Archegos collapse caused by synthetic prime brokerage and risk management failings, says ESMA

In a new study, ESMA analyses how the use of synthetic prime brokerage allowed the family office to remain ‘largely invisible’ to regulators.

The European Securities and Markets Authority (ESMA) has published a study analysing the March 2021 default of New York-based family office, Archegos, which led to significant losses for various global banks.

Although at the time it was difficult to predict the collapse, due to the fact that Archegos was able to avoid reporting requirements, ESMA’s study uses data from EMIR to analyse Archegos positions and to demonstrate the possibility of tracking the steep increase in concentrated exposures that the family office undertook in February and March last year.

ESMA confirmed that it was the use of total return swaps (TRS) through synthetic prime brokers that enabled Archegos  to avoid revealing its positions to regulators, while also building up leverage which a traditional position developed through a cash prime broker would not have allowed.

“Synthetic prime brokerage financing is considered more efficient than ‘traditional’ financing from a balance sheet and/or funding perspective. Synthetic prime brokerage allows banks to reduce capital and liquidity costs by hedging and netting derivatives exposures against their trading book,” said the regulator.

By purchasing the underlying security, TRSs allow banks to be perfectly hedged, which leads to reduced regulatory requirements when compared to traditional cash prime brokerage financing. In addition, Archegos’ use of derivatives meant the firm did not have to disclose its stakes in the different companies it was exposed to.

“Overall, Archegos operations were largely invisible to regulators and market participants (being swap counterparties),” said ESMA. “As a family office, Archegos was exempted from reporting requirements to the Securities and Exchange Commission (SEC) and Financial Stability Oversight Council (FSOC). By using derivatives, Archegos did not have to disclose its stakes in companies (while the bank counterparties had to disclose their positions).”

ESMA also attributed the large extent of losses borne by counterparty banks to significant risk management issues. Due to the absence of appropriate margin requirements from some of its counterparties, the family office was able to build large and concentrated positions.

“If initial and variation margins posted by Archegos had been higher, counterparties would have been able to cover better some of their losses related to the liquidation of securities with the margins posted by Archegos,” said ESMA.

“In addition, given the market footprint of Archegos in some underlying stocks, concentration add-ons – additional initial margins required to account for liquidation costs of concentrated positions compared to the market absorbing capacity – could have reduced the ultimate risks borne by the counterparties.”

The collapse of Archegos demonstrated how risks associated with leverage, concentration and interconnectedness can rapidly develop – highlighting the need for more work to be done to monitor risks related to derivatives and leverage.

“Over a year on from the Archegos saga, there are still far more questions than there are answers from a risk perspective. Just how many other funds are left holding cash equity positions that act as misdirection to mask trades that are the exact opposite of the position?

“In other words, a fund manager may own some of the equity in much more renowned stocks such as Microsoft or Tesla and, at the same time, may also be synthetically shorting the same company through total return swaps in order to bet against the stock,” said Oliver Blower, CEO of fintech firm VoxSmart, speaking to The TRADE.

“Is it a case of the bigger the name, the bigger the risk? Who knows, but one thing is for certain, it would be a brave firm that decides against carrying out a root-and-branch review of the context around their swaps trades as the post-Archegos analysis rumbles on.”

ESMA claims that its study shows some of the ways in which extensive data collected by trade repositories under EMIR can be used by NCAs, central banks and ESMA itself, to monitor risks.

“Looking forward, further work is needed to put forward a framework whereby different regulatory reporting could be analysed together to enable Authorities to monitor risks,” concluded the regulator.