This is an article about Archegos Capital Management (“Archegos”), a small family office that has grabbed a lot of media attention the past few days. The forced unwind of the firm’s equity positions last Friday had sharp (downward) effects on several stocks’ prices, as well as on the prime brokers that were on the other side of Total Return Swaps (“TRS”) with Archegos. Although this situation involved a small investment firm and the problems look contained, at least for now, the issues that led up to this event might have longer term effects on investment firms, prime brokers, and the financial markets at large. At the end of the day, Archegos will cost banks several billions dollars. However, unlike the issue over 20 years ago with macro hedge fund Long Term Capital Management (LTCM), Archegos is small and the issues appear contained, whereas LTCM led to systemic risk that forced the US government to step in and orchestrate a rescue so that the hedge fund could be liquidated in an orderly basis, a process that took nearly two years.
Background on Mr Hwang
Bill Hwang, the founder of Archegos, is a graduate of UCLA and received his MBA from Carnegie-Mellon in 1990. He apparently held sales positions at a couple of brokerage firms after finishing his formal education before being hired by legendary investor Julian Robertson at his hedge fund, Tiger Management, in 1996. Mr Robertson closed his hedge fund in 2000, but seeded Mr Hwang with $25 million to start a new hedge fund – Tiger Asia Management – in 2001. Tiger AM was based in New York City, where Mr Hwang lives. Total assets at Tiger AM grew to over $5 billion during the ensuing 11 years. However, in 2012, Mr Hwang (and a partner at the firm) reached an agreement with the SEC, pleading guilty to insider trading and wire fraud involving several Chinese stocks (banks). He paid $44 million in fines and disgorged $16 million in profits. You can read the SEC settlement here. Following the settlement since I presumed Mr Hwang was barred from the securities industry, he converted his hedge fund into a family office named Archegos Capital Management. As a family office, Archegos managed only Mr Hwang’s personal fortune and no third-party money. By converting his investment company to a family office, Mr Hwang avoided having to register his company as an investment advisor with the SEC, allowing him to maintain strict privacy as far as his operations and investment activities. As an aside, investors of all types are required to file 13D reports each quarter with the SEC when they hold more than $100 million of US equities, but this does not apply when the returns on equities are realised through total return swaps (since the assets are not owned by his firm). Mr Hwang is considered deeply religious. He is also co-founder of a foundation, the Grace & Mercy Foundation.
Background on Archegos Capital Management
Archegos Capital Management is based in New York City. Since Archegos is a family office managing no third-party money, it has very limited regulatory disclosure requirements and is very private. As a result, information on the firm is very limited. Based on a LinkedIn profile, the firm employs between 11-50 employees. A second source mentioned that the firm employs 27 people, so this should give you a feel for the firm’s size. The company has a URL address, but the website no longer seems to work. The profile of the company suggests that it invests in equities in the US, China, South Korea and Japan. Total assets under management (AuM) at Archegos is not formally disclosed, but recent articles about the unwind event suggest that the private family office has around $10 billion of its own money at risk but substantially more (up to $50 billion) when taking total return swaps and the leverage they afford into account.
Leverage using a Total Return Swap (“TRS”)
A total return swap is a contract that involves an investment firm – normally a hedge fund or family office – entering into a contract with a bank / broker-dealer, in which the bank holds an equity position (or other asset) on behalf of the customer and forwards all income on the position to the investor, in exchange for the investor paying fees to the bank, including a “borrowing cost” normally expressed as a spread over a floating-rate index. Although the bank owns the asset, a TRS means that the investor realises all income and gains (or losses) on the underlying position. This structure effectively “masks” the end exposure of the position, at least as far as regulatory filing requirements, because the bank is the owner of record. A TRS provides the investor with significant leverage since he does not have to fund the entire position, but rather provides some agreed (unleveraged) collateral upfront and borrows the rest from the bank on the other side of the TRS. This results in high effective leverage. Banks that provide these services usually do so through their prime brokerage operations, which I will discuss more below.
If the combination of current returns (if any) and price appreciation on the underlying asset(s) are greater than the cost of the margin financing and fees, then the investor realises a positive return over the life of the contract. However, if the price of the underlying asset decreases by a certain amount (which depends on the level of leverage / collateral coverage), the bank will reduce its exposure to the asset or liquidate it entirely to ensure that it maintains its collateral coverage as agreed in the TRS. You can perhaps imagine how an unwind event can exacerbate the downward pressure quickly on the price of the underlying asset, which is what happened with Archegos. To complicate matters, it has been reported that Archegos held only a few positions in large size, and a few highly concentrated positions spread across several prime brokers undoubtedly complicated matters and made the deleveraging more problematic.
Margin requirements (haircuts) for derivative transactions like TRS’s vary depending on the hedge fund, the prime broker and the asset class. I found references to leverage generally ranging from 2.5x to 10x, with the lower end of this range probably more applicable to the more volatile single asset classes like individual equities. This contrasts to individual margin requirements for retail investors for stocks, which are usually fixed at 1:1 (50% LtV).
Let me end this section by providing a simple example on how margin calls might work. Suppose a firm has $10 million of assets and wishes to have exposure to Apple stock. The firm can approach a prime broker and buy the shares directly with margin, or it can enter into a TRS. Either way, the prime broker might allow leverage of 4:1, meaning that the investor can buy $50 million of APPL shares by posting $10 million as cash collateral. The prime broker will have effectively lent $40 million to the investor and has $10 million of cushion via the unleveraged collateral. Let’s assume the price of APPL falls so that the position is now worth $45 million rather than $50 million. This would cause the collateral cushion of the prime broker to decrease by $5 million, to $5 million. At this point, the prime broker could invoke a margin call. The investor would have to either post an additional $4 million of collateral to restore the ratio to 5:1 ($45 million: $9 million), or the prime broker would sell sufficient stock ($20 million) to restore the ratio to 5:1 ($25 million: $5 million).
More about Prime Brokers
TRS and others sorts of collateralised asset lending, custodial services, asset monitoring / servicing platforms and risk management services are provided by prime brokers. Nearly all large commercial banks and investment banks provide prime brokerage services to their hedge fund customers. I do not have access to specific data, but from what I could gather reading this article, 55% of the prime brokerage market is concentrated in the hands of four large banks. The largest three prime brokerage firms are Goldman Sachs, JP Morgan and CS (in that order), and the next three (not sure of order) are Morgan Stanley, BofA-ML and Barclays. Looking at the customer side, just over one-half of hedge funds have one prime broker, and the remainder of hedge funds have multiple prime brokers (average 3.4).
One important thing to note is that whilst any one prime broker knows its risk exposure to its hedge fund clients, the prime brokers do not necessarily know how much its customers are engaging with other prime brokers, certainly not on a real time basis. For example, if a hedge fund “holds” shares in a specific company in a TRS across three prime brokers, only the hedge fund knows the actual magnitude of its exposure in this stock, because the three prime brokers only see their exposure and are not necessarily aware of other prime brokers providing similar margin financing. Apparently, in the early stages of problems regarding Archegos becoming known to the firm’s prime brokers, they attempted to coordinate on a response so that the liquidation due to margin calls could occur in an orderly basis over some period of time. Ultimately, this “partnership” proved short-lived as a couple of prime brokers – first Goldman Sachs and then Morgan Stanley – decided to look out for themselves by closing their positions quickly on Friday. Those that did not close their position early, namely Nomura and CS (and perhaps others we do not know yet), suffered the most as selling pressures pushed down the stock prices sharply and quickly resulting in significant losses for these firms.
Can a bank’s risk management team be “compromised”?
You might be wondering how the risk management teams at prime brokers can find themselves in the position of improperly evaluating the risk of lending to certain investor-clients. More specifically in the case of Archegos, there is a very big question as to why such prominent banks were willing to transact with a firm in which the principal had admitted to insider trading less than 10 years ago?
As far as the first issue, prime brokerage is a very profitable business for many investment banks and is an important growth engine. According to the website thetradegnews.com, prime brokerage was a $30 billion revenue business for banks in 2020 and a significant contributor to the profitability of the equity divisions of most large investment banks. Revenues related to prime brokerage grew an average of 8%/annum between 2015 and 2020. As far as stretching leverage to very high levels, dealing in questionable asset classes, and/or transacting with controversial managers with a storied past or that “sail close to the wind”, the risk departments of investment banks undoubtedly face enormous pressure from front office personnel that wish to increase their revenues. Higher revenues generally lead to higher bonuses, and as you know, bonuses are a very significant part of the remuneration of senior banking professionals. More liberal lending standards across a broader array of assets and/or adding new hedge fund and private family office clients increase prime brokerage revenues and profitability. You can perhaps understand how investment firms, whether hedge funds or private family offices that might be “on the edge”, might be championed into an acceptable risk category so as to increase the commercial revenues of the prime brokerage division of banks. Ideally, risk management at a firm provides the appropriate back bone in these circumstances, but what is important to understand is how higher revenues and profits personally benefit bankers, and how – during times of weakness – these standards might be compromised.
It is hard to tell is these sorts of circumstances played a role in several very prominent top-tier investment banks on-boarding a client with the storied past of Archegos, not to mention how the family office’s general investment strategy (large, concentrated risks in equities) and significant leverage were ultimately approved.
What exactly happened with Archegos?
References in the press suggest that Archegos might have had leverage provided as high as 500% (5:1), implying that a decline in price of 20% in the underlying stock would reduce collateral coverage to 1:1, and that a margin call would most likely occur well before then, when there was risk that the collateral coverage was quickly approaching this level. This could mean a decline in the price of the stock from the original purchase price, or the basis, of only 5% to 10% (assuming initial leverage of 5:1) could trigger selling of the shares. As a stock or stocks were sold by the prime brokers involved to bring the collateral coverage back in line with the margin requirements, it obviously triggered even more downward pressure on prices. When multiple prime brokers are running for the fire exits as fast as they can, the first ones out will do the best, and the last ones out will suffer the most significant losses. This appears to be exactly what has happened.
There were large block trades in the shares of several companies last Friday (March 26th), most of which were assumed to be related to restoring the margin levels or liquidating entire positions pursuant to TRS’s for Archegos. The block trades made that day by two large prime brokers that got out relatively early – Goldman Sachs and Morgan Stanley –totalled around $18.6 billion for the day and were in the following stocks (ordered by value of trade, largest to smallest): Baidu, Discovery (two classes collectively, A and K shares), Tencent Music, Vipshop Holdings, ViacomCBS, Fartech, GSX Techadu, iQYQi and Shopify. The common industry themes appeared to be US media companies and Chinese internet companies, so the portfolio was not only highly concentrated in a few names but was also not very diversified by sector. The table below shows how the shares have performed since year-end 2020, the end of January, and since they reached their 52-week high, all of which occurred between mid-February and mid-March.
As you can see in this table, the 52-week highs of all nine stocks were above year-end 2020 levels. Moreover, the 52-week intraday high prices for these nine stocks occurred between January 27th (GSX Techadu) and March 25th(Tencent Music). As of (near) end-of-day on March 31st, four of the stocks were below their FY2020 closing price, and all are off between 45% and 75% of their 52-week highs that were reached only a few weeks before. GSX Techadu is a significant outlier as it is down nearly 80% from its 52-week high. You can probably understand given our discussion on margin and the rapid decline in the prices of these shares why prime brokers were very quickly forced into margin calls under TRS contracts or had to sell all of the shares pursuant to TRS contracts with Archegos. Of course, the large block trades sharply exacerbated the price declines, and it is just now that some of the stock prices are starting to stabilise.
As far as the exposure to these stocks by the prime brokers, I could not find specific amounts of the shares held by each prime broker backing TRS’s for Archegos, although I did find in Unhedged.com the change in number of shares held between year-end 2020 and March 22nd 2021, which could represent – at least partially – Archegos-driven volumes during the accumulation phase. Of course, whether it applied to Archegos or to other investment firms, when a stock falls this quickly, it triggers margin calls by prime brokers across all investment firms that have highly leveraged derivative transactions involving this particular stock. Here is the data with respect to stocks held by Archegos, which is interesting. The second column labelled “Change in Exposure, 12/31-3/22” is the increase in value associated with the 7-8 stocks in which Archegos has TRS’s.
There is a correlation I suppose with the pain felt and amount of exposure, but the fact is that it is weak because the most important thing given the sharp drop in prices last Friday was selling the underlying shares as quickly as possible. Goldman Sachs and Morgan Stanley seemed to move the fastest, both announcing on Monday that the effect of Archegos on their quarterly results would be rather insignificant. In total, an estimated $20 billion of shares of these companies were sold on Friday, nearly all thought to have been block trades via Goldman Sachs and Morgan Stanley. This outcome could not be contrasted more sharply with Nomura and CS. Nomura announced on March 28th that it could be facing up to $2 billion of losses related to an “un-named hedge fund”, believed to be Archegos (Bloomberg article here). Speculation is also ripe in the media that CS could take a $3 billion to $4 billion hit because of the Archegos debacle. Naturally, given the way this saga unfolded and the way the losses are affecting different firms in different amounts is causing both the SEC and FCA to look more closely at this matter in the coming weeks.
Is Archegos an isolated event, or could another shoe drop?
Although Archegos might not be material in terms of the broader market once the dust settles, it does raise some interesting issues that might cause other problems. 1. Archegos might not be the only investment firm to have a risk profile consisting of a few highly concentrated share positions supported by high leverage. Hedge funds offer more visibility because they have to file their positions at the end of each quarter, but family offices (which manage no third-party money) have limited to no reporting requirements especially if using derivative transactions like TRS’s. 2. Archegos might be isolated, but it could cause prime brokers to step back and reassess the risk they are taking with their hedge fund clients and family offices. If margins were to be reduced across the board for equities, even gradually, this could lead to overall deleveraging in the global equity markets that could de facto be similar to selling pressure as margin loans are reduced. 3. The coordination of prime brokers in troubled situations seems to have no rules. I have little doubt that Goldman Sachs will most certainly not have curried favours with the likes of CS and Nomura as it unloaded the Archegos positions in block trades late last week, leaving these CS and Nomura (and possibly other prime brokers) holding the bag. I cannot leave this topic without mentioning the role that exceptionally easy monetary policy is playing in the world of leverage of financial assets like equities. By fixing overnight borrowing rates near 0%, the Federal Reserve has in essence stoked the interest in investment firms leveraging their portfolios of financial assets at a near-nil cost, enabling these firms to turbo-charge their returns. When you hear market pundits speak of things like “leverage in the system” and “excess liquidity leading to inflated asset prices”, this is exactly what they are talking about. It is so inexpensive to borrow today that hedge funds and family offices might feel they are leaving money on the table by not leveraging their conviction trades. I suspect this sentiment is in fact broadly felt across all asset markets. The Fed has been clear that it has no intention or raising rates in the short-term, but this will happen in 2022-23, and perhaps sooner rather than later if inflationary tendencies continue to drift into the market. When the Fed starts to raise the overnight borrowing rate – as I have said before in my blog - the Federal Reserve will – figuratively speaking – need to thread a needle to avoid tipping the economy into recession or worse, likely causing asset prices to fall as rapidly as they have increased. When this is combined with excessive leverage, you can imagine how badly this may end for highly leveraged investment firms and their prime brokers.
This series of transactions leading to the sharp decline in share prices, significant losses by some prime brokers, and the likely demise of Archegos Capital Management, remain somewhat opaque, and I’ve pieced together the sequence of events the best I can. I hope this article gives you at least some understanding of this unusual situation, as well as more generally some background information on prime brokers and total return swaps. I would very much appreciate any thoughts or insights in the “comments” section of this post, as derivative transactions like these are not my area of expertise or background, and definitive information is very difficult to come by.
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