Template:Equity derivative charging

Remember our theory of the game, synthetic PB ninjas: synthetic PB is just margin lending done with swaps. That should offer some clues about how clients pay for it. The economics are the same. This is about the economic cost of entering margin loans, not the economic exposure you have to the stock you have bought. Though that does come into it.

Costing of physical prime brokerage

In a physical margin loan — representing a long equity position — the client expects two types of cost:

• Financing: The financing costs it will incur from its prime broker in borrowing the money it needs to buy the stock, and
• Commission: The brokerage commissions it will incur from its equity broker in buying (and when it is ready to, selling again) the stock.

To offset its costs, the prime broker can rehypothecate the stock, which it holds in custody for the client. Now when it does so, the PB does not take price risk to the stock: remember; it does not have a directional view on the stock. So it will not sell the stock outright, but more likely will use it as collateral in the market, to raise cash (under a repo) or high-quality assets (under a stock loan). If the stock increases in value, happy days for all concerned: the PB will receive more cash, and at the limit may reach its rehypothecation limit and have to return some of the rehypothecated stock to the client. If the stock declines in value, the PB will be able to raise less cash against it, but will be able to call for more margin from the client.

In a short position on margin, the client expects the following costs:

• Financing: The financing costs it will incur from its prime broker under the stock loan by which it borrows the security it wants to short, and
• Commission: The brokerage commissions it will incur from its equity broker in selling (and when it is ready to, buying back) the stock it has borrowed.

Here the client also has something it can offer the prime broker to offset its internal funding costs: the proceeds of sale of the borrowed stock, which it banks in its cash account with the PB. That has the effect or reducing its overall indebtedness. Now its exposure moves around under the stock loan with the prime broker. If the stock increases in value, the client’s liability under the stock loan also increases, and the PB will call for margin. If the stock decreases in value, happy days for all concerned: the PB will receive more cash, and at the limit may reach its rehypothecation limit and have to return some of the rehypothecated stock to the client. If the stock declines in value, the PB will be able to raise less cash against it, but will be able to call for more margin from the client.

Costing of synthetic prime brokerage

Under an equity swap, the client never actually buys the stock, but it puts on a Transaction with its prime broker that replicates the economics of doing so, on margin: