What is Archegos – and why has it created such financial chaos?

The collapse of the hedge fund raises awkward questions, 12 years on from the financial crisis, about the culture within global financial institutions and the adequacy of their regulation, says Ben Chu

As the ‘family office’ of a hedge fund veteran called Bill Hwang, Archegos was not compelled to publish information on the size of its assets and liabilities (Fuller)

Late last week something big and rather disturbing occurred in the world’s financial markets.

Some giant global investment banks simultaneously started selling very large volumes of stocks in various firms, worth tens of billions of dollars.

The price of some major quoted companies in the US and China – including ViacomCBS, Discovery, Baidu and Tencent Music – slumped alarmingly as a result.

It soon became clear that these banks were engaged in a fire sale on behalf of a hedge fund – a specialist financial investment company – that had blown up, called Archegos Capital Management.

There is nothing unusual about a hedge fund collapsing.

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These funds often take on extraordinarily large risks, and as a result they tend to lose money and go bust quite frequently.

What was unusual about the failure of Archegos was its sheer size.

As the “family office” managing the money of a hedge-fund veteran called Bill Hwang, Archegos was not compelled by US regulators to publish information on the size of its assets and liabilities.

Yet the fact that such huge volumes of shares were being offloaded by investment banks to wind it down confirmed it was massive, with some estimates suggesting it had assets worth some $10bn, and overall exposure of up to $50bn.

That would make this the biggest hedge-fund failure since the collapse of another giant hedge fund called Long-Term Capital Management in 1998 – an event so traumatic for markets that the US central bank, the Federal Reserve, was forced to step in and orchestrate a rescue.

The current crisis is still unfolding. More potentially destabilising sales of Archegos’ positions are possible.

But already many experts are warning that the episode raises awkward questions, 12 years on from the global financial crisis, about the culture within global financial institutions and the adequacy of their regulation.

The collapse of Archegos has not only cost its investors dearly, but its lenders too.

Hedge funds of this sort generally have what are known as “prime brokers” – large investment banks which hold their assets, transact their trades, and also lend them money in return for hefty fees.

What has become clear from the Archegos story is that a host of Wall Street investment banks were acting as prime brokers to the hedge fund, all lending it money, meaning that they were all on the hook financially to some degree when it went bust.

Reports suggest that the Japanese investment bank Nomura will register a loss of $2bn as a result of the clean-up operation. Credit Suisse has also warned that it is on the hook for major losses, possibly up to $4bn.

Two possibilities arise from this. The first is that the investment banks did not know that the hedge fund had multiple prime brokers, and hence were in the dark about the potentially hazardous size of their exposure if it got into trouble. The second is that they knew, and still felt comfortable lending to it.

If the first is true then they did not do their due diligence, and this suggests a dangerous gap in the way these firms evaluate client risk. If the second is true then it suggests that investment banks are allowing greed for large fees from clients to trump prudence, in a disturbing echo of the run-up to the 2008 financial crisis.

Another concern is the way that Archegos traded. Reports suggest that a great deal of its trading activity was not through buying shares in companies directly, but through trading in derivatives linked to the underlying firms. This eliminates the usual disclosure requirements for the investor, and can also reduce their tax bill.

$282bn

Gross market value of derivatives linked to equities in June 2020, Bank for International Settlements

The trouble with this kind of speculation is that it tends to be very opaque – the trades are done privately between financial entities, rather than through public exchanges. And when an entity with major derivative positions collapses, it can cascade down in unexpected ways, both for the trader and the wider market.

Derivatives linked to stocks had a gross market value of $282bn at the end of June 2020, according to data from the Bank for International Settlements (though this is a small fraction of the trillions of dollars in derivatives linked to currency and interest rates). 

Another regulatory blind spot, some argue, is “shadow banking” itself, including hedge funds. Even those hedge funds which, unlike family offices, take money from outside investors are very lightly regulated compared to investment banks, whose chain of implosions was at the heart of the global financial crisis.

“The shadow-banking system remains non-transparent in material respects and much larger than it was in 2008,” warns Dennis Kelleher of the Better Markets campaign group.

It is a dereliction of duty for regulators … to allow these systemic risks to continue to build up unseen

Dennis Kelleher, Better Markets

“It is a dereliction of duty for regulators … to allow these systemic risks to continue to build up unseen and unregulated.”

Bob Jenkins, a former financial regulator at the Bank of England, says regulatory authorities across the world need to ensure disclosure of trading positions held by hedge funds in firms via derivatives, to ensure they are not concealed.

Mr Jenkins also argues that systemically vital investment banks should be required to maintain much greater loss-absorbing capital buffers to ensure that they can cope better with unexpected situations where clients blow themselves up and leave their lenders on the hook. One reason why investment banks seem to favour trading in derivatives is that the capital requirements around this form of activity are lower, and thus the short-term profit opportunities for bankers are higher.

“It is not the regulator’s job to protect investors from volatile markets or loss, and it is not the regulator’s job to protect banks against greed, stupidity or loss – it is their job to ensure that the greedy, stupid banks can absorb the loss without putting depositors and the economy at risk,” says Mr Jenkins.