The writer is a former banker and author of A Banquet of Consequences
The gnashing of teeth and twisting of hands as a result of Archegos’ problems miss a fundamental problem that remains to be resolved: the misuse of guarantees.
The hedge fund synthetically bought Chinese and US stocks using derivatives known as total return equity swaps. Off-balance sheet transactions did not require payment of the full purchase price, but simply agreement to respond to margin calls. These are payments made to a counterparty to help cover potential losses on trading positions.
Archegos is said to have deposited an initial amount, the initial margin, against the risk of a significant market movement or non-payment of a margin call. As the initial margin is a fraction of the value of the shares, these swaps allow the creation of a large position with up to 10 times the leverage.
In the aftermath of 2008, regulators accelerated the use of collateral to secure bank exposures to “shadow banking participants” such as hedge funds. However, the system has always been faulty.
First, the initial margin may be too low. It is based on historical volatility. Periods of unusual and artificially created stability and market trends increase the risk of insufficient initial margins. The pressure to increase business volumes translates into insufficient concern for security and excessive leverage. Hedge fund brokers frequently lower collateral levels in a race to the bottom.
Second, subsequent margin calls or “swing” calls occur after a price movement, with counterparties having time to settle the payment.
When there are large, rapid movements in one direction, the protection offered can quickly become outdated. In this case, Viacom, one of the underlyings on which Archegos had bet, Suddenly falls following the announcement of a $ 3 billion stock sale and analyst downgrades. Once losses exceed posted margins, the derivative provider has unsecured credit exposure to the counterparty.
Third, high quality cash or securities, usually government securities, have traditionally been the primary form of collateral accepted. Increasingly, a wider range of securities, including stocks, are eligible. The theory is that by reducing the value recognized as collateral (known in the markets as a haircut), potential price fluctuations of riskier collateral assets can be taken into account.
Unfortunately, this exposes the arrangements to the same pattern issues as when setting the initial margins. It also introduces a “misguided correlation”, where the underlying risk increases as the value of the collateral decreases.
Finally, assets must be realized in the event of default. The whole system needs the ability to trade the required amount of both synthetically acquired securities and collateral in a short period of time.
This assumption is questionable when the swap is used to gain exposure to illiquid stocks and in an environment of reduced liquidity. In the case of Archegos, the problems may have been exacerbated by a portfolio highly concentrated in less traded stocks.
All of the above factors seem to have been present with Archegos. There were other familiar ingredients – bank greed to generate fees, lax risk management, inadequate expertise, loopholes in risk modeling, and operational problems. As usual, some of the banks concerned, eager to protect their skin, broke ranks by liquidating positions. The messy flow that resulted may have made the problem even worse. The irony is that the overall loss, which would be around $ 10 billion, could be at least 50 to 100 times the fees generated by these transactions.
None of this is new. The extreme brevity of financial memory continues to be a factor in such episodes.
Archegos’ problems to date appear to be contained, with the institutions involved and their shareholders absorbing the losses. But the systemic problems associated with the use of collateral remain. Transactions with other hedge funds, exchanges between banks and, most importantly, central clearing houses for derivatives all rely on the same technology. With a high proportion of 640 billion dollars the total amount of derivative contracts being cleared and guaranteed by guarantees, the risks are not negligible.
Late, regulators expressed concern and superficial changes could be proposed to the rules. They are, however, unlikely to address the over-reliance on shadow banking to provide credit or the use of collateral to deal with counterparties that would not normally be eligible for credit lines. negotiation. It will certainly not address the fundamental problem that a system based on leveraged speculation is hostile to financial stability.