The Archegos Capital debacle has exposed the hidden risks of the lucrative but opaque equity derivatives business through which banks empower hedge funds to make outsize bets on stocks and related assets.
The soured wagers made by Bill Hwang’s family office have triggered significant losses at Credit Suisse and Nomura, underscoring how these tools can cause a chain reaction that cascades across financial markets.
Archegos was able to take on tens of billions of dollars of exposure to stocks including ViacomCBS through total return swaps, a type of “synthetic” financing that is popular with hedge funds since it allows them to make very large bets without buying the shares or disclosing their positions.
The lack of transparency means firms such as Archegos can enter into similar swaps with several lenders, which are not privy to the investor’s overall exposure, magnifying the risk to hedge funds and banks if the positions backfire.
Global banks earned an estimated $11bn in revenue from synthetic equity financing including total return swaps in 2019, double the level of 2012, according to Finadium, a consultancy.
The business, which has grown rapidly since the financial crisis, accounts for more than half of banks’ total equity financing revenue, Finadium calculates — more than traditional margin lending and lending out shares for shorting combined. Synthetic financing continued to take share from other forms of equity financing in the first half of this year.
Banks earn steady income streams on total return swaps through the regular fees investors such as hedge funds pay to enter into the agreement. The investor is then paid by the bank if the stock or other related assets including indices rise in value. The bank also provides investors with any dividends that come with holding the stock.
The bank offsets its exposure by either owning the underlying shares, taking the opposite position with other clients with an opposing view, or buying a hedge from another financial institution.
If the stocks should fall, the investor has to post regular margin payments, usually quarterly, to make the bank whole.
“Since most swaps are executed on large notional amounts . . . this could put the total return payer (typically a commercial or investment bank) at risk of a hedge fund’s default if the fund is not sufficiently capitalised,” according to Deloitte.
This is exactly the situation Archegos faced when several of its positions cratered, leaving the banks to sell off the hedges — the stocks — in a great rush. The situation was made more severe because Archegos had entered into swap agreements with multiple banks.
Because equity total return swaps are bespoke or “over the counter” contracts between two parties, they are not cleared and reported through an exchange. Nor are investors required to report their synthetic equity exposure to the US Securities and Exchange Commission, as they would if they had the same amount of exposure through a cash holding.
“We have a fundamental problem in the reporting of holdings of synthetic equity that is not secret and is not new,” said Tyler Gellasch, a former SEC official and executive director of Healthy Markets, an advocacy group.
“If there are five different banks providing financing to a single client, each bank may not know it, and may instead think by it can sell its exposure to another bank if they run into trouble — but they can’t, because those banks are already exposed.”
The growth in the equity total return swap market “developed as natural outcome of Basel and Dodd-Frank rules that often favour [total return agreements] over cash equity financing”, said Josh Galper, managing principal of Finadium, referring to the international and US reforms that followed the financial crisis.
For the banks, providing synthetic equity exposure is an attractive business because when clients’ positions are consolidated against one another, it requires less regulatory capital than traditional margin lending.
“Capital ratios, liquidity ratios and the ability to net down trades can make total return swaps more advantageous” than other forms of equity finance, Galper said.
Banks’ disclosures make equity total return swap exposure hard for outsiders to measure.
“Though the big banks have pages and pages of disclosure related to derivatives, they are typically at a level so high that you don’t get close to seeing information about exposure to individual counterparties/securities,” said Dave Zion of Zion Research Group, which specialises in accounting.
“The information on concentration of credit risk tends to be at an industry level and it will focus on net derivative receivables”, whereas gross numbers can be more revealing when it comes to exposure to market risk, he said.
Some banks treat equity total return swaps as collateralised loans for accounting purposes, according to Nick Dunbar of Risky Finance, a consultancy specialising in bank disclosures. “They don’t get booked by the derivative trading desk of the bank, so they don’t appear in the Basel III filings” of risk-weighted assets, leverage and credit risk that all global banks are required to make.
The lack of disclosures means that the equity total return swap business, which is generally a source of steady profits for banks, conceals rare but severe risks. One banker on an international banks equity derivatives desk said that “it was very hard to know who owns what”, and as such equity total return swaps are “a classic case of picking up nickels in front of a steamroller”.
“You can pick up those nickels all day. That steamroller moves pretty slowly. But if you trip, boy, do you get run over,” he said.