The Archegos Capital saga blew up last Friday when Goldman Sachs and Morgan Stanley began winding down huge positions in US and Chinese stocks. It was a response to a failed margin call from an unnamed investment fund, now unveiled as Archegos Capital.
The family office was set up and run by Bill Hwang, an alumnus of the Tiger Management hedge fund with a history; he paid $44m to settle a US insider trading case in 2012, and in 2014 he was banned from trading in Hong Kong for four years. At first blacklisted by banks, they eventually fought to win his once lucrative business.
Archegos had secured billions of dollars in credit from several investment banks using opaque financial derivatives that enabled it to amass massive stakes in companies under the radar. When its highly leveraged bets collapsed, it was hit hard and struggled to stump up enough cash as collateral to cover its margin. Â
That sparked a fire sale across Wall Street, with the rest of Archegos’ lenders racing to exit their positions or risk running up billions of dollars in losses. As markets around the world scramble to digest the reports, thorny questions are being raised and there are several important lessons in corporate governance and regulatory oversight emerging. Â
Salvatore Cantale, Professor of Finance at IMDÂ
The Archegos blow-up raises concerns over the regulatory oversight of family offices. They may be vulnerable to weak governance because those with fewer than 15 clients are excluded from even the most basic reporting requirements that larger hedge funds face. The US Securities and Exchange Commission lets family offices decide whether they want to register and open their books; Archegos discloses very little.
The waters were muddied by the complex financial derivatives that Archegos used to make trades that soured and spread across Wall Street. The instruments are called total return swaps, which allow investors to pay a fee for cash based on the performance of an asset. Swaps enable investors to amass stakes in companies without disclosing their holdings, especially if they are held with multiple banks, raising questions about risk management.
The Archegos saga underscores the need for tougher reporting requirements — to improve transparency and prevent financial contagion in wider markets. It’s unclear to what extent prime brokers knew about their own exposure to Archegos, because it magnified its position by holding swaps with several banks. But I suspect that if the banks were aware how leveraged the fund was getting they would have not extended credit with such high leverage ratios. The story is likely to draw the ire of regulators, but it is the responsibility of the board to evaluate a bank’s risk management procedures. It is clear that boards need to strengthen governance practices by improving lines of communication with the executive committee. The buck stops with the board.
“It is clear that boards need to strengthen governance practices by improving lines of communication with the executive committee: the buck stops with the board”- Salvatore Cantale
Karl Schmedders, Professor of Finance at IMDÂ
The Archegos debacle exposes the risk of financial leverage. A swarm of investment banks from Goldman Sachs to UBS provided billions of dollars in credit to the family office, so that it could make highly-leveraged bets on a host of US and Chinese stocks. But Archegos defaulted on margin calls — when capital falls below agreed levels, triggering bank calls for cash or collateral — triggered by a plunge in shares of ViacomCBS. Â
A coordinated exit from these huge positions would have limited the impact in wider markets and paired back the losses facing lenders. But multilateral talks broke down, and the banks promptly begun selling to staunch their own losses, triggering days of market volatility, hitting stocks such as Baidu and Tencent. The prime brokers — who loan cash to hedge funds and process their trades — that did not join the fire sale fast enough were left nursing heavy losses; Nomura warned it faces a $2bn hit.
In my view, there should be a cap on the leverage that banks can offer clients — especially those with a chequered history, amassing big stakes behind the scenes such as Bill Hwang — to reduce the risk to the wider stock market. Regulatory intervention would be timely, given how the era of ultra-low interest rates — putting pressure on banks’ profit margins — has fuelled a rise in leveraged investing. It’s provided lucrative fees for banks — that competed fiercely for Archegos’ business — but is now coming under heavy scrutiny following sharp share reversals.
27 November 2023 • by Michael Skapinker in Finance
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