Template:M gen Equity Derivatives 12.8

Negotiation tips

If you have the privilege or representing a dealer, prepare to experience one of the great old chestnuts of the equity derivatives world. Dispute rights.

Buyside counsel will delight in requesting elaborate dispute mechanisms, which they will have cribbed from their days as deal counsel on synthetic CDO squared deals, when they earned their fortunes penning cascading dispute provisions that would run for five unpunctuated pages. A couple of things to note:

Firstly, in those CDO squared the counterparty was, needless to say, the dealer’s own SPV, and it would neither seek a dispute provision, much less invoke one if it had it. That it did have one was an elaborate charade put on by the dealer for the sake of credulous ratings agencies, who laboured under the motivated irrationality of believing a calculation agent dispute right did a damn of good, and might meant that these piles of toxic waste could earn a AAA rating. I mean, just fancy.

Secondly, the disputability of derivative valuations, generally, falls into two camps: one one hand, those of liquid, publicly observable asset classes — such as those in the spot FX and listed equities markets — whose valuations derive from objectively-reported, independent market transactions and there isn’t really a great deal of scope for debate and, on the other, those that asset classes that comprise exotic, bespoke, “bull-market” transactions, which spring from the fevered imagination of credit structurers and depend on fantastical internal models of convexity curves, volatility smiles and other such exotic confections. These, no-one but the mad professor who confected them could calculate, much less want to, and for absolute certain the person employing said mad professor — the dealer — would not dream of allowing anyone else to second guess those calculation because upon them is predicated the very, colossal, PNL on which the trade is predicated.

Buyside counsel will delight in requesting elaborate dispute mechanisms, which they will have cribbed from their days as deal counsel on synthetic CDO squared deals, when they earned their fortunes penning cascading dispute provisions that would run for five unpunctuated pages. A couple of things to note:

Firstly, in those CDO squared the counterparty was, needless to say, the dealer’s own SPV, and it would neither seek a dispute provision, much less invoke one if it had it. That it did have one was an elaborate charade put on by the dealer for the sake of credulous ratings agencies, who laboured under the motivated irrationality of believing a calculation agent dispute right did a damn of good, and might meant that these piles of toxic waste could earn a AAA rating. I mean, just fancy.

Secondly, the disputability of derivative valuations, generally, falls into two camps: one one hand, those of liquid, publicly observable asset classes — such as those in the spot FX and listed equities markets — whose valuations derive from objectively-reported, independent market transactions and there isn’t really a great deal of scope for debate and, on the other, those that asset classes that comprise exotic, bespoke, “bull-market” transactions, which spring from the fevered imagination of credit structurers and depend on fantastical internal models of convexity curves, volatility smiles and other such exotic confections. These, no-one but the mad professor who confected them could calculate, much less want to, and for absolute certain the person employing said mad professor — the dealer — would not dream of allowing anyone else to second guess those calculation because upon them is predicated the very, colossal, PNL on which the trade is predicated.

Anyway, I digress. Suffice to say equity derivatives belong to the former category. They are an access product: the dealer provides exposure without taking a naked proprietary position one way or another. It hedges delta-one, so and is remunerated by means of (i) a commission for putting the trade on and taking it off, and (ii) managing the spread between the financing cost it charges and the net funding cost of its hedging activity. (For a full account, see prime brokerage charging). Equity derivatives dealers do not take a proprietary position.

They broadly determine the prices of your swap exactly as they would for cash equity brokerage: by buying or selling shares, only for its hedge, not for your account. Just as you wouldn't get a dispute right on cash brokerage trade — good luck saying, “yeah, I have another broker telling me it could have got a better price” to a stock broker —nor, really should you on a synthetic. The whole theory of the game is that it is a liquid market and the dealer has better access to that market than you do. If you can get better prices elsewhere, go elsewhere.