Equity give-up
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Synthetic Prime Brokerage Anatomy™
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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,[1] 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[2] 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[3] 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[4] stamp duties payable on equity derivatives. There are all kinds payable on cash equity transactions.[5] 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).
See also
References
- ↑ 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.