Cum-Ex Trading – Update and Frequently Asked Questions – Series 3
In Series 2 we looked at the use of ETFs as an alternative way to access shares in order to effect a Cum-Ex strategy. In this instalment we move on to consider the use of Physically Settled Futures in these structures, why this alternative was required and the differences in execution compared to simply using Stock.
Why use Physically Settled Futures at all?
In response to prior Cum-Ex activity, in 2009 the German government moved to put in place regulations whose purpose was to eliminate opportunities to make multiple tax reclaims on the same share. The circular issued by the BMF [1] put in place the requirement for the claimant of Withholding Tax rebates (the share buyer) to confirm, via their auditor or tax advisor that there was no arrangement between the buyer and a short seller.
This left Cum-Ex participants with two options. Continue to effect the strategy in the same manner, with advisors notifying that there were no arrangements, or to find another way to conduct Cum-Ex without violating the new guidelines.
One option here was to set up funds for the purchase of shares, which by their nature benefitted from a fast track reclaim process that circumvented the guideline. The other was to exploit the fact that the ruling was focussed on (short) share sales and hence did not cover similar exposures coming into being via the instigation of, say, futures contracts.
How do Physically Settled Futures work?
Futures contracts confer the obligation on the buyer to buy an asset at a pre-agreed price at a future date. The seller of the futures contract has the corresponding obligation to sell the asset at the pre-agreed price on that future date. Many futures contracts are cash settled as a simple contract for difference, but some require physical settlement to be enacted by delivering the asset for the pre-agreed price.
Hence, for physically settled futures there are 3 key dates:
The Trade Date
The Expiry Date
The Settlement Date (Shares are delivered)
For the purposes of Cum-Ex, this allowed participants to mirror a short share sale by entering into physically settled futures which expired before Ex-Dividend date but the delivery of shares occurred after Ex-Dividend date. In this way, a manufactured dividend could be generated which in turn would trigger the tax rebate process, without the requirement to report the arrangement between the two parties. The longer standard settlement period for Physically Settled Futures (T+4) also gave participants more flexibility for delivery of the stock Ex-Dividend2, especially when many participants using stock-driven strategies were all aiming to buy in shares based on a T+2 settlement window.
Futures contracts are often standardised, but Physical Flex futures contracts could be customised to ensure that the expiry and settlement dates spanned the appropriate Ex-Dividend date.
How does the Cum-Ex strategy differ from using shares?
As shown in the diagram below, the structure does not differ wildly from the strategy utilising Stocks, as a recap have a look at the diagram in Series 1.
The sale of the Physically Settled Futures contract Cum-Dividend by the Seller, serves to create the same “Cum-Ex” profile via the definition of the contract Expiry and Settlement Dates. The Seller of the Futures contract is short of the stock on the expiry date and hence a manufactured dividend payment to the Buyer is generated which triggers the tax rebate claim. Stock is then bought in from a Share Provider Ex-Dividend to cover the short position. As in the standard trade, two tax rebates are made based on one dividend paid and one tax levied.
As in the case of using stocks, additional hedges (often Cash Settled Futures) are additionally conducted between parties to stabilise the proportion of profits attributed to each participant (Short Seller, Buyer & Share Provider).
The Proceedings of the Bonn Court case [2] show that the Participants used Physically Settled Futures in some of their funds to instigate alleged Cum-Ex trades in the years 2009-2011. This would have made settlement easier, as they and others scaled up their business and new entrants emerged deeming the sourcing of Ex-Dividend shares increasingly difficult.
We have looked in Series 3 at the alternative use of Physically Settled Futures in a Cum-Ex strategy. In the next article, we will consider how the use of pre-release ADR’s may drive dividend tax arbitrage opportunities and how these may be effected.
[1] BMF v. 05.05.2009 - IV C 1 -S 2252/09/10003 BStBl 2009 I S. 631
[2] Proceedings of the District Court Bonn, File Number: 62 KLs - 213 Js 41/19 - 1/19
FMCR is an industry-recognised equity dividend arbitrage expert and is currently undertaking multi-faceted investigations into high profile potentially irregular activities in several European markets.