Archegos: a spectacular failure in risk management
by Dan diBartolomeo myopic view of prime brokers The recent failure of the Archegos hedge fund/family office was a spectacular example of the persistent deficiencies in hedge fund and broker risk management. The fund went from about a $30 Billion position to total collapse, leaving at least $7 Billion in publicly announced losses associated with failed margin calls across prime brokers at Credit Suisse, Nomura, UBS, and Morgan Stanley. A fifth prime broker, Goldman Sachs, has commented only that their losses are “immaterial.” Many investors have been left wondering how four of the world’s most sophisticated investment banks could be subject to massive losses associated with routine margin lending on a set of equity total return swaps. While not all facts have been made public, we believe that the problem arose from both weak procedures and some obvious analytical failures. Of the involved firms, Credit Suisse has already announced a change in policy to “dynamic margins” for equity return swaps. The implications of this announcement is that the prior policy was “static margin,” meaning that an investor’s deposit in a margin account did not have to grow as the value of the transaction increased. We also know that Archegos was dealing with at least five prime brokers. It is unclear if the five firms involved were aware of the existence of very similar Archegos positions at the others. This myopic view could have allowed “pyramiding” of positions by Archegos.
example of pyramiding Here is a simplified hypothetical example of how this pyramiding could have been accomplished. Investor H enters a one-year total return swap with Broker C with a transaction cost of 1% for stock X for a notional amount of $100. According to the terms of the swap, if stock X goes up over the year, C owes H 99% (100-1) of the total return on $100 worth of stock X. If stock X goes down over the year, H owes C, 101% (100 +1) of the total loss on $100 worth of stock X. Investor H deposits $25 in cash with C to cover possible losses in a decline in the price of stock X as a margin deposit. Broker C can hedge their risk by buying $99 worth of stock X which drives the price of stock X up from $100 to $200. Broker C credits $99 (.99 * (200-100)) to investor H’s margin account which now has a balance of $124 ($25 + $99).
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Intelligent Risk - July 2021
