As the implosion of Archegos shook the global markets, it lost $11 billion with Credit Suisse taking a hit of $4.7 billion. Here are four things that went awfully wrong with the Archegos story.
Misusing family office loophole
In short, Archegos was a risky hedge fund in the guise of a family office. Any family office is meant to protect the wealth earned over generations. The Bill Hwang family office, which went under the name of Archegos was meant to circumvent the tough regulations that covered hedge funds and portfolio funds that are currently regulated by the Dodd-Frank Act. However, the Act leaves out family offices since they do not handle public money. It was this loophole that Archegos exploited by taking high-risk bets under the garb of a family office.
The enthusiasm of prime brokers
Prime brokers are banks that execute trades and also structure and fund them. It is the most lucrative side of the broking business where the prime broker earns a fixed fee, plus the interest on the funded part. Some of the biggest US, European and Japanese banks like Citi, Goldman Sachs, Morgan Stanley, Credit Suisse, and Nomura are all active in the lucrative US prime broking segment. This competition meant prime brokers were lax on risk management for blue-chip clients like Archegos. That was the genesis of the entire Archegos crisis.
How TRS exacerbated the fall
Archegos structured most of its trades through a product called Total Return Swaps (TRS). Unlike equity, a TRS is a bet on price movement. If the price goes up, the prime broker earns the fee, interest, and a small share of profits. If the price goes down, the prime broker gets the fee and also compensation for capital loss. In short, the position of the prime broker is guaranteed; except if the client goes bust. That is exactly the situation that transpired at Archegos. The fund had TRS on stocks like Viacom CBS and Baidu so when prices started falling the prime brokers had no choice but to dump the positions in the market-leading to huge losses and the crash.
It was all about leverage
Behind this elegant structure of prime brokers, family offices, and Total Return Swaps, the underlying story was one of unbridled greed resulting in too much leverage. For example, a futures trade is itself a leveraged position as you only pay a margin. If the prime broker also funds this margin, then the actual risk due to leverage is exponentially high. As Archegos began earning millions for the prime brokers, they started giving more leeway to Hwang in terms of the value of stocks offered as collateral. When the fall happened, the leverage risk just got magnified. Archegos was always sailing close to the wind. Leverage exposed the hollowness of the high-risk strategy!