It is still unclear exactly where Archegos Capital fits into the annals of spectacular hedge fund blow-ups. But the early signs are that it will probably prove the biggest since Long-Term Capital Management’s collapse in 1998.
The saga erupted into the open last Friday, when Goldman Sachs and Morgan Stanley broke cover and started dumping multibillion-dollar positions in US and Chinese stocks. They did it on behalf of an unnamed investment fund that had failed a “margin call” — essentially a demand to put up more collateral against its trades.
That sparked an epic whodunnit across markets, with Archegos — an obscure investment group run by Bill Hwang, a former Tiger Management hedge fund manager with a chequered past, quickly identified as the primary party involved. By Monday, Credit Suisse and Nomura were admitting that they would probably lose billions of dollars in the fallout.
At this early stage, there are still far more questions than answers. Here are some of the more pressing ones.
First and foremost: What on earth were some of the world’s biggest investment banks thinking when they enabled an opaque family office whose founder had a history of regulatory issues to rack up multibillion dollars worth of leverage? Hwang paid $44m in fines to settle US illegal trading charges in 2012, and in 2014 he was banned from trading in Hong Kong.
True, Archegos’ status as a family office means that it was exempt from a lot of the standard regulatory disclosures demanded of hedge funds. But banks’ prime brokerage desks — which service hedge funds with research, trade structuring and leverage — appear to have failed basic “know your customer” processes.
Each bank may have felt comfortable with their exposure to Archegos, assuming they could always ditch its positions to cover themselves. But they failed to appreciate that if everyone has to dump tens of billions of dollars worth of equities, the collateral they may have embedded in their contracts is going to be wholly inadequate.
In LTCM’s infamous blow-up in 1998, the fund adeptly took advantage of Wall Street’s hunger for fees to play banks up against each other and get access to hefty leverage from each of them — with each often unaware of their rivals’ true exposure.
But at least LTCM was at the time the biggest hedge fund in the world, founded by storied Salomon Brothers traders and advised by Nobel laureates. Aside from the under-appreciated size of Archegos — and the fat fees it probably paid to prime brokers — the fund and Hwang were essentially non-entities on Wall Street.
Which leads us to another question: What is Archegos Capital exactly? The size and leverage of its positions would be extreme even for one of the more aggressive members of the hedge fund industry, let alone a family office. In truth, it seems more like a Reddit day trader got access to a Goldman Sachs credit card and went bananas.
Prime brokers have estimated that it managed about $10bn of capital before this debacle erupted, which is a lot for the family office which was hardly a hedge fund titan.
Historically, family offices have not had to register with the Securities and Exchange Commission because of an exemption for firms with 15 clients or fewer. The Dodd-Frank Act that tightened regulations in the wake of the 2008 financial crisis removed this exemption to shed more light on the hedge fund industry. However, the SEC has let family offices decide for themselves whether they should be registered and file regular reports. A search for Archegos on the SEC’s “Edgar” reporting system yields pretty much nothing — itself eye-catching. Its use of financial derivatives known as swaps to build positions might have allowed it to circumvent reporting requirements on big stakes.
Finally, but most importantly: Can the Archegos blow-up trigger a wider financial conflagration, as LTCM did two decades ago?
Luckily, the answer is probably no — with some caveats. LTCM was far bigger, more woven into the fabric of several systemically important markets. The Archegos losses will be humiliating to many banks, and in some cases ruin their financial year, but they are much better capitalised since 2008.
That said, there is a danger that a debacle of this magnitude encourages the entire investment banking industry to scale back how much leverage they offer their hedge fund clients. If so, then the forced liquidation of an isolated, gung-ho investment group could become a snowball that triggers a broader hedge fund deleveraging. For now, markets are taking the debacle in their stride, but that could still change.
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