In a letter to shareholders in 2002, Warren Buffet was vocal about derivatives instruments, stating that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” . Needless to say, his comment aged well – following the aftermath of Long-Term Capital Management in 1998, the same thing happened again – this time with Archegos Capital Management. This article has three objectives. First, it will dive into a reasonable amount of detail of how equity derivatives can be used as a method of synthetic financing. With this in mind, the article will also present an alternative view to how the Archegos downfall played out from a liquidity spiral perspective. Finally, the article will conclude with some regulatory implications of the usages of synthetic instruments, both from the perspective of the receiver and the lender using Archegos to illustrate. But first, allow me to explain how TRS works with an example.
The Mechanics of Total Return Swaps
Suppose I am a hedge fund or a family office. I conducted extensive research on a particular stock, and I want to find a broker that will help me buy it. But here is the catch – I want to buy it, but I don’t want to own the stock myself. So, what can I do? I can enter into a total return swap (TRS) contract with my bank’s prime brokerage (PB) unit. Put simply, I will tell my PB which stock(s) I want to buy, and based on how those stocks perform over a certain period of time (usually quarterly), I will get paid based on the collective performance of the stocks (% gains). In return, I will also need to pay the bank a cost, which is usually Libor or Euribor plus a spread. The PB will buy the stocks on my behalf (which will also be their hedge), and pay me according to how the stocks perform. So how does my fund make money? As long as the costs that I pay are smaller than the returns I receive from the PB, then I am fine. In other words, the spread between the two (the premium) is in my favor. To visually see this happening, this graph from Tavakoli is a good source :
Total Rate of Return Swaps (TRORs) can be used interchangeable with TRS, as they stand for the same thing. I won’t go into all the technical definitions and details because that’s not the scope of my article – however, I do want to explain why a fund would choose this type of derivative instead of simply buying the stock in the first place. In the process, I hope to crystallize why funds favor this form of financing if they want to generate ‘leveraged alpha’ – as was the case with Archegos.
Why Synthetic Financing over Equity
Synthetic financing is an alternative way for banks to lend cash to their clients without using shares. What does this mean? It means that instead of selling stocks to hedge funds, banks will buy the stock themselves, and transfer the economic benefits of holding those stocks with a derivative instrument – as discussed above, TRS’s are one way to do this. However, why would banks and their PB units even consider doing this in the first place? It is mostly a culmination of historical factors that can be analyzed from three perspectives: (1) Basel III and Dodd-Frank Accords, (2) the establishment of counterparty clearinghouses for equity financing and (3) low interest rates and the shrinking US repo market. Before I discuss each, it is worth noting that I will be referring to the effect of each one on the cost of cash and the impact on the balance sheet of the PB. All three perspectives lead to the same conclusion: they have increased capital charges for banks to hold collateral. This means that it is no longer economically viable for PB’s to hold cash on their books on behalf of hedge fund clients because it means that clients which do not make the bank enough fees are turned down. Borrowing from basic corporate finance, if the cost of capital is high, then the return on invested capital needs to be even higher or the business is destroying value. So, to do this, banks need to innovate by turning to synthetic financing.
Basel Accords – Since the implementation of Basel III standards, capital requirements and new liquidity standards have made equity financing much more costly because Basel III asks banks to put aside much more collateral to cover credit risks in case loans default in distressed periods. The amount of capital requirements is determined via risk-weighted assets (RWAs) and over time they have been increasing – Basel II stated 2.5%, then it rose to 4.5% in 2011. Basel III also introduced an additional 0-2.5% in countercyclical capital buffers, and ‘Systemically Important Financial Institutions’ (SIFIs) surcharges that can be as large as 6% depending on the economic importance of a banks to the stability of the financial system.
As the capital requirements increase, banks see their Return on Equity falling. This means banks need to start making cuts on their non-core activities and turn away clients that don’t use enough balance sheet. To avoid this, synthetic financing is preferred because banks can net down their hedge positions and reduce their balance sheet costs.
Low Interest Rates – the current low interest rate environment means that the economic benefits of holding cash on balance sheets is minimal. This means that a number of Wall Street’s biggest banks are going to charge to have cash deposits at least until interest rates rise because if they don’t, Liquidity Coverage Ratio costs will be unrecoverable. There is also the issue of liquidity charges. Banks fail either because they have too little equity to unwind in distressed periods, or because they do so much maturity transformation that they end up with a liquidity funding problem. Basel III also introduced the Liquidity Coverage Ratio, which requires banks to have at least 30-day’s worth of high-quality liquid assets (HQLA) so that in a distressed scenario, banks can use this buffer as a defensive tool against retail bank runs . These liquidity enhancements essentially become a cost for the banks because it forces brokers to think more about how to match assets and liabilities on their trading balance sheets if they want to avoid runs.
But there are also risks: Central Counterparty Clearing – Clearing of OTC derivatives like TRS’s is likely to become much more abundant. This means even more pressure on a bank’s balance sheet because clearinghouses will put aside more cash to cover the risk of the underlying assets in the TRS defaulting (or just falling in value as was the case with ViacomCBS).
The image below shows more alleyways from where cost pressures can come from . Please do reach out to me should you be interested in knowing more about each one:
If equity has become more reserved for meeting capital and liquidity requirements, then PB units of the big banks are more inclined to offer synthetic-based PB relationships as opposed to traditional cash services. While synthetic financing allows PB’s and hedge funds to draw out many of the issues arising from traditional equity financing, things can still go wrong. Because synthetic financing instruments are a double-edged sword, the potential for unlimited profits is as large as the potential for unlimited losses. Therefore, the following question is: do extra regulatory requirements need to be placed on synthetic instruments like Total Return Swaps, or is the big issue in the way that family offices like Archegos are operating? The answer lies somewhere in the middle.
The Liquidity Spiral Effect
What happened at Archegos was a great demonstration of the liquidity spiral effect. It is unthinkable to believe that an experienced trader like Hwang had absolutely no assets to liquidate so that he could afford the initial margin calls. Therefore, below is a fresh, visual perspective on how the situation unfolded:
These liquidity spirals are usually used to explain how wholesale bank runs work, but they are also a great way to explain Archego’s downfall. Initially, if your positions fall in value, there will be funding problems both for Archegos and for the PB’s too. In this context, funding problems would be the margin calls, and to solve this problem one would need to sell assets to afford them. Since Archegos couldn’t pay margin, then PB’s began to offload their hedges – the long positions on the shares. Once they do this, asset prices will begin to move away from fundamentals and margin requirements will only become higher for Archegos. Asking for higher margins can only mean higher losses on the existing positions, which will create even more funding problems for Archegos. In a way, we can see that this spiral is self-fulfilling, and there was no way out for Archegos.
Two comments must be made about these spirals. First, they need to be triggered by an event. It is widely said that in the Archegos case, this trigger was an equity raise by ViacomCBS underwritten by Morgan Stanley. This equity raise caused a significant ownership dilution which began to push the price down . However, to believe that ViacomCBS was the sole trigger of the liquidity spiral also implies that Archegos must have been fairly exposed to it. The graph below shows how ViacomCBS’s capital raise triggered the decline in the stock .
The second point to make is that it is hardly ever the case that losses are initially that big to the point where margin calls cannot be paid immediately. My hunch is that some of the banks realized that Archegos was building huge positions throughout multiple PB’s without disclosing their total exposure. These banks decided to sell their long positions in fire sale block trades straight away, which ultimately became an attenuator of this liquidity spiral.
Disclosure of Equity Swap Positions
One of the residual questions in the Archegos downfall is whether this could have been avoided if the family office’s positions were public. Every quarter, hedge funds must publish a comprehensive list of holdings in 13-F filings, and must also file a 13-D if they amass more than 5% in economic interest in a firm. Family offices are completely exempt from doing this after SEC reforms passed in 2011 . From the PB’s side, there is an even bigger problem: while PB’s have strict synthetic leverage financing limits and capital requirements, the primary flaw is that the full notional amount of a derivative exposure does not need to be included in the bank’s exposure reports. According to Basel III standards, the amount to include from a derivative transaction is equal to the sum of the replacement cost (RC) of the current exposure, plus a ‘premium’ for any potential future exposures (PFE). The problem lies in the way this PFE is calculated – as a % of the derivative’s maturity date :
Intuitively, one can argue that 3 large changes need to happen. First, TRS positions must be included in 13-F and 13-D filings. In some situations, Archegos held more than 10% in synthetic economic interest in several companies. Of course, this would only make sense if family offices are to register as investment advisors under the Advisers Act of 1940 if they manage more than $750m in assets – this is the second change. Third, margin and leverage limits for family offices must be revisited, but only if this leverage actually poses a systemic risk to financial stability. It is unthinkable that Archegos was allowed to leverage some of its trades with anywhere between 8-20x leverage when current regulator-prescribed limits do not allow more than 6x leverage on equity swaps and historically, hedge funds do not exceed 2.5x.
On the other hand, one can argue that changing any of the aforementioned themes would do anything to help. First, it is extremely difficult to regulate family offices and distinguish between their characteristics to pass a new regulatory reform. In addition, family offices don’t manage anywhere near as many assets as hedge funds do, so registering a small amount of assets with the SEC would be rather useless. Third, even if family offices did register with the SEC, one must question whether this build-up in leverage would have been noticed given that it was built up gradually over time. Also, since 13-D filings are not made public, then there would be no way to know how large these economic interests were. Therefore, even if the SEC required family offices to disclose positions, nothing would guarantee that they would act on time. Fourth, the SEC is probably not going to be able to do its due diligence on every single registered investment advisor, since historically they have only examined about 15% of them. Therefore, adding more investment advisors would only deteriorate the SEC’s budget.
The bottom line is as follows: the Archegos incident was a tale of an excessively-leveraged fund with zero regards for portfolio diversification, caught in the middle of a liquidity spiral ignited by an unforeseen capital raise. If the SEC is going to devote any attention whatsoever to fill in regulatory gaps in the system, it should do so from the perspective of Prime Brokerage lending. However, one still needs to bear this question in mind; was the Archegos incident a warning signal of the system’s hidden leverage? How much of it is lying below the surface?
Master in Finance student at Imperial College London