Template:Hypothetical broker-dealer capsule

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 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 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 prices and so on.

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 attorneys seem to be taken in by it even, if they won’t buy arguments on actual economic substance.

About the economic substance: synthetic equity derivatives don’t resemble disguised custody arrangements at all:

(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

(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, lending it out for cash, so again the prime broker won’t be holding a physical hedge at allm, let alone one it is covertly custodying for its swap 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.