Archegos: Not So Fast!
It’s been a few weeks since the Archegos story broke and everyone seems to have moved on. As popularly told, it’s the emblematic story of inscrutable hedge funds, excessive leverage, regulatory failure, avaricious brokers, panic, and billions in losses. In other words, business as usual on Wall Street, but there’s more to it than has been popularly reported:
The prime brokers involved possibly colluded to limit their losses. No, it’s not ok to get together with your competitors to discuss influencing prices, no matter your motives.
Although tempting, don’t blame the risk managers too quickly. This was a general failure of management, not necessarily risk management. The fact that numerous prime brokers took on a client with a record such as Bill Hwang’s, and then allowed him substantial leverage, is a shameful indictment of senior management and a violation of basic common sense.
As usual, clients got the short end of the stick but will soon be back for more. Access to deal flow is everything.
Regulators should take their share of the blame. They knew of the reporting loophole and the possible systemic risk for at least 10 years and did nothing. Can we finally update reporting requirements to include all derivatives and get rid of the family office loophole?
Contagion risk should not be overstated. Despite a lot of media hype (“the biggest hedge fund blowup since LTCM,” etc.”), the market absorbed the selling without much effort. Apocalyptic risks that could come out of the blue are always present in the market. The real question is their probability and the costs of hedging against them.
At this point, the sordid details of Archegos’ rise and fall are well-known so I will only rehash the juicy bits:
Bill Hwang, né Sung Kook Hwang, was a Tiger Cub and formerly the PM of Tiger Asia Management, a hedge fund specializing in TMT. In 2012, he pled guilty to insider trading of Chinese bank stocks and paid a $44 mm fine to the SEC and HKD 45 mm to the Hong Kong authorities.
He then formed Archegos Capital Management, a family office with $500 million of his own money. He based the firm in NY since he was banned from trading in Hong Kong. Archegos’ AUM reportedly peaked out at $10 billion (was it all Hwang’s money?)
None of these details were a secret to the eight (maybe more) prime brokers that took Archegos and Hwang on as a client. Despite his background, they traded total return swaps with Hwang and offered him serious leverage, possibly as high as 10:1.
Hwang was well-known as a shooter and liked to push stocks in tech, media, and Asian stocks. Among his favorites were Viacom, Discovery, GSX, Tencent, Techedu, Baidu, Iqiyi, Shopify, Farfetch, and Vipshop.
The house of cards fell apart when Viacom, one of Archegos’ main holdings, and ironically one of the stocks that Hwang was pushing the hardest, announced a $3 billion sale of stock and convertible debt. The stock fell over 50% over the next few days. This triggered margin calls that Archegos could not meet since apparently all of its excess cash was pumped back into positions.
Archegos’ prime brokers then went to Defcon 1 (despite popular perception, the most extreme level) and held a series of meetings on how to avoid calamitous losses. Credit Suisse was allegedly pushing the idea of a temporary stand still so that all parties could figure out how to liquidate the positions without causing panic (and, by the way, causing them tremendous losses).
As in all such arrangements, the winner is usually the first out the door. Reportedly with the complicity of Hwang, Morgan Stanley and Goldman were the first to jump, quickly liquidating Archegos’ holdings at a block discount to a group of unlucky hedge fund clients who were not informed of the extent nor magnitude of the impending liquidation.
The net result, so far: Credit Suisse is reported to have lost $5.5 billion, Nomura $2.85 billion, Morgan Stanley $911 million, UBS $434 million, and Mitsubishi $300 million. CS responded by bloodletting, firing the chief risk officer, the co-heads of its prime brokerage division, and the head of investment banking. It also cost the chair of the Board’s risk committee his seat.
There’s a lot of craziness here, even by Wall Street standards. Let’s review.
1) Collusion and conflicts anyone?
As the situation became obviously dire for the PBs, "Emissaries from several of the world’s biggest prime brokerages tried to head off the chaos by holding a call with Hwang before the drama spilled into public view Friday morning. The idea, pushed by Credit Suisse, was to reach some sort of temporary standstill to figure out how to untie positions without sparking panic, the people said."
Summarizing, Archegos’ prime brokers got together, possibly more than once, to discuss the situation and how to best deal with it (that is, not to "head off the chaos" but really to avoid getting destroyed). And as in all such agreements or understandings, it didn’t work -- some of the participants jumped the gun, leaving the others holding the bag. Morgan Stanley, Goldman, and Deutsche seemed to have given little credence to any agreement with the other PBs, tacit or not, and sold immediately. And good for them: you have a trading problem, deal with it quickly and completely and don’t waste time.
But here's a question that no one is asking: could the meeting itself be considered collusion, an understanding to influence or manipulate prices? As Adam Smith famously put it,
"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick, or in some contrivance to raise prices." Sure, they can say that they were acting for the good of the market and in order to limit a possible contagion, but I highly doubt they would have been that concerned had they not been ridiculously long and facing significant losses. In other words, the meeting was to protect their own self-interests and nothing more. Also, this is not the same as when regulators call a meeting to discuss defensive steps, such as what happened in 2008.
Regulators are allowed to call meetings to defend market integrity; that’s one of the reasons they exist in the first place. That is decidedly not the function of individual firms and opens the door to charges of manipulation and collusion.
For Morgan Stanley, there’s another wrinkle – they and JP Morgan were the joint managers for a stock and convertible offering for Viacom, an Archegos holding. Viacom was logically seeking to take advantage of its elevated stock price (possibly due to Archegos?) to sell $3 billion of additional stock into the market. MS sold about 4 million shares through the convertible preferred and another 9 million of stock. Goldman was also a seller of the debt and stock. The offering at $85 received a lukewarm response, to say the least, and closed at $70.10 on March 24. This triggered the Archegos margin calls. The net result: on one hand, these firms’ prime brokerage divisions were starting to panic about Archegos, and on the other, they were selling shares of Viacom, an Archegos holding, to their clients. The timing for the investors that participated in the Viacom offering was unfortunate, to say the least. Was it just a series of unfortunate and coincidental events for MS and the other PBs? The firms maintain that there are strict internal divisions. As a spokesman for Goldman said, “There are strong informational barriers between the parts of the firm that manage capital raising for corporate clients and our relationships with institutional investors.” On the other hand, here’s Harvey Pitt, former chairman of the Securities and Exchange Commission: “There’s definitely the potential for a conflict. The fact that if there were sufficient leverage issues raised that it could promote selling and selling pressure and indeed force the selling pressure, makes it very real that the potential for a conflict was always present.” In the end, and whatever happened, the investors got the short end of the stick.
2) From Animal House: “…You ****ed up - you trusted us! Hey, make the best of it! Maybe we can help.”
Morgan Stanley reportedly sold off the positions to some of their hedge fund clients before the full extent of Archegos’ troubles were made public and knowing full well that its other prime brokers would be doing the same very soon. You could argue that the hedge funds are big boys and would probably do the same if the shoe were on the other foot, but that’s some serious realpolitik, even by Wall St. standards. It’s ridiculous that I even have to mention it, but your counterparties are not your friends! Pathetically, I strongly suspect the clients will be back after a short “I’m mad at you and not speaking to you” hiatus. Access to deal flow is everything.
3) Failure of management, not necessarily risk management
Everyone seems to agree: this was a colossal failure of risk management. Indeed, that is the common refrain after any trading disaster. But was it? I would argue that this was failure of management in general, not necessarily just risk.
The credit and market risks inherent in a highly levered client position are obvious. Undoubtedly, the risk managers from the various prime brokers were well aware of their individual risks and communicated them daily. What they didn’t know was Archegos’ risk with its other prime brokers. Although that’s impossible to know exactly, any experienced risk manager will tell you that if a client has substantial leverage with you, you can be pretty sure they have it with others. Also, I find it hard to believe that compliance did not reject Hwang solely on know your customer grounds. After all, he was an admitted insider trader and stock manipulator! I strongly suspect that the risk managers involved had some idea of Archegos’ gross leverage and that compliance flagged Hwang on blatant KYC grounds, but both were either loathe to bring it up or overruled altogether by management.
This brings up a subtle distinction. There is big difference between knowing the risks involved and the desire to do anything about them. In this case, management decided that the fees involved, or their standing in the prime brokerage community, overrode any risk considerations. This was a bad business decision, plain and simple, and shouldn’t be ascribed solely to the risk managers. Whenever risk personnel are being admonished to be more “commercial,” you can be sure that losses will soon follow.
There is another lesson to be learned here. Trying to squeeze unrealistic margins from historically low margin, high volume businesses inevitably lead to bad behavior and a general lack of common sense (although not perfectly analogous, the Wells Fargo unauthorized account scandal comes to mind). Put another way, if you see abnormal margins coming from low margin businesses with high fixed costs, be suspicious. In the case of Credit Suisse, their reported objective was to move up the prime broker rankings by focusing on fewer clients to improve profits. The strategy was successful (CS was #4 in prime brokerage) -- until it wasn’t. The latest in a string of client related losses at CS (Greensill Capital, Malachite Capital, Luckin Coffee, etc., etc., etc.), it cost the co-heads of the prime brokerage unit, the firm’s chief risk officer, the head of the investment banking division, as well as the board chair of the risk committee, their jobs. Of course, they weren’t operating in a vacuum; others higher in the CS food chain perpetuated the strategy and should also be held accountable. And just because several of the prime brokerages got out with their hides intact, doesn’t necessarily mean that they practiced prudent risk management. They didn’t, and should examine whether they were skilled or just plain lucky. After all, they got involved with Archegos and Hwang to begin with!
4) Don’t depend on regulators!
Much has been made of Archegos’ status as a family office and how it managed to avoid the reporting requirements incumbent on hedge funds. Its status was important but was not strictly necessary for Archegos’ to implement its strategy. More important was the TRS composition of the portfolio.
Regardless of its status as a family office, Archegos was not required to publicly disclose its TRS positions. Rightly or wrongly, the SEC does not require the disclosure of equity derivatives, regardless of size, composition, or risk. It comes down to who is the beneficial owner of the stock, i.e., who has voting rights. Since TRS positions do not bestow voting rights, they slip by the SEC’s public reporting requirements. Cleary, current reporting requirements are antiquated and need updating.
This loophole has not exactly been a secret to regulators. Legal challenges and appeals have been going on since at least 2008 (CSX Corp. v. The Children’s Investment Fund Management) In addition, the Dodd-Frank Act stipulated in 2010 that all swaps should be reported to a Swap Data Repository (SDR) and failing that, the relevant commission (the SEC or the CFTC). 11 years later, the SEC is allegedly close to disclosing new rules governing security-based swaps. The CFTC is also to blame. One could argue, quite convincingly, that TRSs or CFDs on a single stock are in fact a look-alike to single stock futures whose sole reason and design was to escape proper futures regulation, position limits, and margin requirements. In that case, the CFTC should have been regulating them as such. They could have, and had over 10 years to do something, but obviously didn’t.
The solution? Brokers should have access to traders’ positions across counterparties; family offices should be subject to the same reporting requirements for publicly traded instruments as hedge funds; and the SEC and CFTC (or some combination) should be enforcing gross position limits, including all derivatives.
The worst part? With both the SEC and CFTC semi-comatose, I’m not sure that even reporting derivative positions to them, or any other regulatory body for that matter, would make much of a difference in how the Archegos situation turned out.
5) A general comment: not everything is a systemic risk!
When the extent and size of this affair were made public, commentators were quick to trot out the “sky is falling” or “the sky could have fallen” narratives. None of the warnings were particularly original, the usual diatribes about how derivatives and counterparty failure could result in cascading losses that could threaten the world as we know it. I suspect that some of these anxieties are related to uncertainties and fears related to the current bull market and the COVID crisis. The longer bull markets go up, the louder the chorus of naysayers, hysterics, and prophets of doom. Undoubtedly, the 24-news cycle and social media add to the anxiety.
The question is not whether unknown risks that come out of the blue are present or not. Of course they are – “unknown unknowns” have always been, and always will be, a part of the business. The real question is their probability and the cost of hedging against them.
I leave you with a quote from the movie Men in Black:
“There's always an Arquillian Battle Cruiser, or a Corillian Death Ray, or an intergalactic plague that is about to wipe out all life on this miserable little planet, and the only way these people can get on with their happy lives is that they DO NOT KNOW ABOUT IT!”