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Synthetic prime brokerage and the risk of tax recharacterisation: Difference between revisions

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Synthetic prime brokerage and the risk of tax recharacterisation (view source)

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{{a|pb|[[File.Dramatic Look Gopher.gif|thumb|center|DID SOMEONE SAY [[recharacterisation|RECHARACTERISATION??]]]]}}
{{a|pb|[[File:Dramatic Look Gopher.gif|thumb|center|450px|DID SOMEONE SAY [[recharacterisation|RECHARACTERISATION]]??]]}}
===Why a [[synthetic equity]] position is not a secret [[custody]] position tax fiddle===
 
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.  
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.  


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====But what about the [[pledge GMSLA]]?====
====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 loan]]s 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 {{eqderivprov|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<ref>Because these are [[collateral upgrade]] trades, the [[broker]]s tend borrow ''high'' credit-quality assets ([[treasuries]]) and collateralise them with ''lower'' credit-quality assets ([[equities]], right?) and as such there tends to be a handsome [[haircut]] on the collateral, meaning the brokers are significantly ''over-collateralising'' the lenders. If collateral is posted by [[title transfer]], as it would be under a regular {{gmlsa}}, counter-intuitively, the lender is net borrowing from the borrower and, across a portfolio of lenders, in ''big'' size. Thus the borrower generates a huge net credit risk exposure to the lenders for which it gets punitive LRD charges.  By converting its collateral arrangement into a [[pledge]] (with no right of [[reuse]]) it eliminates that credit exposure, and avoids the [[LRD]] charge. We don’t think this changes the force of the argument: the [[broker-dealer]] will commingle its swap hedges with rehypothecated client custody long assets, and there is no guarantee all or any are lent out on pledge, and certainly no commitment made in the swap confirmation.</ref>, and has nothing at all to do with the swap counterparty’s wish to maintain beneficial or legal ownership of the shares.
It is true that the [[agent lending]] world — an enthusiastic part of the synthetic equity financing business — has recently moved towards collateralising [[stock loan]]s 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 {{eqderivprov|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<ref>Because these are [[collateral upgrade]] trades, the [[broker]]s tend borrow ''high'' credit-quality assets ([[treasuries]]) and collateralise them with ''lower'' credit-quality assets ([[equities]], right?) and as such there tends to be a handsome [[haircut]] on the collateral, meaning the brokers are significantly ''over-collateralising'' the lenders. If collateral is posted by [[title transfer]], as it would be under a regular {{gmlsa}}, counter-intuitively, the lender is net borrowing from the borrower and, across a portfolio of lenders, in ''big'' size. Thus the borrower generates a huge net credit risk exposure to the lenders for which it gets punitive LRD charges.  By converting its collateral arrangement into a [[pledge]] (with no right of [[reuse]]) it eliminates that credit exposure, and avoids the [[LRD]] charge. We don’t think this changes the force of the argument: the [[broker-dealer]] will commingle its swap hedges with rehypothecated client custody long assets, and there is no guarantee all or any are lent out on pledge, and certainly no commitment made in the swap confirmation.</ref>, 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====
====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 [[dealer]]s 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 [[dealer]]s 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.
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 [[dealer]]s 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 [[dealer]]s 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.
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