Equity derivatives balance sheet treatment

Equity Derivatives Anatomy™ →This page on the premium JC →intro →prem →sa A Mesopotamian balance sheet yesterday. Resources About the Equity Derivatives Definitions | (full wikitext) | (nutshell wikitext) | Equity v credit derivatives showdown Hot topics Synthetic Prime Brokerage Anatomy | The Triple Cocktail | Cancellation and Payment | Calculation Agent TOC | 1 General Definitions | 2 Option Transactions | 3 Exercise of Options | 4 Forward Transactions | 5 Equity Swap Transactions | 6 Valuation | 7 Settlement | 8 Cash Settlement | 9 Physical Settlement | 10 Dividends | 11 Adjustments and Modifications | 12 Extraordinary Events · 12.8 Cancellation Amount · 12.9 Additional Disruption Events · 12.9 List of ADEs · 12.9(b) Consequences of ADEs | 13 Miscellaneous Index: Click ᐅ to expand: Equity Derivatives Prime Brokerage Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

If you had ever wondered what the balance sheet treatment is for synthetic prime brokerage, you are not the only one.

Is it any more punitive than physical prime brokerage?

Quick refresher on the difference between synthetic and physical prime brokerage:

	Physical prime brokerage	Synthetic prime brokerage
Overall description	Customer borrows margin loan from PB to purchase asset. PB clears and settles customer asset. PB optimises its funding costs for the margin loan by reusing customer assets into the repo market, but must return them on customer demand (e.g., to sell them).	Customer buys equity swap from PB paying total return of reference asset. PB buys asset for its own account as hedge for swap exposure. PB optimises its funding costs for the hedge by reusing the hedge into the repo market
Who owns assets (before reuse)?	Customer (custody assets)	PB (hedge for own account)
Who benefits from upside of assets	Customer	Customer
Who has risk to assets?	Customer (while solvent)	Customer (while solvent)
Where is PB risk to Customer?	Margin loan	Equity swap

Here is why it might be: when a prime broker writes a swap it typically executes a physical hedge — that is, buys the swap Underlier into its own inventory. It then rehypothecates it into the market, to optimise its funding position using a stock loan or a repo. But an asset sale plus buyback is not a “true sale”: is not the asset stuck on the broker’s balance sheet, thereby attracting an ugly regulatory capital charge? If you go to sell an asset but simultaneously agree to take it back somehow, does the straining shadow of that asset ever truly “get off” the balance sheet?

Conventionally, no: this is why accountants are so keen on “true sale” opinions, whereby a lawyer will tell them that, for sure, sans crossed fingers, jinx, white rabbits or no returns, that something you sold has truly sold and has no chance of coming back.

And this seems to be different to a conventional margin loan: with so-called “physical PB” the customer (and not the PB) beneficially owns the asset. The prime broker holds it in custody, as a trustee. At this stage, the share is not on its own balance sheet (though the margin loan with which it was purchased certainly is). Therefore, in theory, that asset can be reused to optimise that funding position without the asset ever touching the bank’s balance sheet. In theory: typically, however, in the reuse process the asset would hit the broker’s balance sheet, as the broker sweeps all its customer assets, and its own swap hedges, into the same rehypothecation engine which takes title to those assets and pipes them into the Broker’s “long box” in a triparty system).

So, hang on: what is going on here?

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See also

• Tri-party agent
• Securities financing
• True sale opinion