Synthetic prime brokerage: Difference between revisions

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 *'''Terminating''': You can terminate a synthetic position on any day, at market (subject to usual [[Market Disruption Event - Equity Derivatives Provision|market disruption]] and [[Hedging Disruption|hedging disruption]] provisions (for more on this see our old friend the {{eqderivprov|triple cocktail}}). Thus you ''can'' make your [[prime broker]] liquidate its hedge, but you ''can’t'' force it to sell the hedge to you or any of your friends and relations (something it might not want to do if it has an investment banking relationship with the issuer and you are an activist {{tag|hedge fund}}), but of course it can if it wants to. Since — given the [[commercial imperative]] — it is highly incentivised to keep you happy, don’t by that surprised if the [[prime broker]] ''does'' want to sell you its hedge, but that this freaks out its [[compliance]] team, who will wish you just bought it in the market.
 ===The tax issue===
-'''In short''', this is the '''[[tax]] risk and the famous [[hypothetical broker-dealer]]''': In some jurisdictions, derivatives are taxed differently to equities (as regards [[stamp duty reserve tax]] for example, and in the US, under [[871(m)]]) so it is important that your synthetic position doesn’t look like a play to avoid tax. [[Tax attorney|Tax attorneys]] — especially American ones — will fret mightily if it does. One of the key indicators here will be the degree to which the contract permits you to influence or control your [[prime broker]]’s hedge. A derivative counterparty should care not one whit about its broker’s hedge — other than its cost. If it does takes an unhealthy interest, the [[fear]] will be that the swap position is [[recharacterised|really no more than]] a disguised custody arrangement of shares that you have actually bought, and on which you should have paid tax, [[stamp duty]] and so on. Depending on which tax specialist you ask, this might extend even to your interest in the [[PB]]’s the hedge execution price. Thus, you will see much chatter about the termination price being the one a “[[hypothetical broker-dealer]]” might achieve selling [[fungible]] securities, and [[volume-weighted average price]]s and so on.
+'''In short''', this is the '''[[tax]] risk and the famous [[hypothetical broker-dealer]]''': {{hypothetical broker-dealer capsule}}
-So who, why, which or what is this '''[[hypothetical broker-dealer]]'''? Well, he’s 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 and watching the same stuff on Netflix — but ''not'' the actual [[broker-dealer]]. He’s the actual [[broker-dealer]]’s “sober me”, only ''he gets drunk too''. Now this might strike you, as it strikes the [[JC]], 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 attorney]]s seem to be taken in by it even, if they won’t buy arguments on actual economic substance.
-About the economic substance: synthetic equity derivatives don’t resemble disguised custody arrangements at all:
-:(i) a synthetic prime broker will hedge delta-one across its whole client portfolio — some of which will be [[short]], and some [[long]] — so there is no one-to-one relationship between each client’s long position and the [[prime broker]]’s net [[physical hedge]] in the first place; and
-:(ii) even if there were, the [[prime broker]] will almost certainly finance the [[net]] [[long]] portion of its [[delta]] anyway, to reduce its [[funding cost]]s, lending it out for [[cash]], so again the [[prime broker]] won’t be holding a physical [[hedge]] ''at all''m, let alone one it is covertly custodying for its swap clients.
-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.
 Now, since the advent of Section [[871(m)]] the practical value of the [[hypothetical broker-dealer]] language — if it had any — has diminished since in most cases equity swaps are taxed consistently with physical share transactions. But<ref>Assuming, again, that it had any.</ref> it has not vanished entirely so, if your US tax people run true to the  [[JC]]’s experience, you may have to persevere with it. <br>