Billions in Secret Derivatives at
Center of Archegos Blowup
By Sofia Horta e Costa, Tracy Alloway, and Bei Hu
March 29, 2021, 6:24 AM EDT Updated on March 29, 2021, 7:58
AM EDT
Archegos used equity swaps or CFDs, people familiar
have said
Instruments are
popular with hedge funds, allow non-disclosure
The forced liquidation of more than $20 billion in holdings
linked to Bill Hwang’s investment firm is drawing attention to the covert
financial instruments he used to build large stakes in companies.
Much of the leverage used by Hwang’s Archegos Capital
Management was provided by banks including Nomura Holdings Inc. and Credit
Suisse Group AG through swaps or so-called contracts-for-difference
(CFD), according to people with direct knowledge of the deals. It
means Archegos may never actually have owned most of the underlying
securities -- if any at all.
While investors who build a stake of more than 5% in a U.S.-listed company usually
have to disclose their position and future transactions, that’s not the case
with stakes built through the type of derivatives apparently used by Archegos.
The products, which are made off
exchanges, allow managers like Hwang to amass stakes in publicly traded
companies without having to declare their holdings.
The swift unwinding of Archegos has reverberated across the
globe, after banks such as Goldman Sachs Group Inc. and Morgan Stanley
forced Hwang’s firm to sell billions of dollars in investments accumulated
through highly leveraged bets. The selloff roiled stocks from Baidu Inc. to
ViacomCBS Inc., and prompted Nomura and
Credit Suisse to disclose that they face potentially significant losses
on their exposure.
One reason for the widening fallout is the borrowed funds
that investors use to magnify their bets: a margin call occurs when the market
goes against a large, leveraged position, forcing the hedge fund to deposit
more cash or securities with its broker to cover any losses. Archegos was
probably required to deposit only a small percentage of the total value of
trades.
The chain of events set off by this massive unwinding is yet
another reminder of the role that hedge funds play in the global capital
markets. A hedge fund short squeeze during a Reddit-fueled frenzy for Gamestop Corp. shares earlier this year
spurred a $6 billion loss for Gabe
Plotkin’s Melvin Capital and sparked scrutiny from U.S. regulators and
politicians.
The idea that one firm can quietly amass outsized positions
through the use of derivatives could set off another wave of criticism directed
against loosely regulated firms that have the power to destabilize markets.
While the margin calls on Friday triggered losses of as much as 40% in some shares,
there was no sign of contagion in markets broadly on Monday. Contrast that with
2008, when Ireland’s then-richest man used derivatives to build a position so
large in Anglo Irish Bank Corp. it eventually contributed to the country’s
international bailout. In 2015, New York-based FXCM Inc. needed rescuing because
of losses at its U.K. affiliate resulting from the unexpected de-pegging of the
Swiss franc.
Much about Hwang’s trades remains unclear, but market
participants estimate his assets had grown to anywhere from $5 billion to
$10 billion in recent years and total positions may have topped $50
billion. Hwang didn’t respond to requests for comment.
CFDs and swaps are among bespoke derivatives that investors trade privately between
themselves, or over-the-counter, instead of through public exchanges. Such
opacity helped to worsen the 2008 financial crisis and regulators have
introduced a vast new body of rules governing the assets since then.
Over-the-counter equity derivatives occupy one of the
smallest corners of this opaque market. Swaps and forwards linked to stocks had
a gross market value of $282 billion at the end of June 2020, according to data
from the Bank for International Settlements. That compared with $10.3 trillion
for swaps linked to interest rates and $2.4 trillion for swaps and forwards
linked to currencies.
Dark Corners
Equity swaps are a small part of the opaque OTC derivatives
market
SOURCE: Bank for International Settlements
NOTE: FX swaps include 'outright forwards and forex swaps'
and currency swaps
Regulators have begun clamping down on CFDs in recent years
because they’re concerned the derivatives are too complex and too risky for
retail investors, with the European Securities and Markets Authority in 2018
restricting the distribution to individuals and capping leverage. In the U.S., CFDs
are largely banned for amateur traders.
Banks still favor
them because they can make a large profit without needing to set aside as much
capital versus trading actual securities, another consequence of regulation
imposed in the aftermath of the global financial crisis. Among hedge funds,
equity swaps and CFDs grew in popularity because they are exempt from stamp duty in high-tax jurisdictions such as the
U.K.
— With assistance by Lulu Yilun Chen, and Donal Griffin
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