB and selling them short, you just put on a total return swap, where you pay the return of the share price and the PB pays you a floating rate. Your PB will borrow the shares for its own hedge and sell them short, and will pass on the cost of the stock borrow to you (by deducting it from the floating rate).
- Terminating: You can terminate a synthetic position on any day, at market (subject to usual market disruption and hedging disruption provisions (for more on this see our old friend the triple cocktail). Thus you can make your prime broker liquidate its hedge, but you can’t force it to sell the hedge to you or any of your friends and relations (something it might not want to do if it has an investment banking relationship with the issuer and you are an activist hedge fund), but of course it can if it wants to. Since — given the commercial imperative — it is highly incentivised to keep you happy, don’t by that surprised if the prime broker does want to sell you its hedge, but that this freaks out its compliance team, who will wish you just bought it in the market.
The tax issue
In short, this is the tax risk and the famous hypothetical broker-dealer: 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.
Now, since the advent of Section 871(m) the practical value of the hypothetical broker-dealer language — if it had any — has diminished since in most cases equity swaps are taxed consistently with physical share transactions. But[3] it has not vanished entirely so, if your US tax people run true to the JC’s experience, you may have to persevere with it.
The long version: If that wasn’t compelling enough here, in a service to the market, is a longer form essay from the JC on “synthetic prime brokerage and the risk of tax recharacterisation”
Loss of Stock Borrow under Synthetic PB: For synthetic prime brokerage, it is common for the PB to pass on its stock borrowing costs (well: it is a synthetic equivalent of a stock borrow and a short sale, after all, so this makes sense). It does this by subtracting the prevailing borrow rate from the floating rate it pays under the swap. Therefore the Non-Hedging Party wears the ultimate cost of the expensive stock borrow, so there’s no real need to impose a Maximum Stock Loan Rate (though prime brokers will typically impose one as a matter of course).
Difference between synthetic PB and normal equity derivative master confirmations
Term, in a word. Under a normal equity derivatives MCA, the parties trade at arms length for a specified term, at the end of which both knows the trade terms out. So:
- The parties specifically agree to the trade up front — there is no sense of the “facility” nature of synthetic PB (even if that facility is technically uncommitted), where the broker more or less stands ready to take on any trade at the request of the client. Thus a broker under an MCA can assess the market at the time of trade and take a view for the duration how it feels about hedging risks, and perhaps price them into the trade.
- Initial margin may also be fixed.
- By contrast, in synthetic PB, the expectation is that the broker will put the trade on at the pre-agreed rates, and will keep it on until the client wants to take it off, whether that is over night or five years. Assessing the potential for market disruption is therefore more fraught, hence more flexibility in the ability to get out of a trade if hedging conditions unexpectedly change. While a broker will have a greater flexibility to adjust initial margin under a synthetic equity master confirmation, this doesn't impact the pricing of the risk per se. And there may well be a margin lock-up, meaning the broker can’t quickly get out of the trade.
How synthetic equity swaps are traded
Unlike other derivatives, synthetic equity trades a lot like a cash equity: The client goes to a equity broker to get a firm price indication, the broker then “gives up” this thing that wasn’t actually an order in the first place (it’s complicated: see the box) to the prime broker who then, at the client's request, writes the swap at the price directed by the hedge fund. So the swap provider, which lives in the prime brokerage business, really is a glorified custodian. Cruel people would say that’s not a bad description of a prime broker, come to think of it.
A client can close out its synthetic equity swap in exactly the same way: it obtains a firm price from an executing broker, instruct the closure of the swap at that price, and indicate that the PB can sell its hedge to the executing broker.
About give-ups
Note: equity give-ups are the standard way of executing delta-one equity swaps in the European market, a common method in APAC, but unheard of in the U.S. This is mainly due to their varying attitudes towards tax.
Under a cash equity give-up, the hedge fund seeks a firm price indication for a cash equity from an executing broker, but does not act on it: rather, the hedge fund says, “all right, sir: hold that thought”, and runs off to its favourite prime broker, whom it instructs to enter into a swap at the exact price quoted by the executing broker, directing the PB’s attention to the winsome executing broker who is sitting by the phone, dutifully holding its thought, all dressed up and with nowhere yet to go.
In practice, the executing broker is not quite that demure. It will pre-emptively “allege” the cash trade to the hedge fund’s prime broker,[4] which is rather like buzzing in on University Challenge before Bamber Gascoigne has finished asking the question: “a little birdie tells me you are going to instruct me to trade on an equity to hedge an equity swap you’re about to put on with your client hedge fund X. Well — here it is!”
Once the PB has accepted the EB’s “allegation”, the PB “prints” the trade with the hedge fund, usually in the form of a synthetic equity swap[5] transacted under an ISDA Master Agreement.
Calling this a “give-up” is a misnomer, since nothing is actually “given up”. In theory — even if not awfully often[6] in practice — the prime broker can feign ignorance and refuse to transact with the executing broker, thereby hanging the executing broker out to dry with any recourse against anyone for the equity trade it has executed.
The executing broker may have stern words to the hedge fund about this, but not ones that would sound in actual damages (but — you know — good luck with your ongoing relationship with that broker, right?): the entire theory of their arrangement is that the hedge fund never committed to any trade with the executing broker. All care, no responsibility.
Why all this delicate tiptoeing around the subject? Tax, in a word. There are no[7] stamp duties payable on equity derivatives. There are all kinds payable on cash equity transactions.[8] So the name of the game is that the fund is arranging a transaction between two brokers, not executing one.
Regulated broker-dealers may have intermediary exemptions from these; clients like hedge funds generally will not. So if the taxman decides that the fund has bought the security from the executing broker and then sold it to its prime broker, then the hedge fund gets hit for stamp duty twice. If the broker buys directly from another broker, there will be at the most one dutiable transaction (and, if intermediary relief applies, there may be none).
Common, tedious, points of dispute when negotiating a synthetic equity swap master confirmation
- I want to be co-calculation agent:
- I want a right to dispute your calculations: See “I want to be co-calculation agent”
- You can change initial margin whenever you like? What’s that all about?
- What do you mean you want a thirty day termination right?
- Hypothetical broker-dealer. What’s that all about? (In brief: See Section 871(m)).
- Hang on. An indemnity for your tax risk? Are you serious?
See also
- Archegos
- 871(m) of the Internal Revenue Code of 1986
- synthetic prime brokerage and the risk of tax recharacterisation
- Hypothetical broker-dealer
References
- ↑ This has been apt to confuse people; be warned.
- ↑ This might, at first, seem a bit upsetting, but once you talk to your tax accountant you will feel much better. This really is as much for your own good as for your prime broker’s.
- ↑ Assuming, again, that it had any.
- ↑ Whose identity the hedge fund may have “inadvertently” let on during the post-coital conversation. WAIT: THERE WAS NO COITUS, REMEMBER?
- ↑ A.k.a a “contract for differences” or “CFD”.
- ↑ That is to say, ever.
- ↑ Okay — mostly no stamp duties. In the US, Section 871(m) has gone some way to equalising the tax payable under synthetic and cash transactions, which means the resting state of squeaky-bummitude of your US tax attorneys is now some way more comfortably positioned than it was in the old days.
- ↑ SDRT in the UK, FTT in various European jurisdictions, and in the US a typically baroque arrangement covered in Section 871(m) of the Internal Revenue Code.