Archegos Is No Big Deal, But Sounds a Warning Nonetheless

(Bloomberg Opinion) -- Following the implosion of Archegos Capital Management, finance professionals everywhere are asking what, if anything, regulators should do. The answer for this particular case is: not a lot. Yet the firm’s collapse points to the possibility of something worse in future, and this danger does warrant attention.

Archegos is the fund in which Bill Hwang, a wealthy investor with an insider-trading rap, managed his family money. He used some of the money, along with more borrowed (via derivatives) from banks, to make billions of dollars in bets on stocks including ViacomCBS Inc., Discovery Inc. and Baidu Inc. When some of the stocks fell, he suffered big losses. Banks that had lent to him lost money, too. The total damage has been estimated at as much as $10 billion — headline-worthy, but not enough to threaten financial stability.

For Archegos and its creditors, the story could end there. People took risks and paid the price. As long as no innocent bystanders were harmed, there’s little regulators need to do, other than ensure nothing illegal took place.

But what if Archegos had been bigger, or had been one of many funds doing the same trade? Could banks and the broader system have withstood the losses? Would regulators have noticed risks building before things got out of hand? On these fronts, the answers are less satisfying.

One issue is the extent to which investors use borrowed money, or leverage. For funds such as Archegos, and for many other lightly regulated “non-banks,” the primary limit on leverage is margin — the amount of their own funds they must put up to gain a given amount of exposure. Like a down payment, margin protects the counterparty, typically a bank or clearinghouse, in the event of loss. To gain exposure via derivatives to $100 in stocks, a hedge fund might have to put up initial margin of $20, enough to cover a 20% loss. If stocks start falling, banks might demand more, triggering selling to raise the cash. The less margin there is in the system, the greater the chances of contagion as forced selling spreads and losses cascade from borrowers to their lenders and to their lenders’ lenders.

Who sets margin levels? For the kinds of derivatives Archegos was using, it’s banks. Trouble is, the banks have incentives to keep margin low to attract more business — sometimes too low, as the losses at some of Archegos’s lenders demonstrate. In the next couple years, new rules will require the banks to follow margining procedures established by regulators. This might help — but it won’t address the problem of procyclicality: Banks and clearinghouses tend to increase margins as crises hit, making them worse.

Greater transparency is part of the answer. Regulators could more easily head off disasters if they knew what was going on in markets. As things stand, they don’t. They’re just beginning to collect trading data on the kinds of equity derivatives that Archegos employed, and if the recent history of credit derivatives is any guide, they’ll need years to make sense of it.

The Securities and Exchange Commission’s disclosure rules fall short, too. The 13F forms that many investment funds use to report their holdings emerge only quarterly and with a long delay, and in any case cover neither family offices such as Archegos nor most derivatives. Investors must also file a public report when their stake in any single publicly traded company exceeds 5%, but this doesn’t apply to exposures gained via derivatives. As a result, big, concentrated positions can go unnoticed — until they go wrong.

Regulators should update disclosure rules to take account of derivatives, so they and the public will be alerted when positions become large enough to cause trouble. They should redouble their long-running efforts to collect and assemble derivatives data into a workable early-warning system, and to ensure that systemically important banks themselves know what they’re doing. And they should seriously consider setting minimum margin requirements (and analogous “haircuts” in repo lending markets) high enough to ensure stability in difficult times.  

The Archegos implosion wasn’t a systemic problem. But if regulators don’t get their act together, the next such collapse could be.

Editorials are written by the Bloomberg Opinion editorial board.

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