Synthetic prime brokerage and the risk of tax recharacterisation

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Controversial view, perhaps, but the tax disposition which led to someone inventing the “hypothetical broker dealer” — a creature as beloved of the equity swap market as the reasonable man is of the common law — is, in this commentator’s view, predicated on a fundamental misapprehension as to how a synthetic equity swap, and the hedging and financing behind it, works.

This fear of “recharacterisation” — obligatory nod to our dramatic look gopher — also disregards the IRS’s known acknowledgment that synthetic equity swaps are a thing; a bona fide class of transactions of genuine utility and wide use in the market.

So what is the problem?

The putative concern is that, should there be too close a connection between an equity swap and the means by which the swap dealer hedges it, thew dealer could be judged to be “acting as nominee owner” of the hedge for its client — a sort of undisclosed custodian — meaning the client becomes liable to that universe of stamp taxes and withholdings that apply to actual transactions in equity securities, but do not apply to swaps.

Now you might think the obvious answer here, for a revenue authority nursing this particular concern, would be to tax equity swaps the same way it taxes cash equity transactions, and sure enough, for the most part, this is what the IRS now does, by dint of Section 871(m) of the Internal Revenue Code of 1986. But — US legislation being as susceptible to pork-barrel exceptions as ever — there are some obscure classes of security to which 871(m) does not as yet apply — real estate investment trusts for example — so at the periphery this remains a live, if diminished, issue.

Hence the need for this essay. For, 871(m) or no, it is very hard to see how a delta-hedging swap dealer — especially a successful one, with a large portfolio of equity swaps — could be seen to be “acting as nominee owner” in a meaningful way, given how in practice it delta-hedges and finances its own physical positions.

Hedging

The concern here is that, though the master confirmation says the client has a derivative exposure only and that the dealer need not ever hold the underlying, by referencing “actual hedge execution” in the confirm the dealer may be telegraphing that, in practice it will always hold a cash position which will always correspond one-for-one to each client’s order. Thus, the dealer could be viewed as a “nominee owner”. The argument runs like this:

• Even though it doesn’t have to, economically it would be foolish for a dealer not to hedge one-for-one.
• Since, logically the dealer has no skin in the game and has a long the whole physical position for each client, it has no reason not to do as client asks in terms of voting on the shares and so on, plenty of commercial reasons that it should.
• The client therefore effectively controls that long position, getting the “duration” benefits of a continuous holding without being on the register of shareholders (which tbh the IRS doesn’t really care about) or liable for tax on the position (about which it assuredly does).

So for one thing, if that’s right, it’s hard to see how “hypothetical broker dealer” language fixes it, since it doesn’t change that economic reality. They’re just “magic words”. They don’t affect what happens in practice under the swap at all. Show me a chap who relies on magical words, not economic reality, to get his tax treatment and I’ll show you a tax audit waiting to happen.

But in any case that isn’t right: it’s not the complete picture. The dealer delta-hedges across its whole book, across all client positions, long and short, as a single economic position, and then finances it in the market — lending it out — in both cases without reference to or the knowledge of the client.

Thus:

There is no delta-one hedge at the client level, even economically

The dealer’s existing hedge inventory is (a) constantly churning, (b) does not translate 1:1 with each individual long client position. At any time, the dealer’s long exposure to a given cash security will equal its net long exposure across all clients, long and short, in the dealer’s whole book. The dealer’s total holding is a function of its total client portfolio shape, not that of any individual client.

Therefore, if the book is 500 long and 300 short, the dealer will hold just 200 positions. If the 500 long clients want the dealer to vote their shares they’re — out of luck.

Nor does the dealer hold continuous positions in shares for the life of any transaction: It buys and sells every day to reflect changes in its net aggregate exposure caused by all client activity. It churns. Therefore:

• Individual clients couldn’t even with the dealer’s facilitation, exercise rights attaching continuous single holdings.
• All swap clients are at risk of hedging disruption every day whether or not any particular one has adjust its own position.

Financing

The dealer lends out its aggregate long position (mostly) by title transfer

And then we consider the financing operation of the dealer’s swap book into account. the dealer generally lend most, if not all, of the dealer’s net aggregate long position out into the market every day. It does this by title transfer. Where it can, it will lend the whole book out. It doesn’t, generally, hold any more physical securities hedges, as legal owner, at all.

None of these things are consistent with a physical, enduring holding that could resemble a “nominee ownership”. It is clearly, categorically, a purely economic exposure. The point is it is not that the dealer isn’t a nominee owner for a given client according to the legal theory, but that it isn’t a nominee, or any kind of owner, at all. This would also be the case under a US law MSLA, even though the collateral is pledged, as generally the Lender has a right of rehypothecation.

But what about the pledge GMSLA?

It is true that the agent lending world — an enthusiastic part of the synthetic equity financing business — has recently moved towards collateralising stock loans by way of pledge, not title transfer, and with no right of reuse. To the exent you lend out your hedge book by pledge, the clever argument above is somewhat diluted as the nexus between Hedging Party and physical hedge is not quite so conclusively broken. But, really not much. The pledge initiative is entirely due to changes to how LRD is charged these book financing arrangements, and has nothing at all to do with the swap counterparty’s wish to maintain beneficial or legal ownership of the shares.

The IRS position on the product generally

As far as we know the IRS labours under no illusions about the synthetic equity swap product, understands it and is comfortable with how it trades. This is why it introduced 871(m). “High delta” equity derivatives are a widely traded, liquid, and standardised product; the IRS understands it, accepts it, and has already taken direct measures to ensure they are taxed appropriately (ie 871(m)). The IRS’s goal is to stop dealers disguising nominee ownership arrangements, not to stop them paying the delta one value of securities to clients under genuine swap contracts. If that were their aim, the “hypothetical broker dealer” language wouldn’t work anyway; the dealer would have to adjust the delta away from 1 by a meaningful amount. In turn, that would significantly transform the product: the point of the synthetic equity swaps is to exactly replicate the performance of a stock through derivatives. It is hard to see the IRS’s interest in targeting legal “verbiage” to see if they catch dealers out by extracting tax from those who have forgotten to use the word “hypothetical” here or there in a master confirm. If that were a genuine risk, the dealer should not be doing this business at all.