Hedge Position Adjustments - Equity Derivatives Provision
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Synthetic Prime Brokerage Anatomy™
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Hedge Position Adjustments are a flourish you might see in a synthetic prime brokerage master confirmation, as a gloss to the other terms in the 2002 ISDA Equity Derivatives Definitions about Final Price and so on. As the sample in the box suggests they allow the dealer to pass through extraordinary costs of providing synthetic exposure to its clients. These chiefly take three forms: unexpected costs of hedging, the most obvious of which are stamp duties, financial transaction taxes and other costs imposed on the dealer who hedges its obligations by transacting in the underliers; outright failures of the hedge (because hedge counterparties go bust before settling), and unexpected conversion costs.
Clients, and their counsel, if schooled in the ways of the ninja will at first baulk, but there is method to the madness. Your starting proposition is this:
Remember this is only a market access product. This is just equity brokerage done with derivatives. The only reason, dear client, you aren’t actually buying the equity yourself, and thereby exposing yourself directly to these perfidious duties, taxes, counterparty failures and FX conversion costs, is because you can’t, or for your own reasons you have decided you would rather have someone else — your dealer — on the register of shareholders instead of you. Your dealer is gamely assuming all these risks and costs to give you exactly that exposure. It is only fair that you should agree to assume these risks.
That will not immediately clinch it, but it should have your buyside advisors at least pausing for thought.
Objections run along the following lines:
“Ok but how am I supposed to pass this on to my clients?” This one specifically apposite for taxes that are imposed suddenly, out of the blue, and particularly retrospectively. Retrospective taxes are bad form, but there are some jurisdictions where consensus has it that they could happen: places like China, India, Taiwan, Morocco, Kazakhstan, Qatar and Romania. Who came up with this idiosyncratic list? Search us, but we suspect there are wounds and scar tissue behind it.
It is certainly true that investors come and go, and it is hard for an investment manager to explain to a new investor in 2021 that her returns will be deprecated by some tax liabilities just incurred from a position closed in 2006, but why should this become the dealer’s problem? In practice dealers tend to be a bit phlegmatic: the real-world likelihood of retrospective taxes actually being imposed or enforced must surely decrease over time, so dealers will set arbitrary “sunset periods” of two, three or five years, and figure they will just wear any tail risk beyond that.
“I didn’t choose your hedge counterparties, so why should it be my problem if they blow up?” Fair enough — but also, you did choose not to pick your own counterparties, but rather to leave it to your dealer, and who is to say you wouldn’t have chosen the same one — or even one who blew up worse? Just because you are getting exposure through a dealer’s swap facility shouldn’t absolve you from all hedge counterparty risk: that is a real cost of investing in a market. Given that hedge counterparties are usually cash brokers on DVP executions (or fully collateralised stock loans) there is very little pure risk being run here: this one is far enough down the tail that people tend not to die in a ditch about it on either side of the argument.