Even at the once level headed Wall Street Journal, it seems now that any perceived wrong doing by banks is an opportunity for a headline article. This time around the topic is dividend arbitrage in securities lending, which has been flogged, abused and otherwise derided for years. Is it regulatory arbitrage? Of course it is. Is it legal and will be it commonplace until tax authorities harmonize their rules? Yes again. Unfortunately the WSJ has thrown mud into otherwise clearer waters.
The article, “Fed Questions Bank Maneuver to Reduce Hedge Funds’ Dividend Taxes,” offers one new piece of information concerning a little known lawsuit by Vulpes Investment Management (Singapore) against Bank of America. The lawsuit alleges that BofA owes $10 million to Vulpes from old div arb trades. BofA in turn was asked by the Richmond Federal Reserve about the practice. BofA senior management investigated and decided it was too profitable to ignore.
We are irked however because we thought the article was simplistic in its analysis. The article completely missed the part of the business that is generated by pension plans, insurance companies and asset managers. This is where most of the business actually lies, not with hedge funds. This is just a question of scale: pensions alone hold US$30 trillion in assets, according to the 2013 Towers Watson Global Pension Study. Hedge funds hold US$2.8 trillion. Some long only asset holders have moved away from div arb due to political considerations – it doesn’t look good to avoid paying taxes. Others have decided to stay in to earn the revenues. Its a personal choice for each investor and their stakeholders. At the same time, a recent review in Professional Pensions, “Securities lending could help offset lower bond/equity returns,” shows the upside to securities lending including div arb trades. Dividend arbitrage is not just the cut and dry “banks make $1 billion a year” headline that the WSJ went with.
Even the Charlotte Observer, based in Charlotte, North Carolina, was more sedate in its analysis. Their article, “Fed questions BofA on tax strategy for hedge funds, noted that “‘In the course of our regular and intensive supervision of Bank of America, we identified dividend arbitrage trading as an activity that required further examination of the risk and governance of the business,’ Richmond Fed spokesman Jim Strader said in an email to the Observer. “Bank of America has cooperated with our examination of the practice.'”
Our upshot is that the WSJ article came across as a scold on securities lending without looking more closely at the market; div arb is not perfect from the moral perspective of tax avoidance, but it is legal. The article is certainly not great press for securities finance in general. But more to the point, if tax authorities want to get serious about tax harmonization (or tax coordination between individual EU countries), then the trade would end. Until tax harmonization happens, the div arb trade and others like it will continue. It would be helpful if the WSJ, with its wide distribution, took note of that fact.
We did our own deep dive on the dividend arbitrage trade in September 2012, “Regulation, Taxation and the Outlook for Lending in European Securities“.