Bill Hwang was considered a stock-picking genius throughout Wall Street. After setting up his family office in 2013, Hwang turned the $200 million that was left over from a shuttered hedge fund into $20 billion over the course of seven years, establishing himself as one of the most liquid investors throughout banking circles.
It was this kind of reputation that enabled Archegos Capital to gain access to funding from some of the top investment banks and prime brokers in the world, including Credit Suisse, Goldman Sachs, Morgan Stanley and UBS. Then in March 2021 – exactly 12 months after pandemic-driven volatility was dubbed March madness – it was all gone, leaving the prime brokerage industry with a combined loss of over $10 billion, of which over half went to Credit Suisse.
The liquidation of Archegos has gone down as one of the most dramatic events in recent financial history, alongside such incidents as the collapse of Long-Term Capital Management (LTCM) in 1998 and Lehman Brothers in 2008.
The industry had shored up its leveraging models since LTCM, while the financial crisis had shown the necessity of appropriate margin against loans and the quality of collateral. So what went wrong? How could the default of a single counterparty cause so much havoc?
Duping Wall Street
A key reason why Hwang’s positions swelled to overwhelming levels while also remaining hidden from other counterparties was because he was able to use swaps – specifically total return swaps – giving him exposure to certain securities without directly owning them. Through these swaps, Hwang was able to conceal his identity, the size of his positions and who he was also borrowing from.
As the price of these stocks went up, Hwang was able to take out more swaps while putting down very little cash down as collateral. Eventually, Archegos was leveraged by five times its size with its portfolio amounting to $30 billion, mostly in US and Chinese technology stocks, of which Credit Suisse was exposed to $20 billion.
None of these positions appeared to raise any alarm bells at the big banks. Prime brokerage, specifically synthetics prime brokerage which includes Delta One and swaps trading, has become an incredibly profitable segment for investment banks. Research at the beginning of last year from Aite Group estimated that total revenues for the prime brokerage industry would top $30 billion, representing 8% compound annual growth between 2015 and the end of 2020.
Yet Hwang was also convicted of wire fraud and insider trading in 2012, and was then banned from trading by Hong Kong’s regulator in 2014. To say that the risk management divisions at these prime brokerage firms were asleep at the wheel would be a huge understatement.
The stocks that kicked off the collapse were US media group ViacomCBS and Discovery. In March, Archegos’s long position in these two stocks soared, where it was able to secure most of its financing from Credit Suisse, according to a report by the Wall Street Journal. As the share price of these stocks began to fall, it triggered margin calls that Archegos failed to meet.
What followed was a $20 billion fire sale as the banks, or at least some of them, rushed to sell off the fund’s positions to make back that cash. As the dust settled, Credit Suisse reported $5.5 billion in losses tied to Archegos, while Nomura tallied nearly $3 billion, and Morgan Stanley just under $1 billion.
Lessons from the collapse
The Swiss bank has now published a scathing report into its failings with Archegos by law firm Paul Weiss, Rifkind and Warton, where it interviewed 80 current and former employees, as well as collecting over 10 million documents relating to the implosion.
The report found that neither business nor risk personnel had engaged in fraudulent or illegal activities related to the Archegos collapse, but risk systems had failed to operate sufficiently to identify critical risks.
“There were numerous warning signals— including large, persistent limit breaches —indicating that Archegos’s concentrated, volatile, and severely under-margined swap positions posed catastrophic risk to [Credit Suisse],” said the report. “Yet the business, from the in-business risk managers to the global head of equities, as well as the risk function, failed to heed these signs, despite evidence that some individuals did raise concerns appropriately.”
Credit Suisse failed to action a response to Archegos’s “continuous” potential exposure limit breaches throughout the end of last year and into the beginning of 2021, the report added, and highlighted that Credit Suisse agreed to reduce Archegos’s default margin rate on swaps to 7.5% subject to certain conditions, following claims from the family office that it had been able to obtain more competitive rates from rival prime brokers.
According to reports, Credit Suisse only made $17.5 million from its relationship with Archegos in the preceding year. It is now planning to write down $35 billion of hedge fund balances, where it will focus on its underlying risk positions and the types of clients it services.
Elsewhere, Nomura is planning to close its cash prime brokerage businesses in the US and Europe, dealing a major blow to its global ambitions.
While Credit Suisse is bearing the brunt of the collapse, there are much wider consequences happening for both hedge funds and other prime brokers.
For prime brokers, the first is around transparency. Since the financial crisis, hedge funds have geared towards a multi-prime broker model for diversification and to mitigate concentration risk with a single provider. However, in this model, the prime brokers do not have any transparency into who else their hedge fund client is using. This lack of transparency enabled Archegos to borrow without raising the alarms at the big primes.
The next is on their risk models. According to Ajay Patel, a client solutions analyst at Lab49, certain risk factors originated in the same structural changes that have made prime brokerage a more competitive industry. “That Archegos could access margin loans on accommodating terms is partly a function of a crowded market conducive to banks taking on more risk,” he says.
Nearly every prime broker will have had to recalibrate how they calculate risk, how they are pricing leverage, margin procedures, as well as reviewing their client book to see how directly or indirectly impacted they were. For the most part, margins were raised and some riskier clients have been cut.
Others are going to much greater lengths to reduce risk. JP Morgan has reportedly told its hedge fund and family office clients it will ask for them to post variation margin up to seven times a day on their single-name equity swaps if they lose value intraday.
Already, hedge funds have begun to scale back the amount of leverage they use for their trades. According to data from the US Financial Industry Regulatory Authority (FINRA), hedge funds borrowed $844 billion against their portfolios in June, down from a record $882 billion a month earlier and the lowest since March.
Prime brokers may also have to think about restructuring their offering. Traditional prime brokerage – such as providing lending services to hedge funds – has become increasingly intertwined with the trading desks of investment banks. With increased transparency into these relationships, banks may be forced to draw clear lines between these services.
“Banks could be forced to rethink synthetic financing and how it works alongside their cash business. Trade execution and financing generally happen in one place, therefore there is a certain amount of information that is sometimes available on the trading desk, rather than behind a Chinese wall. As prime brokers ask for greater disclosure, hedge funds will have to be certain that their information will stay in the right place and not spread around the bank that can be used against them,” says Jack Inglis, CEO of the Alternatives Investment Management Association (AIMA).
The final impact is on technology. Prime brokers will be under intense pressure to update their legacy technology infrastructure where it can keep track of risk and margin levels when markets are extremely volatile.
“Unwieldy, legacy-based technology estates obstruct a consolidated global view of client risk across different platforms. Credit Suisse’s risk management systems reportedly struggled to keep pace with its growing exposure to Archegos because of an incomplete roll-out of dynamic margining,” Patel adds.
The result of these consequences could have a significant impact on the hedge fund-prime broker dynamic.
“These recent outsized liquidations will absolutely drive prime brokers and swaps providers to reassess their relationships with hedge funds, the use of leverage and risk-covering margins,” says Jon Yalmokas, global head of prime services, Cantor Fitzgerald. “Those most impacted will no doubt reduce their capacity to service them, and the rest will re-consider the right price and margins going forward. As a result, there will be a recalibration of the prime brokerage landscape.”
As Credit Suisse looks to massively resize its prime services division, a number of other banks could emerge as winners. The likes of Barclays, BNP Paribas, Bank of America Merrill Lynch, JP Morgan and Goldman Sachs have all picked up former clients of the Swiss bank. It also opens the possibility for new players to grab market share.
“Our prime brokerage business is up and running and in growth mode; we will adapt and remain flexible as the market changes. As the market shifts and the competition continues to review their relationships, potentially parting ways with clients, opportunities will be created for firms like ours,” explains Bjorn Franson, director, prime brokerage sales, Mirae Asset Securities.
Incoming regulatory action
Regulators have already begun work to investigate how the collapse of a single counterparty could cause so much havoc. A large part of why the meltdown of Archegos was dramatic was that it was able to exploit several regulatory loopholes. The fact that it was a family office – which invests with its own money and does not handle a client book – meant that it was able to avoid the strict post-trade regulatory regime that has impacted hedge funds and asset managers.
So it begs the question, had Archegos’s swap trades been subject to post-trade transparency rules, would regulators or prime brokers have been able to see the excessive build up in exposure and take pre-emptive mitigating actions to avoid losses?
Another spin on this crazy story is that regulators have delayed key pieces of legislation that, had they come into effect when they were intended to, would have shone a light on the size of Archegos’s positions.
The first is the delay to the application of security-based swap data repositories (SBSDR), despite them being set out in Dodd-Frank. SBSDRs suffered either from not being prioritised sufficiently, ran into difficulties in implementation, or suffered from a lack of political will. This has now changed with Gary Gensler, who implemented the post-financial crisis rules for the derivatives industry, now at the helm of the US Securities and Exchange Commission (SEC). Already, he has approved the application for DTCC to operate as a SBSDR from November this year.
The other is the latest phase of the uncleared margin rules (UMR), which affects OTC FX and equity derivatives. Margin requirements for derivatives portfolios with over $50 billion in notional value were set to be introduced in September 2020, but with COVID-19, regulators had pushed back the implementation of the rules that covered smaller firms to September 2022. That decision meant that Archegos, which held derivatives positions worth more than $50 billion with the prime brokers, was not required by any US regulators to post margin when it first initiated a trade.
Gensler has said his administration has begun work to introduce measures that will increase transparency for equity derivatives. These will most likely include new reporting requirements for total return equity swaps. Regulatory scrutiny will also likely increase on prime brokerage financing, and could force hedge funds to disclose their portfolio holdings, in addition to rules on short selling following the GameStop frenzy in January.
However, hedge funds will be determined to convince regulators that what occurred was unique as Archegos was not required to disclose its positions due to its status of being a private family office. Hedge funds will also want to draw regulators’ attention to their risk management practices when it comes to borrowing from prime brokers.
“Hedge funds will be asking: ‘because Archegos was a family office, was it running portfolios in the same way a hedge fund does?’ What most found is that they weren’t. In addition, prime brokers have always been willing to lend more than what hedge funds want to borrow, but it is prudent risk management to avoid borrowing to the limit of what they could,” adds AIMA’s Inglis.
The fallout of Archegos is likely to have long-term effects on the prime brokerage and hedge fund industry. People will most likely remember its collapse in the same way they recollect LTCM, and the regulatory hammer could fall hard on the industry.
Prime brokers will also likely go through a period of being conservative when it comes to financing and the risk they take on. The descaling of Credit Suisse’s prime brokerage business may not have any material impact on the top of the industry rankings, but there could be a major rejig amongst the mid-tier players. For hedge funds and other family offices, tough times are ahead and may face a squeeze from their providers to post more margin on trades. What is clear, is that confidence will have to be re-established from both provider and clients.