Archegos: The tree hiding the forest?

After the Greensill collapse, the Archegos Capital Management story is raising a new alarm underlining how excess leverage in the system is representing a significant risk for investors.

Lending stock to leverage your positions is a basic financial technique, hence it is very surprising that some banks have been caught off guard with billions of losses affecting their prime brokerage activity. Credit Suisse and Nomura, two of the biggest lenders, reportedly take a USD 4.7 billion and USD 2 billion hit, respectively.

Two main immediate lessons could be drawn from this event:

First, assuming that quality and background of the borrower are less important than the collateral when performing secured lending is a mistake.

Second, in such a situation, in a way comparable to the prisoner’s dilemma, the last to exit is the big loser.

Bill Hwang, the founder of Archegos family office, is not a novice and used to be one of the most successful managers of the Tiger hedge fund with a track record made of aggressive bets. In 2008, when managing the Tiger Asia fund, he took huge losses caused by a significant short position in Volkswagen and was crushed when Porsche increased its position. Aware of the fund’s supposed Asian focus, some investors were surprised. In 2012, he was convicted for insider trading in two Chinese banks by the SEC, settling criminal and civil charges with a USD 60m payment. He was also banned from trading in Hong Kong for four years.

The SEC is now opening an investigation into the trades performed by Archegos when liquidating its multi-billion positions to face margin calls requested by its bank lenders. As declared by former SEC official Tyler Gellasch: “We now have a clear example of someone exploiting the family office exemption and creating systemic risk”.

Indeed, the family office structure used by Archegos is known as one of the less regulated in the market and could potentially be used to operate as a shadow hedge fund. In 2019, family offices have been reported to globally manage USD 6 trillion of assets compared to USD 3.6 trillion for the hedge fund industry. The number of family offices has grown by 38% between 2017 and 2019. However, under the Dodd Franck legislation, they are not required to register with the SEC as long as they serve a single family, do not give investment advice and only perform “conservative investments”. The definition of Family offices is thus unclear and potentially regroups very different aspects.

Banks will certainly strengthen their control of and lending criteria for family offices, especially when led by ex-Hedge Fund stars. Regulators are also expected to get involved more frequently in order to avoid a materialization of systemic risk. At this stage, it is certainly too early to believe that Archegos will remain an isolated case.

The distribution of losses in the banking system is another illustration of the prisoner’s dilemma exposed in “Theory of Games and Economic Behavior” from John Von Neumann and Oskar Morgenstern. A prisoner’s dilemma is a situation where, as an individual, you have an incentive to behave in such a way that the overall outcome for the group will be less optimal. In the context of this game, Credit Suisse and Nomura have been too slow to react. The group of lenders approached Hwang to find a sort of standstill agreement to unwind their positions in a smooth manner, thus avoiding panic selling. But after the information started to be disseminated, other banks like Goldman Sachs, Morgan Stanley, Wells Fargo and Deutsche Bank decided to move alone and traded multi-billion blocks of stocks. Consequently, the underlying stocks used as collateral saw their value collapse and the market entered into panic selling mode. For example, ViacomCBS fell from 100 to 46, with Credit Suisse still being in the market and offering big blocks of the company.

Beyond this archetype and already emblematic case, what should we make of the banks’ behaviour?

The prime broker business reportedly generates USD 30 billion of revenues in 2020. Morgan Stanley recently described it as being “the centre of the machine” for its equity trading division. Despite a decade of regulations and oversight, it seems like investment banks still have room for improvement in their approach of risk.

This article is an opinion article and does not constitute investment advice or recommendations. Neither the author nor SCOR Investment Partners assume any liability, direct or indirect, that may result from the use of information contained in this opinion article.