US put off derivatives rules for a decade before Archegos blew up
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Rules written in the aftermath of the 2008 financial crisis to limit the potential for a blow-up like Archegos Capital have still not been fully implemented, throwing a spotlight on regulators in a fiasco that has shocked Wall Street and raised questions on Capitol Hill.
Crucial parts of the 2010 Dodd-Frank Act, an 848-page law that was meant to shore up big banks and temper excessive risk taking in the derivatives market, have been delayed again and again.
Critics are now arguing that had regulators implemented the rules faster, the implosion of Bill Hwang’s family office and the multibillion-dollar losses it caused two banks could have been limited.
In particular, rules that would have governed the disclosure of Archegos’s derivatives trades are still not in force, and neither are requirements for players like Hwang to post initial margin, payments meant to cover potential trading losses. Hwang was able to place more than $50bn of bets on the share prices of a handful of US and Chinese companies, and could not pay his counterparties when they started going against him.
Diane Jaffee, a portfolio manager at asset manager TCW, said that regulators had implemented Dodd-Frank at an “anaemic” pace. The ability of an unknown family office like Archegos to run up such outsize risks “is like the last hurrah . . . before regulations come in,” she said.
Equity total return swaps like those used by Archegos are overseen by the Securities and Exchange Commission, which has been far slower to write its rules than the Commodity Futures Trading Commission, the main derivatives regulator.
SEC rules are due to finally come into force on November 1. Had they already done so, the SEC would have had access to data on Archegos’s trades, including the size of each transaction and who the family office had traded with — rules already established in other parts of the derivatives market regulated by the CFTC.
“It is a dereliction of duty by the SEC not to have a properly regulated swaps market 13 years after they were at the core of causing and spreading the 2008 crash,” said Dennis Kelleher, president of the advocacy group Better Markets.
The opacity of Archegos’s positions has proven central to the incident, given many of its trading counterparties did not know it had taken similar positions with other banks across Wall Street. It was only when Hwang called Archegos’ many counterparties together for a meeting in late March that it became clear to each bank how large and concentrated the Archegos positions were, people familiar with the meeting have said.
“The SEC is 10 years late on implementing rules that would have provided more transparency into what was happening,” said an executive focused on government regulation at a large hedge fund. “The SEC completely dropped the ball.”
The SEC declined to comment.
Margin requirements were delayed
The SEC has also not implemented rules on margin requirements for derivatives trades conducted away from exchanges and clearing houses, which would affect the broker dealers it regulates.
Broad global rules demanding that asset managers set aside more cash to cover their swaps deals are defined by the Basel Committee on Banking Supervision and International Organization of Securities Commissions (Iosco), the umbrella group for global markets watchdogs. Local regulators are given some leeway to adapt the rules to their markets.
In the US, that job is split among a host of regulators. Federal banking regulators have already introduced margin requirements for large banks trading with each other. However, as Covid-19 struck last year, global regulators agreed to push back the implementation of the rules that covered smaller financial firms trading derivatives from September 2020 to September 2022.
That decision meant a group like Archegos — which held derivatives positions worth more than $50bn, according to people familiar with the trades — was not required by any US regulators to post margin when it first initiated a trade.
Had the delay not been agreed, Archegos would have likely tripped above the designated size threshold last September, requiring it to post margin by Basel and Iosco standards after the value of its notional derivatives exposure eclipsed $8bn. The rules would require enough cash to cover 10 days of possible losses, based on the historic performance of the shares.
“The rules were designed to deal with these risks but they were designed on a schedule that ends up being too late to catch this counterparty,” said a derivatives lawyer at a large international law firm.
Wider markets were insulated
Multiple derivatives lawyers noted that post-financial crisis capital rules had helped insulate wider markets, with some of the banks involved absorbing sizeable losses without the need for state intervention.
Credit Suisse suffered a $4.7bn loss, while Nomura has warned it could lose $2bn. Others, including Morgan Stanley, Goldman Sachs and Wells Fargo, collectively sold more than $20bn worth of stock they held as hedges for their trades with Archegos to limit their own losses. So far, nine banks have found themselves involved in the tumult, including Deutsche Bank, UBS, Mitsubishi UFJ Financial Group and Mizuho.
The banks’ prime brokerage units that enabled Archegos’s supercharged trades have not disclosed how much margin they required when the fund first initiated its transactions. Lawyers who work with banks said they have not typically implemented regulatory minimums before they come into force, because of competitive pressures.
Federal Reserve chair Jay Powell signalled concern, telling the CBS news programme 60 Minutes on Sunday that he was concerned trades with a single customer could result in such substantial losses to these large firms.
“What we try to do is make sure that the banks understand the risks that they're running and have systems in place to manage them,” he said. “This would appear to be a significant shortfall — a failure on that front.”
Credit Suisse, Deutsche Bank, Goldman, MUFG, Mizuho, Morgan Stanley, Nomura, UBS and Wells Fargo declined to comment, as did Archegos.
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