In trying to curb short selling, what the Securities and Exchange Commission hasn’t accounted for is that hedge funds wanting to wager that a stock’s price will fall can do so synthetically—and save on borrowing costs and taxes without anyone knowing what they are up to. So will the SEC crack down on synthetic shorts too?
“One of the big questions about last year’s new rules was about synthetics,” says a lawyer who represents marquee hedge funds. “The SEC was wondering whether it would be missing the boat if it doesn’t deal with synthetic shorts. To try and address the issue is very complicated.” For one, to get a full picture of market sentiment and fund exposure, the SEC needs to factor in equity puts (the right to sell a stock at a future date).
In a roundtable meeting scheduled for September 30, the SEC is expected to address a number of complicated issues regarding short sales, including the role of synthetics. A fund manager can create synthetic short exposure to a stock by entering into a contract with a counterparty, usually a big bank, that agrees to take the opposite view. If the price of the stock declines, the bank posts the difference, and if the stock price rises, the hedge fund does. Not only do these swaps allow one to get the desired economic exposure without having to deal with the cash market, synthetic shorts also receive much better tax treatment, as earnings can be treated as long-term capital gains if held long enough. CS
