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Prime Brokers Will Sell You Those Shares If You Want, But Wouldn't It Be Cheaper To Rent?

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"Bucket shop" has become a general-purpose Wall Street insult - "don't work at Blackstone, it's a total bucket shop" - but it's actually a particular thing, "[a]n establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or delivery of the stock or commodities nominally dealt in."1 The "bucket" bit comes, I think, from the notion that your long order and someone else's short order would be thrown into a bucket together, netting them out with the shop as a bookie, rather than being forwarded to the stock exchange.

These are illegal now in all sorts of ways, and when they existed in the olden days they seem to have been pretty shady, but I've always thought that as a concept they get sort of a bum rap. What's wrong with giving people synthetic exposure to equities, particularly exposure with low initial margin requirements and limited recourse?

Anyway Risk has this truly delightful article today about synthetic prime brokerage:

Basel III raises the capital and liquidity costs of providing cash and stock loans to hedge funds. ... One option for capital-constrained prime brokers is to shift more clients to synthetic financing, which is more efficient from a funding and balance sheet perspective.

Synthetic prime brokers provide hedge funds with leveraged exposure to securities or baskets of securities through derivatives such as contracts for difference (CFDs), total return swaps (TRS) and portfolio swaps. The prime broker essentially swaps the return of specified reference assets for a financing rate. The bank hedges its exposure by purchasing the cash instruments or derivatives and the hedge fund obtains leverage as it is only required to post initial margin on the transaction.

Financing clients synthetically allows prime brokers to realise significant balance sheet efficiencies. The swaps themselves are off-balance sheet items and the resulting exposures are hedged in the bank’s trading book. This means the hedges can be netted off against each other, with house longs covering the house shorts. Only the residual market exposure needs to be hedged, cutting down on funding needs.

“If separate clients are long and short the same underlying on the synthetic side and we hedge the market exposures, we technically don’t have a position anymore. We still have two derivatives, which creates an embedded capital efficiency,” says Jon Cossey, head of equity finance at JP Morgan.

Basically a hedge fund (A) can put up $50 and get long $100 of stock via a margin loan, which attracts all sorts of capital and liquidity charges, or (B) it can put up $50 and get long $100 of stock via a swap, which attracts rather less. Option A has the advantage of "owning the stock," which I suppose is nice for some people, but Option B seems economically preferable.

The article is rich with substantive things to ponder. Start with regulatory arbitrage of capital and liquidity regulation.2 The new Basel liquidity coverage ratio standards impose a liquidity charge on banks "covering the levered positions of some clients with the longs and free cash balances of others," whereas banks who cover the levered synthetic longs of some clients with the levered synthetic shorts of others avoid this. Since these are economically sort of the same thing, you might be troubled by the arbitrage, though then again you might not be. (The actual contracts, after all, are a bit different; perhaps there's a case to be made that the synthetic position does bring less liquidity risk than the cash one.)

Then there is the unintended-consequences angle. While much post-crisis financial regulation seeks to move activity away from opaque over-the-counter derivatives into transparent exchange-traded products, the effect of these Basel rules seems to be pushing the equity markets more toward opaque OTC trades. I suppose that's bad, for opacity reasons and also perhaps for interconnectedness reasons - the bigger the bank, the more efficiency they can get out of just bucketing long versus short client positions, and the more of this they do the more exposure everyone will have to them. Replacing actual customer ownership of financial assets with a ballooning notional amount of customer claims on big banks seems like maybe not what regulators were going for.

And of course those transparent exchange-traded products were a little too transparent for some clients anyway:

Hedge funds also prefer to have synthetic exposure to markets that impose burdensome administrative and reporting requirements on investors. For instance, more than 50% of Barclays’ hedge fund clients moved from cash to synthetic positions in Hong Kong after the regulator introduced its short-selling disclosure rules in 2012. ...

The introduction of a 0.2% FTT in France last August caused a spike in demand for CFDs and equity swaps as hedge funds sought to avoid the tax by taking synthetic exposure to French equities, according to prime brokers. The French FTT does not apply to derivatives and market-makers, creating a loophole that has allowed synthetics to flourish.

The sales pitch of "get slightly cheaper financing and avoid a transaction tax" seems irresistible, n'est-ce pas? Oh of course there are administrative and reporting requirements for synthetic exposure too, or will be, more or less. But when there are different regimes, there will be arbitraging of regimes, and the synthetic regime seems a bit more appealing for many purposes than the physical one.3

More than anything though I just like this story as a work of abstraction. In the olden days you would go buy 100 shares of Amalgamated Social Media Concern Ltd. and get a big fancy stock certificate to carry around with you. In the modern days those shares are all owned by a depository and you just have some claims on the depository for those shares, claims that are recorded in the depository's computers and that get pretty abstract pretty fast. But at least you're a "beneficial owner."

In our postmodern age, all-purpose ownership of the shares becomes ever less relevant, as pure slicing of financial claims gets ever easier and more regulatorily appealing. You put the shares in whatever bucket can house them most efficiently - from a capital, liquidity, tax, reporting, long-term-shareholder-"loyalty-rewards," whatever perspective - and then you sell claims on the bucket. Everyone gets only the sorts of claims (economic upside, voting rights, transferability, financing, whatever) that they want, and none of the things (reporting requirements, financial transaction taxes) that they don't. It's so elegant. And so hyper-modern, even though parts of it sound just a little bit old-fashioned.

Primes push synthetics as Basel III bites [Risk]

1.Oh actually it's two things, the other thing is "a company that will sell a coat of arms associated with the customer's surname, regardless of whether the customer can actually claim a relation to the original armiger," but we're not talking about that though I GUESS WE COULD.


Ironically, the government permits a bank to use its own internal models to help determine the riskiness of assets, such as securities and derivatives, which are held for trading—but not to determine the riskiness of good old-fashioned loans. The risk weights of loans are determined by regulation and generally subject to tougher capital treatment. As a result, financial institutions with large trading books can have less capital and still report higher capital ratios than traditional banks whose portfolios consist primarily of loans.

That's from Sheila Bair's Journal op-ed today on risk-weighted assets, which is sort of funny because while lots of people say "using asset risk-weighting is misguided so banks should be regulated to a pure leverage ratio," Bair says "using Basel risk-weightings is misguided so banks should use different, better risk-weightings." (Or as she puts it, " It does make sense to look at the riskiness of banks' assets in determining the adequacy of its capital. But the current rules are upside down, providing more generous treatment of derivatives trading than fully collateralized small-business lending.") I'm philosophically sympathetic to that approach - risky things really are riskier than less risky things, and you can certainly quibble with some of Basel's choices - but also sort of epistemically skeptical. Every bank regulator in the world has been working on Basel III for years but wait Sheila Bair has a better idea! Okay, sure.

3.So e.g. activist investors in the U.S. may (still!) find synthetic financing congenial as a way to arbitrage HSR and reporting requirements. Activists in Canada soon may not, though 85-delta synthetic financing might work. Arbitrages all the way down.