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{{a| | {{a|spb|{{Synthetic equity swap - FWMD}}}}{{quote|A contract in which one party makes payments based on a set rate while the other party makes payments based on the return of an underlying asset, in this case, stocks. A party that purchases a total return swap is, in effect making a bet on whether the underlying asset... will increase or decrease in value by the end of the term of the swap, Thus, if someone [takes] a long position in a swap, the counterparty to that swap will pay that person the amount of the increase in the price of the stock during the life of the swap contract if this price goes up, and the purchaser will pay the counterparty the amount of the decrease in the price of the stock during the life of the contract if the price goes down. | ||
[[ | |||
Furthermore, as BILL HWANG, the defendant and other [[Archegos]] conspirators understood, the [[Swap dealer|Counterparties]] generally did not enter into [[Synthetic equity swap|swap contracts]] with Archegos in order to bet on the increase or decrease of the stock price. Rather, the Counterparties did so to profit from the financing fees charged on the transaction. Accordingly,to avoid market exposure on a swap contract, the Counterparties themselves purchased the stock underlying the swap. | |||
:—''United States of America v Sung Kook (Bill) Hwang and Patrick Halligan'', Sealed Indictment 22 CRIM 240}} | |||
A topic of ''great'', sudden, interest in the wake of the [[Archegos]] scandal. | |||
''Also called [[portfolio swap]]s, [[synthetic equity swap]]s, [[contracts for difference]]<ref>This has been apt to confuse people; be warned.</ref> or [[high-delta equity derivative]]s.'' Cryptic crossword fans — JC has become addicted over lockdown — may also be thrilled to know how good “[[synthetic equity swap]]” is for generating anagrams. ''A twisty spy technique'', for example. Or ''witty, peachy inquests''. If you wanted to know ''why typist quit seance'', or have ever been dismayed by ''quite whiny typecasts'', this may be your inner [[equity derivative]] [[structurer]] banging on your cranium and trying to get out. | |||
Why are all these things called “[[synthetic prime brokerage]]”, then? Well, because economically this is ''physical'' [[prime brokerage]] — that is, [[Brokerage|equity brokerage]] done on [[margin lending|margin]] only done with ''[[swaps]]'' on [[shares]], and not ''actual'' [[shares]]. The client never actually owns the [[share]]: instead, his [[swap dealer]] buys it, and passes on the economic return under an [[equity derivative]]. | Why are all these things called “[[synthetic prime brokerage]]”, then? Well, because economically this is ''physical'' [[prime brokerage]] — that is, [[Brokerage|equity brokerage]] done on [[margin lending|margin]] only done with ''[[swaps]]'' on [[shares]], and not ''actual'' [[shares]]. The client never actually owns the [[share]]: instead, his [[swap dealer]] buys it, and passes on the economic return under an [[equity derivative]]. | ||
You may like our longer-form essay — it’s a contrarian piece, be warned — ''“[[synthetic prime brokerage and the risk of tax recharacterisation]]”''. | You may like our longer-form essay — it’s a contrarian piece, be warned — ''“[[synthetic prime brokerage and the risk of tax recharacterisation]]”''. | ||
Anyway. | Anyway. | ||
===Why ''synthetic'' and not ''physical''?=== | ===Why ''synthetic'' and not ''physical''?=== | ||
*'''Going [[long]]''': instead of buying shares on [[margin]] and asking your [[prime broker]] to hold them for you, you just trade a [[total return swap]] with your [[prime broker]] where the [[PB]] pays the return of the share price and you pay a [[floating rate]]. The [[PB]] will (cough, in all probability) buy the physical {{eqderivprov|shares}} and hold them in its own inventory as a [[delta-one]] hedge. But it will do this across its whole book, not client-by-client, much less position-by-position, and it will finance those shares in the market to offset its funding costs, so you shouldn’t imagine your prime broker keeps a little bucket with your name on it containing all the shares it has bought to hedge your swaps<ref>This might, at first, seem a bit upsetting, but once you talk to your tax accountant you will feel much better. This really is as much for your own good as for your [[prime broker]]’s.</ref>. You will be exposed to the price of the assets, but do not control or own the {{tag|prime broker}}’s hedge. This can sometimes lead to disappointment when it comes to voting and [[corporate action]]s, but it’s all for the best. | *'''Going [[long]]''': instead of buying shares on [[margin]] and asking your [[prime broker]] to hold them for you, you just trade a [[total return swap]] with your [[prime broker]] where the [[PB]] pays the return of the share price and you pay a [[floating rate]]. The [[PB]] will (cough, in all probability) buy the physical {{eqderivprov|shares}} and hold them in its own inventory as a [[delta-one]] hedge. But it will do this across its whole book, not client-by-client, much less position-by-position, and it will finance those shares in the market to offset its funding costs, so you shouldn’t imagine your prime broker keeps a little bucket with your name on it containing all the shares it has bought to hedge your swaps<ref>This might, at first, seem a bit upsetting, but once you talk to your tax accountant you will feel much better. This really is as much for your own good as for your [[prime broker]]’s.</ref>. You will be exposed to the price of the assets, but do not control or own the {{tag|prime broker}}’s hedge. This can sometimes lead to disappointment when it comes to voting and [[corporate action]]s, but it’s all for the best. | ||
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'''The long version''': If that wasn’t compelling enough here, in a service to the market, is a longer form essay from the [[JC]] on ''“[[synthetic prime brokerage and the risk of tax recharacterisation]]” | '''The long version''': If that wasn’t compelling enough here, in a service to the market, is a longer form essay from the [[JC]] on ''“[[synthetic prime brokerage and the risk of tax recharacterisation]]” | ||
{{LOSD under synthetic pb}} | {{LOSD under synthetic pb}} | ||
{{Difference between SES and MCA}} | {{Difference between SES and MCA}} | ||
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A client can close out its [[synthetic equity swap]] in exactly the same way: it obtains a firm price from an executing broker, instruct the closure of the swap at that price, and indicate that the [[PB]] can sell its hedge to the [[executing broker]]. | A client can close out its [[synthetic equity swap]] in exactly the same way: it obtains a firm price from an executing broker, instruct the closure of the swap at that price, and indicate that the [[PB]] can sell its hedge to the [[executing broker]]. | ||
===Common, [[tedious]], points of dispute when negotiating a [[synthetic equity swap]] [[master confirmation]] === | ===Common, [[tedious]], negotiation points of dispute when negotiating a [[synthetic equity swap]] [[master confirmation]] === | ||
*'''I want to be [[co-calculation agent]]''' | *“'''I want to be [[co-calculation agent]]'''”, “'''I want a right to dispute your calculations'''” and “'''I want to be a {{eqderivprov|Determining Party}}'''”: See “I want to be [[co-calculation agent]]” and Section {{eqderivprov|12.7(c)}}. | ||
*Why should you be able to pass on taxes, extraordinary hedge costs and other losses as a result of counterparty defaults on your hedge position? See {{eqderivprov|Hedge Position Adjustments}}. | |||
*'''You can change [[initial margin]] whenever you like? What’s ''that'' all about?''' | *'''You can change [[initial margin]] whenever you like? What’s ''that'' all about?''' | ||
*'''What do you mean you want a thirty day termination right?''' | *'''What do you mean you want a thirty-day termination right?''' | ||
*'''[[Hypothetical broker-dealer]]. What’s ''that'' all about?''' (In brief: See Section [[871(m)]]). | *'''[[Hypothetical broker-dealer]]. What’s ''that'' all about?''' (In brief: See Section [[871(m)]]). | ||
*'''Hang on. An [[indemnity]] for your tax risk? Are you serious?''' | *'''Hang on. An [[indemnity]] for your tax risk? Are you serious?''' | ||
{{sa}} | {{sa}} | ||
*[[Archegos]] | |||
*[[871(m)]] of the [[Internal Revenue Code of 1986]] | *[[871(m)]] of the [[Internal Revenue Code of 1986]] | ||
*[[synthetic prime brokerage and the risk of tax recharacterisation]] | *[[synthetic prime brokerage and the risk of tax recharacterisation]] | ||
*[[Hypothetical broker-dealer]] | *[[Hypothetical broker-dealer]] | ||
{{ref}} | |||