Archegos revealed flaws of markets that still need to be tackled

The writer is a former banker and author of A Banquet of Consequences

The teeth gnashing and hand wringing in the aftermath of the problems at Archegos misses a fundamental problem that is still to be addressed — misuse of collateral.

The hedge fund synthetically purchased Chinese and US shares using derivatives known as total return equity swaps. The off-balance sheet transactions did not require payment of the full purchase price but merely agreement to meet so-called margin calls. These are payments made to a counterparty to help cover potential losses on trading positions.

Archegos would have lodged an upfront amount, the initial margin, against the risk of a large market move or non-payment of a margin call. As the initial margin is a fraction of the value of the shares, such swaps allow creation of a large position with up to 10 times leverage.

In the aftermath of 2008, regulators accelerated the use of collateral to secure bank exposures to “shadow banking participants” such as hedge funds. However, the system has always been flawed.

First, the initial margin may be too low. It is based on historical volatility. Periods of unusual and artificially created stability and trending markets heighten the risk of inadequate initial margins. Pressure to increase business volumes results in inadequate concern for safety and excessive leverage. Brokers to hedge funds frequently lower collateral levels in a race to the bottom.

Second, subsequent or “variation” margin calls occur after a price move with counterparties being given time to meet the payment.

Where there are rapid large moves in one direction, the protection afforded can quickly become overwhelmed. In this case, Viacom, one of the underlying stocks that Archegos had bet on, fell sharply upon announcement of a $3bn stock sale and analyst downgrades. Once losses exceed posted margins, the provider of the derivative has unsecured credit exposure to the counterparty. 

Third, cash or high quality, usually government, securities were traditionally the major form of collateral accepted. Increasingly, a wider range of securities including equities are eligible. The theory is that by reducing the value recognised as surety (known in markets as the haircut) the potential price fluctuations of riskier collateral assets can be accommodated.

Unfortunately, this exposes the arrangements to the same model problems as in setting initial margins. It also introduces “wrong way correlation”, where the underlying risk increases at the same time as the value of the collateral decreases.

Finally, the assets must be realised in case of default. The entire system needs the ability to trade the required amount of both the securities synthetically acquired and the collateral within a short timeframe.

This assumption is questionable where the swap is used to acquire exposure to illiquid stocks and in an environment of diminished liquidity. In the case of Archegos, the problems may have been exacerbated by a highly concentrated portfolio in less-traded stocks.

All of the above factors seem to have been present with Archegos. There were other familiar ingredients — bank greed to generate fees, laxity of risk management, inadequate expertise, deficiencies in risk modelling and operational issues. As usual, some of the affected banks, eager to protect their own skins, broke ranks in liquidating positions. The resultant disorderly unwinding may have further increased the problem. The irony is that the overall loss, reportedly around $10bn, may be at least 50 to 100 times the fees earned from these transactions.

None of this is novel. The extreme brevity of financial memory continues to be a factor in such episodes.

The problems at Archegos to date appear contained, with the affected institutions and their shareholders absorbing the losses. But the systemic problems around the use of collateral remain. Dealings with other hedge funds, trading between banks and, most importantly, central clearing houses for derivatives rely on the same technology. With a high proportion of the $640tn total outstanding volume of derivative contracts being cleared and secured by collateral, the risks are non-trivial.

Belatedly, regulators have expressed concern and some superficial changes might be proposed to rules. It is unlikely though that they will address the excessive reliance on the shadow banking system to supply credit or the use of collateral to deal with counterparties who would not normally qualify for trading lines. It will certainly not deal with the fundamental issue that a system built on leveraged speculation is inimical with financial stability.