Archegos Collapse Exposes an SEC Blind Spot

No financial market is without its risks, but if there’s one thing I’ve learned in a career as a securities regulator, market chairman, corporate director and investor, it’s this: The more you know, the less risk you take.

That's why I support greater disclosure requirements for the kinds of investments that are often held in the shadows, away from public scrutiny and awareness despite their size and potential impact on other investors and markets.

Private investors, hedge funds and others have long been able to take short positions in companies — betting against their future rise in value — without disclosure. And with the collapse of Archegos Capital Management, greater attention is now being paid to the ability of institutional investors and money managers  to hold highly complex and risky derivative-based investments without letting anyone know — including their own investors and counterparties.

This can't continue. First of all, disclosure requirements shouldn’t treat certain kinds of investments differently than others. If a hedge fund or investor takes a major long position in a company, defined as greater than 5% of outstanding shares, that has to be disclosed. Why shouldn’t the same standard apply to the same investor taking a major short position?

More critically, greater disclosure helps markets price risk better. Financial crises and major losses often emerge from unseen and undisclosed risks, when nobody understands the size of the potential problem until it’s too late. We always hear after these explosions: “If only we had known.” Right now, the knowing isn't possible. There’s no reason for these risky investments to be disclosed publicly because it’s not required.

The Securities and Exchange Commission and its new Chairman Gary Gensler can and should fix this. Ample and timely disclosure requirements similar to 13F and 13G filings on major short positions and derivative-based strategies would give market participants the information they need to better understand the risks they take, whether they want to be on the other side of those positions or join them.

This is an urgent matter. More of today’s financial markets are controlled by complex, derivative-based and highly leveraged investment strategies. They are often bespoke and hard to value at any given time. And too often, investors in these strategies — including highly sophisticated investors, endowments and other funds — are being told to accept their merits on faith, as well as the risk that goes with them.

Maybe this is fine for some investors, especially those receiving an attractive return. But there is risk in any investment, and the person who takes a large position using an inscrutable strategy is himself a source of unseen risk. A highly leveraged strategy can involve people and institutions who had no idea they were depending on the success of a complex instrument. The cascading effect, as we know from the global financial crisis, is profound. And unseen.

I'm aware, of course, that disclosure requirements can be expensive and create complexity. They may also deprive investors of the secrecy their strategies depend on. But think of the overriding benefits: Greater disclosure brings greater transparency, which leads to healthy markets. The more you know, the less risk you take.

I saw it firsthand at the SEC, which I led for eight years. There, we introduced several important disclosure requirements that revolutionized Wall Street’s practices and brought greater confidence in, for example, financial audits, the release of material information to the public, mutual funds pricing, performance ratings and risk profiles. When we first proposed greater disclosure requirements for these areas, we were told it would be too expensive and too radical. Now, investors and public companies embrace them.

That being said, disclosure can often be used to hide, not reveal. At the SEC I fought hard for “plain language” requirements in prospectuses for companies and mutual funds. It seemed to me then, and still does today, that a convoluted or deliberately dense prospectus is as good as no prospectus as all. Disclosure is not the same as transparency.

I've also seen lawyers use disclosure requirements to present a picture of reality that is opposite the truth. We must remember that the complexity of derivative-based strategies is not a bug but a feature. Any eventual rule should have one overriding goal: Explain the investment as clearly as possible and, importantly, its potential risks, including the amount of potential loss the investment entails.

There is yet another good reason for the SEC to act energetically to promote greater and more useful disclosure requirements: The investing public wants it. Whether it’s in the area of shareholder activism, or the claims made by companies regarding their environmental, social or governance (ESG) efforts, or their political contributions, investors want to know more about how their companies are performing.

This is a good thing. In fact, it’s the very best expression of free market economics. Free people want to make informed decisions about how they invest their money. That’s no impingement on a free market. It’s how we get one.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Arthur Levitt Jr. is a former chairman of the U.S. Securities and Exchange Commission and a director of Bloomberg LP.

©2021 Bloomberg L.P.

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