One of the scariest things about Archegos Capital Management’s fall from grace is there could be others. The only reason we know Bill Hwang’s hedge fund had risk up to its eyeballs using borrowed money is because it got caught out by margin calls.
“If investment banks didn’t do these margin calls, we probably wouldn’t have seen that,” said Francesc Rodriguez Tous, a finance professor at Cass Business School in London who previously worked at the central banks of England, Germany, and Spain. A margin call is a request for additional collateral when a trader’s position or investment drops in value. Given the limited insight into hedge-fund borrowing and derivatives trading, there’s no way to know how many other funds are just a margin call away from collapse.
To recap: Archegos reportedly began to implode last week when its bets on stocks like ViacomCBS started to unravel, spurring the investment banks that had lent the hedge fund money to call for more margin. Hwang’s fund appears to have only put up a relatively small deposit compared to the size of the bets it was making. The contracts Archegos had with banks had certain payoffs depending on the performance of particular stocks. And those trades, despite their size, were apparently hidden from public view because Archegos had used derivatives contracts that allowed it to avoid disclosing its positions.
Why a margin call caused Archegos to collapse
Details are still surfacing, but it seems the financial avalanche was triggered by a relatively benign event: ViacomCBS stock tanked when the media giant issued new shares to raise $3 billion, which diluted existing shareholders. “It wasn’t something massive that triggered this problem,” Rodriguez Tous said. “It was literally one company—a big one—suffering a decline in shares.”
As investment banks asked Archegos for more collateral, at some point the hedge fund reportedly couldn’t meet the requests from the likes of Credit Suisse, UBS, Nomura, Goldman Sachs, and Morgan Stanley. A $20 billion fire sale ensued, with banks selling massive chunks of stock of ViacomCBS and other companies to cover the shortfall. (The fire sale likely included Archegos’ own holdings as well as the hedges the investment banks had in place.) Credit Suisse is expected to face billions of dollars of losses, while Nomura said it was owed $2 billion by a US client that reports indicate is Archegos.
But perhaps the biggest concern is what this says about the banking sector. A hedge fund meltdown can be an unimportant event if it’s an isolated episode, but that changes if the losses infect major banks, which act like financial transformers for the broader economy. If those losses cut into banks’ capital, that can make them less able to lend to companies and consumers that rely on them for financing. “It’s not the first time a hedge fund goes bust and impacts many of the banks,” Rodriguez Tous said. “Clearly there’s a pocket of risk that isn’t well regulated.”
Hedge fund risks to the global financial system
For now, the Archegos crisis appears contained. But the event underscores that even as banks have been heavily buttressed with additional capital since the credit crisis in 2008, there are players, like hedge funds and other investors, taking massive risks and regulators have little insight into their activities.
It also shows how difficult it is to monitor and contain the leverage, or borrowed money, that big time financiers use to amplify their bets. One way to do that is through derivatives like the ones Archegos appears to have used, said Craig Pirrong, a finance professor at the University of Houston. “Investment bankers and others find ways to expend people credit in one way or the other,” he said. “It’s inherent in the financial system, and it certainly escaped the attempts of legislature and regulators to control for a very long time.”
One way to deal with that concern is to force derivatives into a clearinghouse. The idea is to put all those trades into one centralized place, making it easier to monitor the buildup of risks and borrowing across different kinds of players (instead of allowing that information to be fragmented among a bunch of banks who may not know what each is doing). This isn’t practical for many types of derivatives, Rodriguez Tous says, as clearinghouses can only handle contracts that are standardized. Banks and hedge funds often need the flexibility that can only come from specialized, bespoke contracts to hedge their risks and make bets. And clearinghouses, it’s worth remembering, also make margin calls.
If there was an easy answer, hedge fund blowups wouldn’t still be rippling through the financial system, decades after Long Term Capital Management, another firm that used piles of borrowed money to make bets, had to be rescued. But it’s an area that deserves further scrutiny and, despite the challenges, perhaps more transparency: Rodriguez Tous notes that the last credit crisis emanated from banks—a sector authorities had much more information about than they do about hedge funds.
