Hypothetical broker-dealer
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Synthetic Prime Brokerage Anatomy™
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Like the reasonable man, only he trades synthetic equity swaps.
In some jurisdictions, derivatives are taxed more favourably than cash equities (for example, in the UK stamp duty reserve tax is not payable on swaps, and in the US, for certain types of underlier are not caught by Section 871(m)) so it is important that your synthetic position doesn’t look like a tax play. Tax attorneys — especially American ones — fret mightily that high-delta equity derivatives do.
One of the key indicators, they intuit, is the degree to which the contract permits a swap counterparty influence or control its prime broker’s hedge. Chiefly, its ability to direct how the prime broker votes on its entitlements. A swap counterparty should care not one whit about its dealer’s hedge — other than its cost. If it does takes an unhealthy interest, the swap position risks being recharacterised as a disguised custody arrangement. The fear is the swap counterparty has in reality bought the shares, and should therefore pay tax, stamp duty and so on.
An “unhealthy interest” might extend even to the influencing execution price the dealer achieves on its hedge. (This seems potty, by the way, but such is the interior world of the US tax attorney).
US tax attorneys are greatly calmed by the suggestion that a hedge execution price is imaginary, and not real, even though it happens to be identical to the real one. Thus, you will see much chatter about prices a “hypothetical broker-dealer” might achieve selling fungible securities, and volume-weighted average prices and so on. This provides the necessary ontological distance to allow a tax attorney peace of mind.
What is a hypothetical broker-dealer anyway?
So who, why, which or what is a “hypothetical broker-dealer”?
Well, it’s a swap dealer’s imaginary friend. 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 me, 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 strangely, they won’t buy arguments on actual economic substance. La Vittoria della Forma sulla Sostanza to the max.
Do synthetic equity swaps resemble disguised custody arrangements?
No. Synthetic equity swaps don’t resemble disguised custody arrangements at all.
Firstly, for reasons quite unrelated to a given customer’s tax optics, a prime broker will delta hedge its whole client portfolio as the single exposure to the dealer that it is. Some clients will be short, some long, and the dealer will hedge its overall net exposure — so there is no one-to-one relationship between a given client’s long position and the prime broker’s physical hedge, let alone all of them. If all its long customers directed the prime broker to vote “their holdings” it would not be able to because it simply would not hold enough inventory. Indeed, its hedge book could be net short: there is no assurance that the prime broker is holding anything in custody at any time.
Secondly, even if by lucky hap the prime broker’s client portfolio in a given stock was exclusively long, the prime broker would not hold that inventory on its books. That is not the business a prime broker is in. It is a financing optimisation business: the broker would almost certainly finance itsnet long delta in a given stock anyway, to reduce its funding costs. It does this by title transfer, by lending out the stock to raise cash. Even if the prime broker has a corresponding exposure, it won’t be hedging it with holding a physical hedge at all, let alone one it is covertly holding on custody for its clients.
Could it recall the stock for corporate actions though? Not entirely — see the first point above, and secondly because it would upset its funding model, and thirdly it would exacerbate the risk of tax recharacterisation: if a prime broker routinely recalled shares to allow synthetic position holders to vote, it could undermine the argument that these are pure derivative exposures rather than disguised stock ownership.
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.
See also
- Deeming and hypotheticals generally: part of the legal eagles armory of implausible artifice.
- Synthetic prime brokerage
- Synthetic prime brokerage and the risk of tax recharacterisation