Equity shorts in disguise

Posted by Izabella Kaminska on Jun 20 14:20.

Synthetic prime – a.k.a — the art of transforming client exposures.

But, we wonder, could there be more to it than meets the eye?

Let’s start with what ‘synthetic prime brokerage‘, shorting, internalisation, ETFs, and Delta One all have in common.

The quick answer: they’re all key focus areas for banks in a post 2008 world. The more complex answer: they are all being intertwined to help banks find synergies between departments so as to provide the most competitive services to clients and hedge funds.

Synthetic prime brokerage itself is not new — its main feature is the provision of equity swaps to clients, largely for shorting purposes, as opposed to traditional stock lending. It’s been going on for a decade at least.

But, as the Tabb Group wrote in an analysis of the business in June 2010, prime brokers are finding that in order to retain hedge fund business, they are increasingly having to meld traditional prime servies with synthetic offerings like swaps, especially when it comes to access into specialist markets, and add-on features like segregated custody accounts.

In that sense, it’s quite a revolution, with even custodian banks getting in on the one-stop shop Prime custody act.

Indeed, as Tabb noted, the stage seems set for the world of synthetic finance. Especially when it comes to servicing funds’ growing desires for exposure to more exotic emerging markets, but without the associated bureaucratic risks.

As the the Tabb Group in conjunction with RBS wrote:

Hedge funds of all sizes are looking to access new and exciting emerging markets and are increasingly favouring equity swaps to do so. Swaps help manage a broad array of hazards associated with cash equity trading in emerging markets, including the following: *Exposure to turbulent, hard-to-hedge currencies
*The random introduction of discriminatory tax and capital controls
* Cumbersome and expensive registration red tape for local securities trading
*Unreliable technical and telecommunication infrastructure
*Immature clearing and settlement systems

A key benefit of all this for hedge funds is that they can can continue to use long-short strategies while broadening their appeal to clients with strict no-short position mandates. They also remain UCITS III compliant — meaning retail money can be attracted too.

What’s more, the fact that brokers gain critical synergies from utilising synthetic techniques, sees them able to pass on savings to clients, something which often makes synthetic prime much more competitively priced than normal shorting services.

Though there is no such thing as a standard model for the business from a bank’s perspective.

What happens in most is that the risk associated with running the physical positions to back the swaps is passed on to the brokers. That means the hedge funds are one step removed from the lending operations. The brokers themselves are the ones which go out into the market to hedge with physical inventory which ends up on their own balance sheet. The bigger the broker, the greater the synergies — since the skill lies in being able to cross (or offset) the exposure against your own inventory wherever possible, before heading out to the market. This is no doubt thanks to some helpful internalisation algobots.

If a hedge fund, meanwhile, wants access to a more exotic market, one in which the prime broker lacks natural inventory to offer competitive pricing, the model allows for a potential give-up arrangement with a more specialist broker so as to facilitate the one-stop shop nature of the business. The hedge fund sources the shorts but executes via the prime broker.

Inventory sourcing

With the greatest arbitrage opportunities currently seen in the emerging markets space, being able to provide access here is critical. As the Tabb Group noted:

Hedge funds believe that inefficient emerging markets present some of the best opportunities in terms of spreads and easily identifiable risk arbitrage. Generally speaking, emerging market economies are characterised by political instability, strong currency turbulence, and high foreign debt. Meanwhile their stock markets generally lack information efficiency and structure. A situation in which there are multiple, volatile moving parts operating in a low-infrastructure market environment is an ideal situation for the sophisticated arbitrageur.

The problem, though, is that there are natural barriers in many of these markets when it comes to sourcing inventory, especially for shorting purposes.  But synthetic prime can overcome this either by drawing on the regional presence of the broker-dealer themselves, the “give-up” specialist broker route, or alternatively by providing pure synthetic back-to-back swap arrangements, which match the short swaps against a long swaps, leaving the broker-dealer neutral.

But, from the broker’s perspective, being able to source the other side of the position remains critical. It is here, hence, that many banks are coming up with ever more innovative ways to guarantee themselves inventory and/or the opposite swap exposure.

As Tabb notes:

One of the most critical features of the prime brokerage service industry is access to stock inventory. Without access to stock, prime brokers are unable to offer shorting as a service to hedge funds – a key theme to a large number of hedge fund investment strategies. The prime broker always has to be able to access the stock if he is to sell a short swap; otherwise he is simply taking the other side of the market position — something he does not want to do. When it comes to the stock borrow “give-up,” the hedge fund is essentially sourcing stock inventories that serve as the hedge on behalf of the prime broker.

Sourcing inventory and/or long exposure, and incorporating such things as a “give up” mechanism, are key:

Traditionally, many prime brokers have tried to build up inventories by a variety of means including bidding for exclusive access to portfolios and index arbitrage; single-stock forward trades; and portfolio trading. But this expensive and time consuming business, which has often translated into higher service costs to the hedge fund client, is being made more efficient through the infrastructure of the give-up.

But strategies like bidding outright for the exclusive right to borrow long portfolios — often from exchange-traded funds and other passive vehicles — is another way around it. As is providing long swaps to synthetically-replicated ETFs. Creating or sourcing long demand to offset short demand, so to speak.

Meanwhile, the practice of efficiently offsetting the two exposures against each other; internalising; or actually taking a bit of a view on the market, is how Delta One is incorporated into the whole thing.

From the industry’s point of view, everyone is a winner. The hedge funds get their shorts, the broker-dealers earn fees — and arguably make money from taking a view on the market if they want — and those wanting to go long the markets get very liquid offsetting products such as ETFs and other funds or notes.

But one thing to consider is how these dynamics are potentially obscuring and changing the market structure. It’s true that short interest/rate data has never been very transparent, but what little data does exist is potential at risk of only picking up the residual picture — that is, the shorts that can not be internalised or offset by the broker-dealers.

What goes on internally — especially with respect to settlements – is anyone’s guess, however. This is particularly the case when it comes to vertically-integrated banking structures which use their own asset management arms for inventory sourcing.

Decepticons and algobots apart, however, optimum prime does look to be synthetic at the moment.

Related links:
All eyes on broker-dealer internalisation
– FT Alphaville
Prime custody, and the business of collateral
– FT Alphaville
Do banks see ETFs as inexpensive funding for illiquid securities? – Part I – FT Alphaville

This entry was posted by Izabella Kaminska on Monday, June 20th, 2011 at 14:20 and is filed under Capital markets. Tagged with , , , , .

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