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

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

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.

Thus:

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.  

*All swap clients are at risk of hedging disruption ''every day'' whether or not any particular one has adjust its own position.  

====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.  

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.

{{ref}}