The Jolly Contrarian

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,[1] 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.

There’s so much I’ve even made a little table of contents.

Table of contents

Intro

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 this brokerage 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 caused this situation.

After all, this broker was by no means alone in taking a hammering in the fallout from Archegos.[2] 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, the broker gingerly asked Archegos to consider a new margin proposal under which the broker would take $1.35 billion of funds it currently held for Archegos and recharacterise them as initial margin: asked, that is, when it was contractually entitled to demand that, and more, on 3 days’ notice. Archegos promised to consider the request but, meanwhile, demanded the broker pay out $2.4 billion in excess variation margin it was holding. And, two weeks before Archegos blew up causing this broker a $5.5billion loss, the broker paid the excess variation margin out.

If that isn’t painful enough, Archegos then used that excess to put on a further billion and a half dollars in additional long positions in the same stocks with Credit Suisse.

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 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

Archegos’s long bias was driven by the evolution of its swaps portfolio. Given the substantially reduced swap margin, Archegos began putting on long swaps (at the new lower margin) with CS, whereas it had historically held its long positions in Prime Brokerage (at a higher margin rate). The lower swap margins—which Archegos assured CS were “pretty good” compared to what its other prime brokers required—no doubt led Archegos to trade more swaps with CS, and Archegos’s holdings at CS increased markedly.

Here is a sort of convexity risk: If you offer the most favourable terms on the street, then customers will tend to put their positions on with you. If your swap margins are lower than your cash brokerage margins, your customers will tend, all other things being equal, to put their positions on swap. Water runs downhill.

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.

Had weapons. Didn’t use them.

At the same time, the contractual protections CS had negotiated with Archegos were illusory, as the business appears to have had no intention of invoking them for fear of alienating the client.

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.[3]

Not only that, but there is a fundamental asymmetry in the degree of that softness between the parties.

The relationship, after all, is one of service provider and customer: the customer sees its rights and obligations largely as hard-edged economic options, which it is free to exercise without regret, regardless of their impact on “the house”. Thus, Archegos was entitled to withdraw excess variation margin, and its broker had little option but to comply ''without “blowing up the relationship”. On the other hand, the broker’s right to recalibrate initial margin, whilst framed as an equally clear option, was nothing of the kind. It was implicit in the commercial imperative that the right would lie untouched unless the conditions justifying exercise were so unbearably dire as to give the broker no plausible alternative.

Now clearly, this broker miscalculated how bad the conditions were. But this is not Archegos’ fault, nor the lawyers’.

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/

The broker that didn’t bark in the night-time

KING LEAR: Now, our joy, Although the last, not least; to whose young leverage
Thine holdings in thinly traffick’d names, rich in outrageous voguery
Did bunch, distil, concentrate and conspire their margin lenders yet to o’er-extend;
How fared thy numbers, Sirrah? What can you say?
Will a grimace itself engrave upon that storied countenance? What did you lose? Speak.
GOLDMAN: Nothing, my lord.
KING LEAR Nothing?
GOLDMAN: Nothing.
KING LEAR: Nothing will come of nothing, fair squidly vampire: speak again.

—Shakespeare: Tiger King Lear, I, iii

What follows is heavily derivative and based on assumptions and extrapolations from a single footnote and may — most likely is, in fact — entirely mistaken. Nevertheless, even if it is, it illustrates an interesting hypothetical.

While other brokers to Archegos shipped losses most conveniently measured in the billions, one — Goldman — yes, that Goldman — reported “immaterial losses”.

Be assured, other brokers will be stamping their feet, cracking their cheeks, cursing obstreperous ill fortune, beating their fists on the ground, beseeching whichever mischievous God looks after the fates of regulated broker-dealers and wailing “how in the name of all that is holy can it be that while I took a regular shellacking, again, that Goldman outfit got away with it, without so much as a crease in its trousers, again?”

“What kind of second sight, what extra-sensory perception, what gift, what compromising photographs of the Almighty must Goldman have to lead such a honeyed life? What does the Vampire Squid have over the Fates that we other mortal dealers do not?”

Perhaps, I gingerly venture, nothing? Perhaps it is as simple as this: Goldman didn’t have much risk on in the first place. This may be prudent business selection; it may be that Goldman didn’t have much of a relationship with Archegos at all. According CS’s credit risk team in April 2020 — ten months before apocalypse — “Archegos had disclosed that its long positions with CS were “representative” of the positions Archegos held with its six other prime brokers at the time.”

Those six brokers, listed in the report, do not include Goldman.

If this is right, then less than a year before Götterdämmerung, Archegos wasn’t on Goldman’s books at all. If, as it claimed, Archegos preferred to “leg into” positions pro rata across its prime brokers, then a very-late-to-the-party prime broker would not have had much Archegos risk on its book. And with little risk, similarly few revenues to forfeit.

Without a long, deep, fearful, profitable client relationship, a broker had less skin in the game, may have treated Archegos with less reverence than its peers, may have declined to put positions on in such a cavalier fashion, and then been less bothered about upsetting its customer by closing it out at the first sign of trouble. This is consistent with how, by all accounts, Goldman conducted its book during Archegos’ end game.

Now whether this is what actually happened or not is, mostly, beside the point. But it points to another potential source of destabilising risk: a fellow broker who cares less about the commercial imperative than you do. Even a small block sale could have triggered, or amplified, a catastrophic run on concentrated holdings in a thin market with a single, incapacitated bidder.

Juniorisation of the meatware

Below them, and in conjunction with material reductions in headcount across the IB, overtime each and every PSR and CRM analyst became responsible for an ever-increasing number of clients. As employees left PSR, they were replaced with less experienced personnel, a process that one witnessed referred to as the “juniorisation” of PSR. PSR was thus hollowed out, both in terms of the experience of its personal as well as the attention they could devote to their duties.

—CS Report on Archegos

There is a slight tension to this one because, on one hand, it seems utterly right that the systematic downskilling that CS, and every other broker, has carried relentlessly since the financial crisis must massively deprecate an institution’s ability to deal with existential crises like these ones: the JC has railed at length about the the folly of downskilling and outsourcing elsewhere, for exactly this reason. Yet, if there were heroes in this tale, they were the canaries in the coalmine — exactly those juniorised staff who said things like this hedge fund analyst in CRM:

“Need to understand purpose of having daily termination rights and ability to cause margin [with] 3-days notice on swap if client is not amenable to us using those rights.”

I mean, out of the mouths of babes. There was quite a bit of human wreckage at CS in the aftermath, but you really hope the author of that email wasn’t part of it. But the wider point is this: when all is plain sailing, you can, if you wish, operate a complex business through the agency of cheap staff in remote locations with an instruction manual, which you hope has been suitably translated into Bulgarian. But the thing about complex businesses navigating open water is that ocean weather can quickly change, and a quiet potter around the heads can turn into a Fastnet tempest, and then your Bratislavan school-leavers are going to be hopelessly out of their depth. Relying on rigid application of playbook, policy, processes, system, algorithm or work-to-rules especially when, as it happens, your senior management are disinclined to enforce them properly anyway, is no way to survive a hurricane.


How organisations work

Thye episode is a masterclass in how organisations work; how people in positions in responsibility are propelled by internally-constructed second order derivatives of the risks they are meant to be monitoring: what matters is not what happens nor holding adult conversations with customers, even where that requires delivering unpalatable truths but that I should not be held responsible for what happens, a state of affairs one can vouchsafe by ensuring one follows internal models, policies and diktats regardless of their absurdity or fitness for purpose. There is a tension, between Sales on the one hand, whose north star is do not upset the client, and senior management, whose is make sure all the RAG indicators are green.

The job of reconciling this fundamental contradiction is left to those at the coal face, who are obliged to come up with solutions that squeeze the balloon.

When the problem breaks your model, you don’t change the model. Fix the problem.

So, to deal with the problem that Archegos was persistently breaching its stress limits with one CS entity, the solution was to repaper it with another one that had a higher stress scenario appetite. This was an opportunity to head off a coming crisis a year out. inflection point: wrong decision. When, after the migration, Archegos was still substantially in breach of its scenario limit, the business switched from the extreme “Severe Equity Crash” scenario to the more benign “Bad Week” scenario. Even then, six months from disaster, Archegos’ “Bad Week” exposure was still double the $250m limit. Another bad decision.

Quick! Form a committee!

As balloon continued to resist tactical squeezing, and in the wake of the Malachite failure a year earlier, management adopted the “People’s Front of Judea gambit” and, in an initiative to “identify early warning signs of a default” and “enhance its controls and escalation framework across functions during periods of stress,” the broker created a new committee. The job of the Counterparty Oversight Committee (“CPOC”), was to “analyse and evaluate counterparty relationships with significant exposure relative to their revenue generation and to direct remedial measures where appropriate”.

But there was plenty of information, and plenty of oversight already at hand. Indeed, too much: the prime services had two heads (though conveniently, neither saw the US financing business as his responsibility) and, as the Template:CS special report puts it, each was “inundated with management information, underscoring the overall mismanagement of the business”.

As John Gall notes in his Systemantics: The Systems Bible, “prolonged data-gathering is not uncommonly used as a means of not dealing with a problem. ... When so motivated, information-gathering represents a form of Passivity”.

Sometimes, data and oversight gets in the way.

Silos

It was not only the co-heads who operated in silos. Silos, as anyone who has worked in financial services will know, are endemic. They are no regrettable itinerantly of a modern organisation, but a fundamental ideological choice that it makes. “Downskilling” and specialisation — and by “specialisation” I mean “atomising a process into a myriad of functions so limited in scope that they can be carried out by non specialists following a playbook” — is no accident, but precisely what our modernist, reductionist, data-obsessed times demand.

Silos also give everyone grand pooh-bah titles and diffused responsibility. Co-heads of anything is either a failure of nerve (the case here) or a Spartan play to see who is strongest (the Goldman approach, but

Red flags

See also

References

  1. ↑ 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.
  2. ↑ Famously, of all the brokers, Goldman fared bestr, suffering “immaterial losses”. This may well be superior risk management practice — it’s Goldman, right? — but may have something to do with the fact that, according to the Credit Suisse report, Goldman didn’t have Archegos on its books at all until at least April 2020
  3. ↑ This isn’t the place for it, but note: these fundamental qualities of commercial life are utterly illegible to neural networks, policies and algorithms.
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