Archegos Capital, the heavily leveraged family office of former Tiger Cub Bill Hwang, reportedly triggered huge losses in a handful of stocks, including ViacomCBS and Discovery, that began last Friday. Now the new chairman of the Securities and Exchange Commission, Gary Gensler, and other global regulators are considering what to do to prevent a similar implosion.
The stock meltdown impacted six banks who lent money on margin to Hwang’s family office, including Goldman Sachs, Morgan Stanley, Credit Suisse, and Nomura. The chaos apparently started when Hwang couldn’t make his margin calls. The banks started selling shares of the companies on Friday, rocking the markets and sending investors into a tail spin to figure out what was happening.
Even as more details emerge about the bets that Archegos has been taking in recent months, one of the core risks that the family office’s investments posed to the market was the risk that a single stock would implode, according to Andrew Beer, managing member of quantitative investment firm Dynamic Beta. He explained that larger hedge funds in particular have been increasingly crowding into the same names for the last decade. The Archegos situation illustrated these risks in real time. According to Beer, there are many questions for regulators and the market, such as whether banks ramped up high loan-to-value loans via swaps against single stocks that had just doubled or tripled over a year or less, as well as ramping up the dollar amount of loans and swaps as the underlying price of the stock rose.
“This is a regulatory piñata,” Beer said.
Archego’s exposure to stocks like Viacom was masked by holes in the U.S. regulatory regime, according to Eitan Hoenig, a partner at boutique law firm Kluk Farber Law in New York. News reports suggest that Archego used total return swaps to get exposure to the stocks, rather than owning them directly. Even though it was equivalent to borrowing a bunch of money and buying the stock, Archego didn’t have to provide transparency to regulators or abide by margin lending restrictions.
Hoenig said there’s one world of margin rules and restrictions for investors who hold securities and another for investors that get exposure through complex derivatives.
“I would expect people to say, ‘Wait a second, we have a set of rules on how you do margin lending when people actually own the shares, and we have a whole other world, where people don’t actually need to own the shares to make a leveraged bet on an individual stock,’” he said. “The whole purpose of margin lending rules is that we want to limit speculation and we want to limit people selling on a margin call and causing the stock to go crazy, just like Viacom did. It’s much easier for a large institution with prime brokerage connections to use synthetic margin loans than it is to do actual margin lending based on actual securities.”
Marlon Paz, head of Mayer Brown’s broker-dealer regulation and compliance practice, believes the issues fall into two categories: investor protection and systemic risk.
While family offices are generally a far cry from main street investors, they still deserve protection, he said. “You have a family office incurring leverage,” he said. “The number is eye-popping. I would say the SEC will look closely at the question of the level of protection that a financial intermediary owes to family offices.”
Paz, who worked at the SEC during the financial crisis, expects that regulators will look into Regulation Best Interest, or Reg BI. “I say Reg BI is going to have to be revisited to determine where a family office fits: retail or institutional customer,” he said. “If retail, is it in the best interest of a family office to have billions in leverage?”
Then there is systemic risk. The Archego saga illustrates how one family office could inject a lot of counterparty risk into the system when it defaults on certain obligations, putting the banks that lent money to the family office at risk themselves. In part, that’s because family offices aren’t restricted in the amount of leverage they can use, Paz said.
“I would suspect that regulators will review the margin requirements applicable to market participants to ensure that accounts have adequate collateral,” Paz said. “The margin rules that apply to certain family offices are likely going to be reviewed from the perspective of systemic risks. Can we put in a cushion so if there is a shock, the capital markets can absorb the blow?”
Regulators have already taken steps to investigate what happened. According to the Financial Times, the Securities and Exchange Commission and the U.K.’s Financial Conduct Authority have asked the banks involved with Archegos to provide information.