A hedge fund called Renaissance Technologies wants to take $1 billion cash and put it into a prime broker, Deutsche Bank. Then Renaissance wants to leverage that cash 10x to trade $10 billion of assets.
The SEC has a basic margin requirement for brokerage positions of 2:1. Renaissance Technologies should only be allowed to trade $2B.
The banks do what they want to do. They just change what they call it.
From Bloomberg [1]:
- Renaissance pays $1 billion of option premium to a subsidiary owned by Deutsche Bank.
- Deutsche puts $9 billion of its own money into the subsidiary. But it writes a 3-year American call option on the subsidiary’s performance to Renaissance.
- The subsidiary hires Renaissance as an investment manager, for a small fee. Renaissance advises the subsidiary on how to trade.
- In a little over a year, Renaissance exercises its option. Its payout on the option is the upside above $9.X billion, where $9.X billion is Deutsche’s initial leverage plus interest and fees.
Same actions, different terminology. It works great because there’s no margin rule on options, so they could use as much leverage as they liked. Also, Renaissance didn’t have to pay short-term capital gains taxes on all the trading, because they waited a year to exercise the option.
Finance is like one big game of Calvinball, with a crapload more money.
See Also:
1. Senate Literary Critics Don’t Like Fictional Derivatives –BloombergView
2. Simons Strategy to Shield Profit From Taxes Draws IRS Ire –Bloomberg
3. Subcommittee finds “basket options” misused to dodge billions in taxes and bypass federal leverage limits –senate.gov
4. Complex Strategies
Elaine's Idle Mind 