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Synthetic prime brokerage: Difference between revisions
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'''In short''': *'''[[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''': *'''[[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. | ||
Now this is to ignore that (i) a synthetic prime broker will hedge delta-one across its whole client portfolio — some of which will be short, and some of which will be long — so there is no one-to-one relationship between a given client’s long position and the [[prime broker]]’s [[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]] hedge anyway to reduce its [[funding cost]]s, by [[monetise|monetising]] the [[hedge]] (lending it out for [[cash]]), so again the [[prime broker]] won’t be holding a physical [[hedge]] ''at all''. 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. | |||
'''The long version''': | 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> | ||
'''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}} | ||