Banks Are Making It Harder for Hedge Funds to Leverage Their Bets After Archegos

The dust hadn’t yet settled on Archegos Capital Management’s implosion, when hedge funds started shifting their bets toward banks that avoided getting hurt, hoping to keep leveraging up just like before. Good luck with that.

For weeks behind the scenes, Wall Street’s giants have been autopsying failures at rivals including Credit Suisse Group AG and Nomura Holdings Inc., identifying risks that they plan to address by more thoroughly vetting hedge funds or imposing more onerous terms on their trades, according to people close to the discussions. No one wants to be the next to tell shareholders and regulators how they failed to heed the lessons of Archegos.

Inside Bank of America Corp., which refused to do business with Archegos, Chief Executive Officer Brian Moynihan has been quizzing subordinates on what more is needed to protect the firm. The episode has hardened the resolve of Wells Fargo & Co. executives that low-risk margin lending is wiser, even if less profitable. UBS Group AG CEO Ralph Hamers has signaled that clients will have to hand over more information when borrowing.

And in New York, managers of small hedge funds who lack the negotiating clout of trading whales are grousing. For the little guy especially, the saga will make it harder to borrow money from banks to finance bets.

While specific measures will vary by bank and client -- and in many cases are still being ironed out -- the talks and tensions point to greater pressure on clients to reveal their biggest wagers, stricter margin limits on those positions, more frequent collateral adjustments and more rigorous audits. The deliberations were described by executives close to prime brokerage desks and money managers.

“There will be more calories expended, both in terms of those desks doing due diligence in the market as well as in some cases they may outright ask clients about that,” Mike Edwards, deputy chief investment officer at Weiss Multi-Strategy Advisers, a $3 billion hedge fund. Previously, it was “not a requirement at most places that you would disclose to a swap counterparty that you have the same position on at multiple places.”

Such concerns have risen to the top of the regulatory world. Fed Governor Lael Brainard, the head of the Board’s financial stability committee, called for “more granular, higher-frequency disclosures” on Thursday.

“The Archegos event illustrates the limited visibility into hedge-fund exposures and serves as a reminder that available measures of hedge-fund leverage may not be capturing important risks,” she said.

The Securities and Exchange Commission will consider adjusting some of its rules that require investors to publicly report large stock holdings so they will also cover swaps, Gary Gensler, the regulator’s new chairman, told lawmakers on Thursday.

Two Sigma’s Move

The thirst from banks to boost business with clients like Bill Hwang’s Archegos allowed him to shop for the most generous terms and amplify his wagers. He was able to parlay over $20 billion of his fortune into total bets that exceeded $100 billion, built on the back of banks tripping over each other to fuel his leveraged empire. Hwang used that to to make aggressive asks, demanding strikingly off-market margin terms -- such as $8.50 in leverage for every $1 he put in -- for building his book in Chinese stocks. Some banks demurred, others played ball.

In the wake of his fund’s collapse, it’s less likely that other hedge funds will be able to win such terms. Bank officials declined to be interviewed.

Banks Are Making It Harder for Hedge Funds to Leverage Their Bets After Archegos

No bank got hit harder than Credit Suisse when Archegos was unable to meet margin calls from prime brokers in March. The Swiss bank lost more than $5.5 billion after losing a race with peers to sell off the family office’s unusually concentrated and leveraged bets on stocks, in a portfolio that swelled to more than $100 billion.

Not too long after, Two Sigma heard from contacts at Credit Suisse, according to people with knowledge of the exchange: Could the investment firm please trim its exposure and move a few billion dollars somewhere else?

It wasn’t a hardship; investment firms as big as the $58 billion quant money manager are used to shifting between brokerages. But it adds to a broader outflow, as Credit Suisse adjusts risk tolerances and practices, slashing lending to hedge funds by a third. Hedge fund manager Marshall Wace, with more than $50 billion in assets, also shifted business from Credit Suisse to some U.S. banks, a person familiar with the matter said last month.

Unusual Review

Within days of the Archegos blowup in March, Deutsche Bank AG and BNP Paribas SA alone had received more than $10 billion in inflows from a number of clients pulling away from Credit Suisse, according to a person with knowledge of the moves. The investors included D.E. Shaw, Two Sigma and Marshall Wace. Representatives for the firms declined to comment.

Additional inflow recipients include Goldman Sachs Group Inc. and Bank of America, according to people with knowledge of their businesses, both of which are working on measures to keep risks in check.

Inside Bank of America, executives fielding that money have been conducting an unusual review: Examining what went right in the lender’s decision to refuse Archegos as a client this year. That could help the firm avoid potential headaches. Discussions there have revolved, in part, around boosting collateral for certain types of swaps, depending on the situation.

When Archegos came up at the bank’s annual meeting last month, Moynihan lauded senior executives for paying close attention to the amount of risk the board is willing to take.

Archegos had around $3 billion at the start of 2020 before it lost roughly half within a few months, according to a bank executive that worked with the investment firm. By March of this year its portfolio had soared to $23 billion -- making it a prized customer at a handful of banks around the world.

Warning Signs

Reviews by prime brokers have pointed to an array of warning signs that not everyone heeded, such as the dramatic month-to-month swings in the value of its portfolio. There also was its heavy preference for swaps -- rather than direct stakes -- that hid its concentration of bets on a handful of companies. And it used an accounting firm not normally associated with money managers commanding so much firepower.

As Archegos swelled, the reaction among prime brokerage managers was split: At one bank, they expressed amazement to colleagues, at another executives saw it as radioactive and steered clear. Employees at that firm have since been examining other hedge fund clients for similar patterns and expect to have conversations with some about adjusting the terms of their business.

Many big hedge funds set up multiple prime brokerage relationships, sometimes using a few of the industry’s giants -- JPMorgan Chase & Co., Goldman Sachs and Morgan Stanley -- as well as a few others such as Credit Suisse for supplementary leverage on their bets.

But managers overseeing smaller mounts of money typically find they don’t have as many options. Though some banks such as Morgan Stanley make a point of serving fledgling funds, smaller money managers say they generally face more-onerous terms on trades.

Worsening Terms

The Archegos blowup is going to make that situation all the worse, two veteran managers atop smaller firms said. Deeper due diligence costs prime brokerages time and money. Fewer mid-sized prime brokerages will offer as much margin or the breaks on trading terms that were available just months ago. The money managers worry that they face a more take-it-or-leave-it environment than interest in doing business.

The frustrations over Archegos are shared by bigger firms too.

In a letter to investors, Marshall Wace co-founder Paul Marshall raged over how Archegos caught prime brokers by surprise using opaque swaps.

“The prime brokers have paid the price for extending so much risk,” he wrote last month, chiding them for not asking enough questions. “PBs will improve.”

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