How Archegos Defaulting on Margin Calls Stirred the Stock Markets
The American stock markets were thrown into a twister last week following a margin call fiasco that involved secret market bets backed by critical leverages. A number of banks faced losses worth billions and the cascading effects of these losses moved swiftly from New York to Europe to Tokyo and maybe beyond.
At the centre of this crisis is a billionaire named Bill Hwang and his private investment firm, Archegos Capital Management. Turns out that Mr. Hwang ran a heavily-leveraged portfolio using contacts-for-differences (or CFDs) and was consequently forced to liquidate his stocks after a number of positions moved against it. This led to a flurry of market sell-off impacting US and Chinese stocks the most among others and wiping out more than $35bn in market value.
Let’s break it down for you.
Brief Background of the Main Actors Involved
Archegos is owned and managed by Mr. Hwang who is a former protégé of the hedge fund mogul Julian Robertson. After working in the latter’s fund Tiger Management, Mr. Hwang set up his own fund called Tiger Asia in 2001.
He has, however, an impugned history of pleading guilty to charges of insider trading and wire fraud in 2012 and has been penalised in the amount of $44m. Archegos, at its prime, was one of the largest Asia-centric hedge funds operating in New York.
What Led to the “Fire Sale”?
It started when last Friday, two Wall Street biggies, Goldman Sachs and Morgan Stanley, began selling large swathes of shares for an anonymous client who was unable to service a margin call. The sold shares mostly comprised Chinese tech stocks like Baidu, Tencent, GSX Techedu and media stocks like Viacom and Discovery.
Now, three things you need to understand.
One, Archegos had taken bets on many of these stocks using borrowed money. It borrowed from investment banks/brokers like Goldman, Credit Suisse, Deutsche Bank, Nomura, UBS etc. and pledged shares in exchange as collateral (or margin) to them. In these situations, if and when the value of these pledged shares fall, the brokers ask the client for additional shares as collateral. This is what’s referred to as a margin call.
Two, in the event the client is unable to pony up more shares, the brokers tend to sell a part of the pledged shares to recover their capital. This is what Goldman and Morgan Stanley began doing by dumping the Chinese tech stocks and other US media shares pledged by Archegos triggering a “fire sale” in which other brokers followed suit.
Three, the steep and unprecedented sell-off, if it takes flight once, will cause a market-wide chain sell-off by other traders who hold buy positions in the stocks, pressuring the prices further. A double whammy of sorts! That’s what happened here with Viacom shares nosediving by a fourth and Baidu and Tencent declining 33–48%.
The Complex Web of Leverages
A majority of Archegos’ positions were in the form of futures-like derivative financial instruments called contracts-for-difference(CFDs).
CFDs essentially allow traders to place directional bets on the price of securities without actually buying or selling the underlying instruments. Both parties agree on the price of a transaction sometime in the future and upon redemption, only the difference between the actual and the agreed price is settled.
They remain heavily regulated in a lot of countries including the US, where they are technically illegal. However CFDs can still be purchased as bespoke instruments which are privately negotiated and remain off-market. That being said, they are somewhat opaque from an accountability standpoint.
Traders often try to minimise exposure to themselves by using multiple banks to execute the CFD trades (like Hwang did). But, when the market goes against these leveraged bets, the investors are forced to compensate via cash or securities to cover up losses. And if they can’t, the banks start calling on the margins.
FYI: Hedge funds typically would not go up more than 3:1 in terms of leverage. As per market grapevine, Archegos had levered up to as much as 10:1 using CFDs.
Why Did Archegos’ Bets Go Wrong?
The concentrated positions in stocks like Viacom, Tencent, Discovery, Baidu etc. led to a higher degree of leverage for Archegos. For every dollar of its own money it invested in those positions, the firm may have borrowed up to $5 (or even $10) from its brokerage partners!
And thus, remarkably, exposure kept mounting until all of them together came to roost at once last week. Media company shares went into a tumble after receiving downgrades from market analysts and on account of Viacom’s decision to sell approximately $3bn worth stock in order to raise funds for its streaming investments.
Similarly, the Securities and Exchange Commission’s announcement last week to potentially delist Chinese companies from US stock exchanges if they fail to meet auditing standards also led to serious investor pessimism over Chinese stocks with reportedly huge ADR (American Depository Receipts) sell-offs.
The culmination of both these events at once seems to have worsened things further.
Why No One Saw This Coming?
Archegos is a so-called family office, meaning that it is a family investment vehicle which means theoretically, it manages its own money and no other outside capital. However, the value of its positions unwound recently is close to $30bn which suggests its indulgence in a heavy borrowing and betting game.
Two visible reasons why this was allowed to happen are as follows.
First, a glaring regulatory loophole. Under US law, even though all hedge funds, however little or big, are mandated to register, there is an exemption that applies for firms that are owned and controlled by family members/entities and provide exclusive investment advice to family members. Typical examples include Archegos-like funds which manage their own “personal fortune”.
They aren’t completely in the wilderness, but they do maintain presence in a regulatory blind spot, which is possibly how the Hwang family was able to scale such enormous leverages and wagers without scrutiny.
Second, the increasing desire of Wall Street banks to make vicarious money since their own ability to do so was curtailed to a large extent following the financial recession of 2007–10. The banks are disenchanted with slow-moving money that flows from unleveraged asset managers, the ones who “like taking the long way home” as pointed out by Will Emerson in Margin Call. ;)
Instead, the fast-trading hedge funds who pay large commissions and fees on exotic derivatives (swaps, options, futures etc.) seem more lucrative for the banks who are ready to finance them easily. That would explain the current reversal of a time when Goldman Sachs refused to do business with Mr. Hwang on account of his shady past.
Intensity of Market Impact
Credit Suisse and Nomura were the first and biggest to enter the downdraft with shares of each falling by at least 16% in their home countries. Nomura evaluated losses potentially up to $2bn and Credit Suisse between $3–4bn.
Although others like Deutsche Bank, Morgan Stanley and Goldman (who termed its risks “immaterial”) have insisted on having sufficiently de-risked their exposure linked to Archegos by offloading share blocks quickly compared to their peers, it’s too early to determine the exact size of their possible losses. So far, the impact has been limited on Asian and European indices.
However, upsets like these certainly present food for thought about the regulatory laxity over disruptive market behaviour that could spell imminent doom for the global markets in the long run.
(Originally published March 30th 2021 in transfin.in)
