Archegos

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No. It’s still too soon.

—JC, June 2019.

Later...

It is no longer too soon, for on July 29, 2021 the Credit Suisse Special Committee to the Board of Directors has presented its Report on Archegos Capital Management to the board and, for some reason known only to the board, they have published to it to the known world. This seems to be a final act of self-harm from an organisation whose serial acts of self-harm the report catalogues in such clinical, precise detail.

That said, it is an act of self-harm for which the watching world should feel tremendously grateful. Not only a sizzling read, arriving just in time for Bank executives as they head for a fortnight to the sun loungers of Mykonos and Ibiza, but it is a beautifully clear explanation of the business of equity prime brokerage in particular and global markets broking in general, and a coruscating dismemberment of the way investment banking operates, both inside Credit Suisse and without.

—JC, July 2019

This is a proper horror story, make no mistake: Stephen King has not a patch on this.

Everyone involved in the business of prime services, and global markets broking generally, should read the Credit Suisse Report.

And while the goings on at CS were breathtakingly, class-leadingly chaotic — it is hard to believe that any one organisation could have made so many unforgivable errors, in such scale, over such a long period, so consistently, missing many opportunities to cotton on, without catching even one lucky break as the apocalypse unfolded around it — this really is a royal flush of idiocy — the makings of all these joint and several catastrophes is imprinted in the DNA of every multinational organisation. An onlooker who denies it — who does not shudder and think, there, but for the grace of God, go I — is showing precisely the lack of awareness that nearly sank CS.

After all, CS was by no means alone in taking a hammering in the fallout from Archegos. It just took the worst hammering, and has been the most candid about why. Its Special Committee makes a number of excellent recommendations — all worth heeding — but stops short of the one that must have been most tempting to the Board: get the hell out of the broking business altogether.

Almost all the most egregious errors were sociological, and not systemic: they speak of human foibles, the thrall of power, human seduction by the simplicity of models and the internal primacy afforded to capital calculations — a proxy means of measuring ones ability to withstand catastrophe and not avoiding catastrophe as an end in itself — with arse-covering, deference to hierarchy, fiefdoms and silos, inexplicable insouciance in the face of steadily escalating risk and, when it comes to it, outright idiocy.

This sums up how dire the whole sorry business was: In early March, 2021, Credit Suisse gingerly asked Archegos to consider a new margin proposal under which CS would take $1.35 billion of funds it currently held for Archegos and recharacterise them as initial margin: asked, that is, when Credit Suisse was contractually entitled to demand that, and more, on 3 days’ notice. Archegos promised to consider the request, but while it was thinking about it, requested CS pay it the $2.4 billion in excess variation margin Credit Suisse was holding. And Credit Suisse paid it without question.

In other words, two weeks before Archegos blew up, Credit Suisse, knowing it was woefully under-collateralised, still paid Archegos 2.4 billion dollars. Archegos used that money to put on a further billion and a half dollars in additional long positions, making Credit Suisse’s whole situation even worse.

Breathtaking.

Concerns about Archegos

• Trustworthiness: Between 2012 and 2014 Bill Huang and his Tiger Asia fund was convicted of wire fraud, settled charges of insider trading, and was banned from the Hong Kong securities industry for four years. Huang was only able to continue by returning all outside capital to its investors and “rebranding” as a family office exclusively running Huang’s own (and, well, his prime brokers’) money.
• Skill: Over the 10 years between the insider trading debacle and the final collapse, Archegos suffered multiple massive drawdowns. Extreme volatility which sounds like Huang had no real skill as a money manager, and was rather riding around like a child holding a firehose of leverage.
• Controls: As early as 2012 the Credit team had identified Archegos’ key man risk (in Huang), volatility, mediocre operational management practices, fraud risk, and poor risk management as significant concerns.

Mis-margining

Credit Suisse’s margining methodology for swaps was, from the outset, positively moronic. The JC is a legal eagle, not a credit guy, but even he could spot the flaws in this.

• TRS not synthetic equity: CS appears to have documented the trades as “total return swaps” under a standard equity derivatives master confirmation, and not as “synthetic prime brokerage” under a portfolio swap master confirmation. The differences are subtle, but there are two in particular:

• TRS tend to be “bullet” swaps with a scheduled termination date and do not “restrike” their notional before maturity, and they are statically margined.
• Portfolio swaps are designed to replicate cash prime brokerage; the investor does not have a specified maturity date in mind at the outset, and may keep a swap on for a day or five years, so the broker is completely in the dark as to the likely tenor of the trade. This makes fixing an amount of margin upfront fraught. To assist with nerves in the risk department, the notional of synthetic equity re-strikes periodically (like, monthly), and initial margin is calculated daily against the prevailing “Final Price” rather than the original “Initial Price”. Archegos swaps were, typically, bullet swaps margined with a fixed amount up front. As they appreciated, the margin value as a proportion of their prevailing value eroded. Archegos apparently used the variation margin it was earning through those appreciating positions to double down on the same trades — also static margine — pushing the equity price further up, exacerbating the problem. His swap portfolio was a ticking time-bomb.

• They didn’t keep an eye on the direction of the portfolio: Archegos at first used the swap book to put on short positions that offset the long bias on its cash book. It used this bias to argue for lower margins — a request the business accommodated, provided the combined portfolio bias did not exceed 75% long or short. Over time Archegos frequently exceeded these limits, often for months at a time, but CS took no action, accepting Archegos’ promises to correct the bias.
• They didn’t take enough margin: Archegos pressured CS to lower its swap margins, citing more favourable margins it was getting from other brokers due to the effect of cross-margining.

The greatest fool theory

You read variations of the following a lot in the Archegos report: “if we increase margins [to risk-acceptable levels], we will lose the business”. Indeed, you will hear variations of that theme, every day, uttered by anxious salespeople in every brokerage in the City. Salespeople would say this: their role is to say things like this: they speak for their clients, and their own bonus prospects, at the table where business is discussed. But others at that table — notably risk — should be taking the other side of that conversation.

So should your risk team be led, as CS’s was, by ex-salespeople with no experience in risk management? Probably not. Should it be business-aligned at all? Interesting question.

In any case it seems the fears of CS risk executives, that they might be uncompetitive if they raised margins, was flat out wrong. To the contrary, Archegos directed business to CS because it was margining swaps more cheaply than anyone else.

There is an argument that the guy who wins an auction is the stupidest guy in the room. To the broker who lowballs more circumspect peers, the spoils, but at a price its peers consider beyond the pale. Brokerage is an annuity business: it is picking up pennies in front of a steamroller. Credit Suisse found 20 million dollars of pennies in front of the steamroller in a year. The steamroller did it five and a half billion dollars of damage overnight.

Archegos switched positions away from other brokers and to Credit Suisse because CS offered the tightest margins.

Let this be the lesson: sometimes losing business is not such a bad thing.

Formal versus informal systems

And here we see the behavioural crux: we tell ourselves that what matters in risk management are the formal boundaries we draw; the official channels; the technical superstructure of the relationship; the architecture of the parties’ rights and obligations versus each other. But this isn’t true. In practice the relationship is governed by soft, morphing, invisible, informal boundaries. Interpersonal relationships. Understandings. Past practices. Precedents. Expectations. Trust. The commercial imperative.

Not only that, but there is a fundamental asymmetry in that softness between the parties: the relationship, after all is one of service provider and customer. The custome sees the edges of its rights and obligations as, for the most part, hard-edged economic options, to be exercised without fear or favour, regardless of the impact of their exercise on “the house”: if you run a roulette wheel with odds favouring the customer, expect your customers to exploit it mercilessly until you correct your algorithms. Thus, Archegos was entitled to withdraw its excess variation margin, and its broker had little option but to comply ''without blowing up the relationship. On the other hand, the recalibration of initial margin, whilst framed as a contractual right, on three days’ notice, was understood to be nothing of the kind, unless the conditions justifying exercise were so unbearably dire as to give the broker no plausible alternative.

The broker is a service provider; it wishes the client only well. It presents its risk management parameters (for example, rights to raise margin) not as targets it intends to hit mechanistically of their conditions are triggered, but last resorts it will deploy with a heavy heart and only if calamity otherwise awaits.

So while a contractual right held by the client more or less means exactly what it says, the broker it draws its formal boundaries well inside the area it is prepared to let the client, in practice, wander. NAV triggers are never exercised. If the client approaches the edge of that wider area — a real point of no return for the broker — the broker will not mechanicistically pull triggers and detonate positions: instead, it will reason with the client, realising that precipitous action

Red flags

• Key person risk
• Volatile performance
• Mediocre operational management practices
• Fraud risk
• Poor risk management practices and procedures

See also

Report on Archegos Capital Management

• Informal systems