How RenTec Made More Than $34 Billion In Profits Since 1998: "Fictional Derivatives"
Ten days ago Bloomberg reported that as a result of various tax dodges, one of the fastest-trading hedge funds in the US, Jim Simmons' Renaissance Technologies, had managed to avoid paying ordinary income tax on billions in profits, by classifying trades that often times had a holding period of minutes if not seconds, as a long-term capital gain. As part of this finding, it was reported that there would be a hearing chaired by none other than Carl "Shitty Deal" Levin scheduled for tomorrow morning when yet another tax loophole abused by not only RenTec but all of its high churn and HFT peers (because the "friends and family" Medallion is at its core the original HFT fund) would be exposed for all to see. Moments ago, in advance of tomorrow's 9:30 am hearing, the permanent subcommittee on investigations released a 93 page report on just how it was that RenTec engaged in the "improper use of this structured financial product, known as basket options."
As the preamble to the report notes:
The report outlines how Deutsche Bank AG and Barclays Bank PLC, over the course of more than a decade, sold financial products known as basket options to more than a dozen hedge funds. From 1998 to 2013, the banks sold 199 basket options to hedge funds which used them to conduct more than $100 billion in trades. The subcommittee focused on options involving two of the largest basket option users, Renaissance Technology Corp. LLC (“RenTec”) and George Weiss Associates.
The hedge funds often exercised the options shortly after the one-year mark and claimed the trading profits were eligible for the lower income tax rate that applies to long-term capital gains on assets held for at least a year. RenTec claimed it could treat the trading profits as long term gains, even though it executed an average of 26 to 39 million trades per year and held many positions for mere seconds.
Data provided by the participants indicates that basket options produced about $34 billion in trading profits for RenTec alone, and more than $1 billion in financing and trading fees for the two banks.
And considering the topic of tax-evasion and loophole abuse is a rather sensitive and politically-charged one nowadays, to say the least, one can be certain that tomorrow's hearing, full of sound and fury targeting America's wealthiest tax evaders, will be quite a spectacle.
The highlights from the report:
For the last decade, the U.S. Senate Permanent Subcommittee on Investigations has presented case histories showing how financial institutions, law firms, accountants, and others have designed and implemented complex financial structures to take advantage of and, at times, abuse or violate U.S. tax statutes, securities regulations, and accounting rules. This investigation offers yet another detailed case study of how two financial institutions – Deutsche Bank AG and Barclays Bank PLC – developed structured financial products called MAPS and COLT, two types of basket options, and sold them to one or more hedge funds, including Renaissance Technologies LLC and George Weiss Associates, that used them to avoid federal taxes and leverage limits on buying securities with borrowed funds. While that type of option product was identified as abusive in a public memorandum by the Internal Revenue Service (IRS) in 2010, taxes have yet to be collected on many of the basket option transactions and its use to circumvent federal leverage limits has yet to be analyzed or halted.
The basket option contracts examined by the Subcommittee investigation were used by at least 13 hedge funds to conduct over $100 billion in securities trades, most of which were short-term transactions and some of which lasted only seconds. Yet the resulting short-term profits were frequently cast as long-term capital gains subject to a 20% tax rate (previously 15%) rather than the ordinary income tax rate (currently as high as 39%) that would otherwise apply to investors in hedge funds engaged in daily trading. While the banks styled the trading arrangement as an “option” under which profits from short-term trades would be treated as long term capital gains, in essence, the banks loaned the hedge funds money to finance their trading and allowed them to trade for themselves in highly leveraged positions in the banks’ proprietary accounts and reap the resulting profits. The banks offering the “options” benefited from the financing, trading, and other fees charged to the hedge funds initiating the trades. In the end, the trading conducted by the hedge funds using the basket option accounts was virtually indistinguishable from the trading conducted by hedge funds using their own brokerage accounts, and provided no justification for treating the resulting short-term trading profits as long-term capital gains.
Note that the term "illegal" is not used once in the entire 93-page doc, for the simple reason that this latest tax-evading loophole wasn't. Instead hedge funds, having the sources to do so, merely scoured the tax code and sitting down with a couple of less than "moral" banks found yet another tax evasion maneuver, as well as a way to implement it, that was available to everyone who could afford to spend millions on the appropriate tax and legal advice. Call it "capital investment" for the New Normal.
Back to the filing, we find what will surely be Carl Levin's punchline to be used and abused tomorrow: "fictional derivatives."
The facts indicate that the basket option structures examined in this investigation were devised by sophisticated financial firms to allow clients to circumvent federal taxes and leverage limits. The structures rested on two fictions. The first was that the bank, rather than the hedge fund, owned the assets being traded in the designated option accounts, even though the hedge fund bought and sold the assets, was exposed to all significant risks and rewards, and profited from the trading, with little input from the bank serving as the nominal owner of the assets. In effect, the structure purported to enable the hedge fund to purchase an “option” on its own trading activity, an arrangement that makes no economic sense outside of an effort to bypass federal taxes and leverage limits. The second fiction was that the profits from the trades controlled by the hedge fund could be treated as long-term capital gains, even for trades lasting seconds. That fiction depended upon the hedge fund claiming that the profits came from exercising the “option” rather than from executing the underlying trades. In fact, the “option” functioned as little more than a fictional derivative, permitting the hedge fund to cast short-term capital gains as long-term gains and authorizing financing at levels otherwise legally barred for a customer’s U.S. brokerage account.
And, lo and behold, one of the two main enabling banks of this tax dodge is none other than Barclays, which somehow has managed to get itself involved in virtually every possible financial scandal in the past five years.
The basket options sold by Deutsche Bank AG starting in 1998, and by Barclays Bank PLC since 2002, produced a total of more than $35 billion in trading profits, of which at least $34 billion came from options exercised after more than one year. Most of those profits came from assets which were held for less than one year but which were treated by the hedge funds holding the options as having produced long-term capital gains taxable at the lower long-term capital gains rate. The options were also used by the participating hedge funds to trade on borrowed funds using a leverage ratio of as much as 20:1, versus the much lower federal leverage limit of 2:1 that normally applies to brokerage accounts held by U.S. broker-dealers for their clients. These financially engineered products – which relied on high volume trading, leveraged funds, and artificially lowered tax rates to produce their profits – warrant greater attention from federal tax, securities, and banking regulators to prevent their continued misuse.
Some details on the actual trading strategy, with pictures.
In the basket option contracts examined by the Subcommittee, the bank always appointed the general partner of the hedge fund client to act as the investment advisor for the trading account holding the referenced assets during the duration of the option. Once appointed, the investment adviser exercised complete control over the securities included in the option account, designing its own trading strategy and using the bank’s own facilities to execute the trades. In some cases reviewed by the Subcommittee, the investment advisor used algorithms to engage in a high volume of trading, executing more than a 100,000 transactions per day.
Oops, HFTs. Even assuming you can continue your spotless trading record now that your frontrunning gig has been shown to the entire world, there goes your tax-free lunch.
Many of those trading positions lasted minutes, and the overall composition of the securities basket changed on a second-to-second basis. One basket option account later reviewed by the Securities and Exchange Commission (SEC) was found to have experienced 129 million orders in a year. In other cases, the investment adviser purchased securities whose positions remained unchanged for weeks, but all of the basket option accounts reviewed by the Subcommittee were dominated by short-term trading involving assets held less than one year.
By acting as the investment adviser, the hedge fund – the option holder – became the party that actually controlled the trading strategy, the timing of trades, and what assets were selected for the referenced account. The hedge fund was also exposed to all significant rewards and risks associated with the trading. The banks claimed that the hedge funds did not bear 100% of the risk of loss, because the banks provided so-called “gap” protection in the event of a catastrophic market failure. That risk was so small, however, that despite, for example, hundreds of millions of trades that took place in the more than 60 basket options held by RenTec over a decade, including during the worst financial crisis in a generation, neither bank was ever required to satisfy a loss due to a market failure.
To further minimize the gap risk, the option contract contained several provisions designed to limit trading losses in the account to the 10% premium provided by the hedge fund. The key provision accomplished that objective by specifying a loss threshold – sometimes called a “barrier” or “knockout” amount – which if reached would cause the option to cease to exist, or “knockout,” and trigger the ability of the bank to liquidate the account assets.
During the period of the option, the securities transactions were executed in the name of the bank and the resulting securities were held in the bank’s proprietary trading account. The accompanying profits or losses also remained within the account until the option was exercised. The hedge fund chose when to exercise the option. Although the options reviewed by the Subcommittee often had three-year terms and the hedge funds claimed they wanted longer-term financing arrangements, the hedge funds often exercised the options shortly after 12 months. In all cases examined by the Subcommittee, the option accounts paid the profits to the hedge fund option holder.
Deutsche Bank developed its basket option product in 1998, naming it the Managed Account Product Structure (MAPS). Over the next 15 years, Deutsche Bank sold 156 MAPS options, of which 96 had terms greater than one year. At their peak, those 96 options had assets with a total initial notional value of about $60 billion. Deutsche Bank sold the MAPS options to 13 hedge funds, including 36 to RenTec. Of those 36 option contracts, the first 29 had terms greater than one year. The MAPS options sold to RenTec produced profits for that hedge fund totaling about $17 billion. The MAPS options sold to all 13 hedge funds produced revenues for Deutsche Bank totaling about $570 million.
The Barclays’ basket options product was developed in 2002, at the request of RenTec, and was named COLT. Barclays sold 43 COLT options to RenTec, of which 31 had terms greater than one year. At their peak, those 31 COLT options had assets with a total initial notional value of about $62 billion. The COLT options produced trading profits for RenTec totaling about $18.5 billion. They also produced revenues for Barclays totaling about $655 million.
And so on, with all the above complexity driven by a simple motive: to reclassify short-term capital gains into long-term profits, in the process saving about 25% of the absolute profit from any transaction.
What we hope to learn from tomorrow's hearing is whether it will explain why, even as actual stock trading volumes have plunged in recent years, trading in derivatives has literally exploded. Surely everyone engaging in comparable "basket option" strategies would explain at least a part of it.
If nothing else, however, we now know why some of the biggest HFT-related hedge funds in the world: Citadel, Millennium, Balysany and DE Shaw have such an epic regulatory-to-net asset leverage as we showed before: the reason, one as old as time itself: to avoid paying tax. From the report:
In addition to avoiding taxes, the structure was used by the banks
and hedge funds to evade federal leverage limits designed to protect
against the risk of trading securities with borrowed money. Leverage
limits were enacted into law after the stock market crash of 1929, when
stock losses led to the collapse of not only the stock speculators, but
also the banks that lent them money and were unable to collect.
Had the hedge funds made their trades in a normal brokerage account,
they would have been subject to a 2-to-1 leverage limit – that is, for
every $2 in total holdings in the account, $1 could be borrowed from the
broker. But because the option accounts were in the name of the bank,
the option structure created the fiction that the bank was transferring
its own money into its own proprietary trading accounts instead of
lending to its hedge-fund clients.
Using this structure, hedge funds piled on exponentially more debt than leverage limits allow, in one case permitting a leverage ratio of 20-to-1. The banks pretended that the money placed into the accounts were not loans to its customers, even though the hedge funds paid financing fees for use of the money. While the two banks have stopped selling basket options as a way for clients to claim long-term capital gains, they continue to use the structures to avoid federal leverage limits.
And as we showed previously:
And while we understand the Congressional the fascination with RenTec, created by Jim Simons, the 64th richest man in the world with a $15.5 billion net worth, we wonder why the NY Fed's (and the PPT's) very own favorite Spoo-buying counterparty, Citadel, which has a gross leverage of over 9x(!) is not mentioned even once.
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