the Archegos Capital debacle exposed the hidden risks of the lucrative but opaque equity derivative business whereby banks allow hedge funds to make outsized bets on stocks and associated assets.
The sour bets made by Bill hwangThe company’s family office has caused significant losses at Credit Suisse and Nomura, highlighting how these tools can trigger a chain reaction that spills over into financial markets.
Archegos was able to take tens of billions of dollars of exposure to stocks including ViacomCBS through total return swaps, a type of “synthetic” funding that is popular with hedge funds because it allows them to make very large amounts of money. betting without buying the shares or disclosing their positions as they would if they outright owned the stock.
Lack of transparency means companies such as Archegos may enter into similar swaps with multiple lenders, who are unaware of the investor’s overall exposure, which magnifies the risk for hedge funds and banks if positions turn against them.
Global banks achieved an estimated $ 11 billion in revenue from synthetic equity financing, including total return swaps in 2019, double the level in 2012, according to Finadium, a consultancy firm.
The business, which has grown rapidly since the financial crisis, accounts for more than half of total banks’ equity financing income, Finadium calculates – more than traditional margin lending and overdraft equity lending combined. . Synthetic finance continued to participate in other forms of equity finance in the first half of this year.
Banks earn regular income streams on total return swaps through the regular fees that investors such as hedge funds pay to close the deal. The investor is then paid by the bank if the stock or other related assets, including indices, increase in value. The bank also provides investors with dividends linked to the holding of the shares.
The bank compensates for its exposure by holding the underlying stocks, taking the opposite position with other clients having an opposing view, or purchasing hedge from another financial institution.
When inventory drops, the investor needs to make regular payments, ranging from daily to quarterly, to keep the bank whole.
“Since most swaps are executed on large notional amounts. . . this could expose the total return payer (typically a commercial bank or investment bank) to a risk of hedge fund default if the fund is not sufficiently capitalized ”. according to Deloitte.
This is exactly the situation Archegos faced when several of its positions collapsed, leaving the banks to sell the hedges – the stocks – in great haste. The situation was made worse by the fact that Archegos had entered into swap agreements with several banks.
Because equity total return swaps are tailor-made or “over-the-counter” contracts between two parties, they are not cleared and reported through an exchange. Investors are also not required to report their synthetic equity exposure to the United States Securities and Exchange Commission, as they would if they had the same amount of exposure through cash holdings.
Industry is required to report transactions to a data warehouse that provides authorities with information on derivatives, but regulators and users have said the information can sometimes be spotty.
“We have a fundamental problem with reporting synthetic equity holdings that is neither secret nor new,” said Tyler Gellasch, former SEC official and executive director of Healthy Markets, an advocacy group.
“If there are five different banks providing funding to a single customer, each bank might not know it and instead think that it can sell its exposure to another bank if it runs into problems – but it doesn’t. can not, because these banks are already exposed. “
The growth of the total return equity swap market “developed as a natural result of the Basel and Dodd-Frank rules which often favor [total return agreements] on equity financing, ”said Josh Galper, Senior Director of Finadium, referring to the international and US reforms that followed the financial crisis.
For banks, providing synthetic exposure to equities is an attractive activity because when client positions are consolidated against each other, it requires less regulatory capital than traditional margin lending.
“Capital ratios, liquidity ratios and the ability to reduce transactions can make total return swaps more beneficial” than other forms of equity financing, said Galper.
The information provided by banks makes it difficult for third parties to measure exposure to equity total return swaps.
“Although large banks have pages and pages of derivative information, they are usually at such a high level that you don’t come close to seeing information about exposure to individual counterparties / securities,” said Dave Zion of Zion Research Group, who specializes in accounting.
“Information on the concentration of credit risk tends to be at the industry level and will focus on net derivative claims”, while raw numbers may be more revealing about risk exposure market, he said.
Some banks treat equity total return swaps as secured loans for accounting purposes, according to Nick Dunbar of Risky Finance, a consulting firm specializing in bank disclosures. “They are not reserved by the bank’s derivatives trading desk, so they do not appear in Basel III deposits” assets weighted according to risk, leverage and credit risk that all global banks are required to do.
The lack of disclosure means that the equity total return swap business, which is typically a source of regular profits for banks, harbors rare but serious risks. A banker in the equity derivatives office of an international bank said, “It was very difficult to know who owned what”, and as such, equity total return swaps are “a classic case of picking up nickels in front of a steamroller ”.
“You can collect these nickels all day. This steamroller moves quite slowly. But if you stumble, boy, do you get run over, ”he said.
* This story has been edited to clarify the reporting requirements for total return swaps and the frequency of margin payments.