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  Ask A Banker: Derivatives, Gambling And Getting Around Regulation
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ContributorRP 
Last EditedRP  Oct 25, 2012 09:09am
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AuthorMatt Levine
News DateWednesday, October 24, 2012 01:15:00 PM UTC0:0
DescriptionDerivatives let you shift economic outcomes, yes, but they're equally important for shifting outcomes of legal and regulatory regimes – like, just to start with, the gambling laws. Derivatives are tools for hacking the tax code, or the securities laws, or U.S. generally accepted accounting principles. This is called "regulatory arbitrage."

Some examples. A very simple sort of derivative is the "equity total return swap." This is a contract in which a bank agrees to give you money if a certain stock goes up, or pays dividends, and you agree to give the bank money if the stock goes down. So if IBM stock is worth $200 today, and you enter a one-year total return swap on IBM, then if IBM ends up at $220 you'll get $20. If it ends up at $170, you'll lose $30. In any case you'll get the dividends — about $3.40 per share — that IBM pays over that year.

If you buy IBM stock in your Cayman Islands hedge fund, and it pays you a $3.40 dividend, the IRS holds on to 30% of that dividend, so you only get $2.38. But if you buy a swap, the swap pays you the full $3.40 dividend. You've made an extra dollar and change just by changing the formalities.
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