Archegos
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Risk Anatomy™
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No. It’s still too soon.
Later...
It is no longer too soon, for now the Credit Suisse Special Committee to the Board of Directors has presented its Report on Archegos Capital Management dated July 29, 2021 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.
What on Earth did they think they would achieve by releasing this report? It caused another precipitous drop in the firm’s stock price — nearly four percent — to go with the twenty percent drop it suffered when news of the default first broke.
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 beaches of Mykonos and the sun loungers of 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. This is a proper horror story: Stephen King has not a patch on this.
Everyone involved in the business of prime services — or global markets broking generally— should read this report.
And while the goings on at CS were breathtakingly, class-leadingly chaotic — it is hard to credit any one organisation could really have made so many unforgivable errors, in such scale, with so many opportunities for someone to cotton on, and not caught even one lucky break as the apocalypse unfolded around it — this really is a royal flush of idiocy — but the makings of all these joint and several catastrophes live in every organisation in the industry, and any who denies it is showing precisely the lack of awareness that nearly sank CS. After all, it was by no means alone in taking a hammering in the fallout from Archegos.
The 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 all together.
Concerns about Archegos
- Trustworthiness: Between 2012 and 2014 Bill Huang had been convicted of wire fraud, settled charges of insider trading, and had been banned from the Hong Kong securities industry. They were only able to continue by returning outside capital and “rebranding” as a family office exclusively running Hwang’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 Hwang 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 Hwang), volatility, mediocre operational management practices, fraud risk, and poor risk management as significant concerns.
Mismargining
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 I 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 agreement, and not synthetic equity derivatives 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 as a result do not “restrike” before maturity, and are statically margined. Portfolio swaps are designed to replicate cash prime brokerage; there is not a specified maturity date, so the notional restrikes periodically (like, monthly), and initial margin is calculated daily against the prevailing “Final Price” rather than the original “Initial Price”. As Hwang’s positions appreciated, the margin value as a proportion of the position eroded, and Hwang apparently used the variation margin to double down on the same trades, pushing the equity price further up, exacerbating the problem.
- 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 crequently exceeded these limites, 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.