Trading on swap is well established in Asia and now European hedge funds are also considering it, mainly as a way of avoiding transaction taxes. But despite the appeal of the products, increased regulation means potential disruption is looming for users.
Savvy hedge funds can use swaps, provided by their prime brokers, to bypass restrictions on trading equities. One of the principal drivers of using equity swaps – the main product in synthetic prime brokerage – is to access markets in Asia where access to cash products is restricted or investor identification is required. Outside Asia the main reason for use is avoidance of transaction taxes.
Editor's choice
“Over the past couple of years, we have seen the continuation of a trend towards swap products that has been going on for a while, particularly in Europe and to a lesser extent in Asia,” says Paul Fleming, senior vice-president at State Street Global Advisors. “There is a move towards synthetic products, whether it is for tax reasons or for reporting requirements. There are numerous reasons for doing a transaction on swap.”
Two flows
An equity swap involves two cash flows, one typically based on a single stock or stock index, the other based on a floating rate. Within the synthetic prime model, the hedge fund would typically be the equity leg receiver/floating leg payer with the broker taking the other side. The cash flows are intended to replicate those from holding an equity portfolio, with cash exchanged at predetermined dates.
“Everyone fundamentally prefers cash,” says the head of prime brokerage in Europe at a bulge bracket US broker. “It is a bit cheaper and easier. It is often an unintended consequence of regulation that drives the use of swap.”
Not all firms that offer prime brokerage are able to cater for their buy-side clients by delivering synthetic products. David Clarkson, head of prime brokerage for Europe, the Middle East and Africa at JPMorgan, says: “Often dedicated custodial banks don’t have the ability to offer swaps, whereas universal banks and broker dealers will consider derivatives to be an integral part of the prime brokerage offering.”
Why prime?
“As a general guide in prime brokerage, 30% to 40% of financing is done synthetically,” says Chris Barrow, global head of sales at HSBC Prime Services. “There are many reasons for choosing synthetics but a key driver is to access developing markets. As an emerging markets-led bank with operations in places such as Asia, Brazil and South Africa, we offer synthetic solutions in those markets, so inevitably it is a big part of our business.”
Some markets have regulations that place limits on firms’ access to equities. For example, in China trading A shares – those listed on the Shanghai and Shenzhen exchanges – is banned among offshore firms unless they have been awarded status as a qualified foreign institutional investor. Others, typically those in the Middle East and south Asia, have proportional limits on foreign ownership for certain firms, particularly if the firms are considered to be of national importance. Investor identification markets, such as Taiwan and India, require the beneficial owner of a stock to be identified during trading, which raises concerns over information leakage.
Synthetic access to these markets is not absolute, even among pure-play broker dealers. Goldman Sachs, frequently rated alongside Morgan Stanley as an industry leader in prime brokerage, was not able to provide synthetic short positions in China, India, Pakistan or Vietnam as of 2012, although coverage for long positions was available.
Going long
However, a lack of short coverage is not necessarily a problem says Paul Hamill, global head of prime finance at HSBC. “A lot of synthetic business is for longer term. Clients may want to lock up positions for longer duration and that comes back to having a partner with stability of funding, credit quality and balance sheet strength.”
In Europe the rise of transaction taxes in countries such as France, combined with long-standing stamp duty in the UK, has pushed up the interest in trading on swap. “For a long time, hedge funds have traded most of the UK on swaps or synthetically,” says a major US broker dealer’s head of prime brokerage in Europe, the Middle East and Africa. “Over the past year or two, the increase in transaction taxes across Europe has had a similar effect. Almost all of them tend to tax the cash market and not swap market.”
A lesser issue is that firms will need to use a swap structure rather than a cash structure if they are running leveraged Ucits (Undertakings for Collective Investment in Transferable Securities) funds in Europe that can be accessed by retail investors.
Clouds on the horizon
Despite the appeal of the products, potential disruption is looming for users. Regulations are coming into effect at an uneven pace around the world that will ensure any trades of over-the-counter (OTC) derivatives, such as swaps, are cleared by a central counterparty that will effectively guarantee each side of the trade, but only on the basis that both counterparties deposit lumps of assets with it as an insurance policy.
For funds, this will have the effect of pushing up the cost of swap trading. In addition, the leverage ratio under new Basel III capital adequacy rules, due to be phased into effect from January 2014, includes a 10% to 15% add-on factor for determining potential future exposure for financial swaps, making it more expensive for banks to hold derivatives on their books.
“Secured financing is a very balance sheet- and capital-intensive business and recent developments on the regulatory front suggest that most market participants will be more constrained than ever,” says State Street’s Mr Fleming. “Proposals such as the supplementary leverage ratio standards could be really troublesome for most players in the market. It forces banks to gross up their exposures. Unless a change is made to the proposal, they are going to have to work out a way to operate in a world where exposures are grossed up. This could change pricing and/or the distribution of business, as the supplementary leverage ratio could become the binding regulatory constraint for a lot of the big banks.”
The Basel rules have also increased the margin period for which firms with large positions, defined as 5000 trades or more, need to hold collateral. Whereas under previous rules enough margin was required to cover a five- to 10-day period for closing out the positions held, it has been extended to 20 days for securities financing transactions and OTC derivatives under the new rules.
Unbalanced picture
Not all firms will be affected by the increased margin period. The International Swaps and Derivatives Association Margin Survey for 2013 showed that 87.4% of all collateral agreements are with counterparties whose portfolios of collateralised transactions include fewer than 100 OTC derivatives. Just 0.4% of all collateral agreements are with counterparties whose portfolios of collateralised transactions include more than 5000 trades.
Uncertainty surrounds many of these rules, which are still to be implemented, making the significance of their impact on business hard to predict. The best brokers can do is offer a comprehensive range of products so that clients can pick the most cost-effective route to market.
“In our business we have a combined offering,” says HSBC’s Mr Hamill. “Whether clients want to trade synthetically or in cash, we are equally conversant. The sales people covering hedge fund clients are agnostic as to whether their client trades cash or synthetically.”
