Loyola University Chicago School of Law, JD 2022
Last week, the finance industry watched one of the biggest implosions of an investment firm since the 2008 financial crisis. Archegos Capital Management rocked the industry when it was forced to liquidate huge positions in blue-chip companies after some risky investment strategies went south. The financial instruments used in this risky investment strategy are called total return swaps. The Archegos meltdown has lead lawmakers and regulators to call for increased scrutiny of the swaps.
What is Archegos Capital Management?
Archegos is the family investment vehicle founded and owned by Bill Hwang in 2013. Hwang started out as a stock salesman at Hyundai Securities in the early 1990s. He then built Tiger Asia Management, a New York-based hedge fund which focused on Asian investments. In 2012, Hwang pleaded guilty to insider trading of Chinese bank stocks and agreed to pay $44 million to settle charges from the SEC. The agency alleged that he used confidential information received in private placement offerings to short sell three Chinese bank stocks. After the settlement, Hwang closed Tiger Asia Management and Archegos was born. Archegos is estimated to have managed about $10 billion.
What is a total return swap?
A total return swap allows an investor, such as a hedge fund, to invest in assets without owning them. In the deal, the fund makes payments to an investment bank based on fees and an interest rate such as Libor. In other words, total return swaps allow investors to take huge positions while posting limited funds up front, essentially borrowing from the bank.
The investment banks buys assets, such as a basket of stocks and makes payments to the hedge fund based on the total return of the assets. The bank owns the assets, not the hedge fund. So, while a hedge fund may have heavy exposure to a stock through swaps with multiple banks, it is not subject to disclosure laws that a very large shareholder would be. If the underlying assets falter, the hedge fund must pay the bank an amount based on the negative returns plus the regular fees it has agreed to pay.
With heavily leveraged positions, the bank may make a margin call, requiring a client to put up more collateral. If the client fails to comply, the bank may sell the assets, triggering more declines in price.
How did total return swaps play into the Archegos meltdown?
Archegos held large and leveraged bets in U.S. media stocks ViacomCBS and Discovery, as well as a few Chinese internet stocks. Some of the positions were held via total return swaps. In short, these positions went south and resulted in huge margin calls. In a margin call, brokerages demand that an investor deposit additional money or securities into the account when a position falls sharply in value. Archegos was unable to fully meet the obligations of the margin calls and was forced to unload its assets quickly.
How have investors using total return swaps skirted regulation?
The SEC has taken the position that investors are not required to disclose positions in total return swaps unless they have voting power over the related shares. If an investor does not have voting power, they are not deemed to be the ultimate owner of the shares, also referred to as the “beneficial owner.” Investors who become the beneficial owner of more than 10% of a company’s shares are also deemed to be corporate insiders, and thus must report changes in their holdings through other public filings. Therefore, despite Archegos being estimated to have had exposure to more than 10% of multiple companies’ shares, it did not have to report those positions.
How have lawmakers responded?
The Democratic chairman of the Senate Banking Committee, Sherrod Brown, commented on the Archegos situation by saying, “Once again, investment banks put profits first and enabled risky derivatives trading that resulted in billions of dollars in losses. We must make sure our financial watchdogs work together to protect the financial system and our economy. I expect the SEC and other regulators to take a closer look.”
Senator Elizabeth Warren, also a member of the powerful Senate Banking Committee, had similar thoughts on the matter. According to Warren, “Archegos’ meltdown had all the makings of a dangerous situation — largely unregulated hedge fund, opaque derivatives, trading in private dark pools, high leverage, and a trader who wriggled out of the SEC’s enforcement,” She went on to issue a call to action by saying, “Regulators need to rely on more than luck to fend off risks to the financial system: we need transparency and strong oversight to ensure that the next hedge fund blowup doesn’t take the economy down with it.”
The SEC has opened a preliminary inquiry into Archegos, and market watchers are calling for tougher oversight of family offices like Archegos. Others are calling for more transparency in the market for the kind of derivatives sold to Archegos. It remains to be seen whether any of these calls to action with result in any significant regulatory changes to the financial markets.