For anyone who has been following financial news in recent days, you would have heard of the hedge fund Archegos, and how it triggered a collapse of a bunch of stocks in the US and China. The hedge fund used a bunch of complex derivative instruments to bet on these stocks, and as you would expect with most newsworthy sentences that start this way, it did not end well. What happened has been covered extensively in the news (see here and here), so here is a brief overview of what these instruments were.
What is a swap?
A swap is exactly what the word means — it’s exchanging something, in this case, cashflow. Since a swap is a derivative instrument, there has to be an underlying asset that is the basis for it and has a risk associated with it that is being hedged or speculated in. That determines what kind of swap it is. An interest rate swap is an exchange of cash flow based on interest rates and the risk underlying the transaction is the possibility of interest rates moving one way or another. A credit default swap is an exchange of cash flows based on an underlying credit instrument like a bond and the risk is the likelihood of default by the issuing entity. A total return swap (TRS) is an exchange of cash flows based on an asset like a stock and the risk is the possibility that stock price goes down when you’re betting that it goes up or vice versa. A contract for difference (CFD) is another kind of swap with very similar characteristics to a TRS. Archegos was betting using both TRS and CFDs and with a lot of leverage.
How does a total return swap work?
Let’s say a hedge fund wants to make a bet that stock ABC would go up in price in the next 6 months. Currently, the stock is at $100 and the fund wants to bet on 10,000 shares for a notional amount of $1,000,000. The hedge fund (Total return receiver) enters into a TRS with a bank (Total return payer) such that it pays the bank 6-month LIBOR + 1% spread + any losses from a drop in stock price. The bank agrees to pay the hedge fund any dividends in those 6 months and capital gains. The stock is owned by the bank and not by the hedge fund. At the end of 6 months, say LIBOR = 3%, the stock goes up to 105.
Payment to bank = (3%+1%)*$1,000,000 =$40,000.
Payment to hedge fund = (105–100)/100*$1,000,000 = $50,000
Net payment made to hedge fund = $10,000
If the underlying for a TRS is, for example, a 5-year bond making semiannual coupon payments, then the TRS could be structured such that this sort of settlement happens every 6 months until contract expiry with the LIBOR+spread+cap losses being netted with coupon+cap gains.
A CFD is similar to a TRS in a lot of ways, with one difference being that the payment only occurs at the end of the contract period.
Where does leverage and margining come into play?
Take the above example but instead of holding the full notional as collateral for the transaction, the bank requires the hedge fund to only post a 5% margin, i.e. the hedge fund only has to find $50,000 in capital or is levered 20:1 for a notional amount of $1,000,000. So the return of $10,000 is actually on an initial investment of $50,000 which has made the returns to the hedge fund 20x what it would be with 100% financing.
The risk of course is that even if the stock price drops by 5%, then it wipes out the margin completely and would likely trigger a margin call (where the bank asks the hedge fund to post more collateral) much before that point is reached. The really big risk is that the hedge fund has made multiple such bets on multiple stocks with multiple banks and if several margin calls are triggered at the same time, the hedge fund may be unable to raise enough money to satisfy them. Then the bank will be forced to sell the stock to recover some of its losses but because the stock is already falling and the size of the bank sales are pretty big, it just adds to the selling pressure.
This is sort of what happened with Archegos. The hedge fund bet on a handful of Chinese and American Tech stocks through multiple transactions, with multiple banks, with leverage ranging anywhere from 5 to 20 or more and when a fall in those stocks triggered margin calls, the fund was unable to keep up and triggered massive sales in these stocks and multi-billion dollar losses to the Total Return Payers (banks).
Why did banks/regulators miss this?
The details of this are still emerging and hopefully will be clear in the coming weeks, but there are a few key reasons why regulators missed this:
- The fund was structured as a family office, which is not subject to the same regulatory requirements as other financial institutions. Hedge funds were regulated more stringently under Dodd-Frank after the 2008 crisis. However, family offices are not subject to such regulations. The idea is that if it’s your own family money you are betting on for your own personal wealth then you bear the risk entirely. The steep collapse in the price of the stocks triggered by the big sales by the banks calls that logic into question. Thousands of investors lost money because of one hedge fund.
- Archegos mostly structured its trades as TRS/CFD and did not outright buy these shares. So they are “off-balance-sheet” from the perspective of the fund and showed up on the balance sheet of the banks that were the payers in these transactions. There are plenty of regulatory filings over the last few months showing banks like Goldman, Credit Suisse etc. amassing massive amounts of shares in these firms but Archegos name was hidden in these transactions because it was a TRS/CFD and not a share purchase from their perspective.
- Why the banks did not see this coming is the big question here. Most surprising of all is the fact that the head of Archegos is someone who was banned from investment advisory in the past for engaging in insider trading. It has even emerged through reporting that Goldman initially refused to deal with him but gave in because they were missing out on a lucrative opportunity.
It remains to be seen how big the damage is and how many banks will report poor quarterly results because of this. It is also very likely that regulators are going to have a say on this given all the madness in financial markets in recent months.
(*) The title is a reference to Berkshire’s 2003 shareholder meeting where Warren Buffet addresses a question on the increasing risks being taken by the insurance industry (view here). Every few years, some derivative instrument blows up the market and the “Oracle of Omaha” and his prophetic words go viral again (read here his thoughts on derivatives in general and TRS in particular).
