Will the spectacular collapse of Archegos prompt new regulations?
One might think that banks would think twice before doing business with a man who paid $60 million in fines and shut down his investment fund after pleading guilty to insider trading in 2012, and was banned from trading in Hong Kong in 2014. In fact, banks not only did business with Billy Hwang but handed over billions to his Archegos Capital Management Fund – and are now facing billions in losses as his fund collapses. Japanese financial holdings company Nomura and Credit Suisse seem the most exposed but other finance titans including UBS, Morgan Stanley, Deutsche Bank, Citigroup, BNP Paribas, and Goldman Sachs have also been caught with their pants down.
At the heart of the crisis lies a financial instrument known as ‘total return swaps’ or ‘contracts-for-difference’. In essence, these swaps let investors bet on whether the price of certain assets will go up or down without having to own the asset itself. If the bet is right the investor makes money – if its wrong the investor pays money to the bank that owns the asset they were betting on. It’s the sort risky, highly-leveraged trading that gets finance wizards salivating about high returns – but has also rung alarm bells with critics who argue that companies use lax disclosure rules to hide how big the risks they are taking really are.
This seems to be the story of what happened with Hwang and Archegos. After Hwang’s court case he set up a new fund – Archegos – just 12 months later, but banks initially stayed away. Over time, however, the calculus changed. Hwang may have blown up spectacularly once, but he retained a reputation as a moneymaking genius. According to FT reporting, prime brokers at investment banks – the division responsible for the risky business of loaning cash and securities to hedge funds – lobbied to be allowed to make deals with Hwang, slowly overcoming the objections within the banks they worked for. The banks lent their assets to Archegos, allowing it make bigger and bigger bets. The fund flourished, its assets growing from just $200 million in 2012 almost $10 billion this year.
Yet as the fund grew it wasn’t clear that the bankers doing business with Archegos knew about the size of its deals with their competitors, and so underestimated the risks they were running. The dam broke on Friday when markets saw a sudden, unexpected sell-off of billions of US and Chinese stocks by a then-unknown entity – Archegos.
What had happened is that Archegos had failed a margin call. In non-finance speak, Archegos owned large quantities of stock in the US media group ViacomCBS. When the price of this stock declined financial brokers who lent Archegos money based on the value of the assets it owned asked for funds to put up more capital to cover the risk. This is known as a margin call. The problem was that Archegos – which already had huge amounts of cash tied up in complex financial bets – simply couldn’t pay.
The fire sale of stocks on Friday was an attempt to raise cash by Archegos to meet the collateral requirements. However, a selling spree on that scale had the predictable result of cratering the price of the stocks. Banks like Goldman Sachs and Morgan Stanley that helped arrange the sales early on managed to salvage some of their losses from Archegos’ collapse. Others like Credit Suisse and Nomura which failed to act have been left holding the bag.
So, what does this mean for the wider economy? This tale of swaps gone wrong and private funds blowing up has raised memories of the 2008 financial crisis and the fall of Long-Term Capital Management in 1998 which helped spark a minor recession. Thankfully, however, things don’t look as dire this time around partly thanks to post-2008 rules which require banks to keep more cash in reserve as a safety buffer. Still, this spectacular bust is a shot across the bows about the risks present in a financial system which has seen an incredible bull run – and may well spur regulators to take action.