Archegos and Derivatives: What Went Wrong with Risk Management?

By Charlie Browne, Head of Market Data and Risk Solutions, GoldenSource

Archegos Capital Management is now officially preparing for insolvency, after collapsing under the weight of bets it had placed using Total Return Swaps (TRS) that went wrong. Their excessive leverage on TRS, accompanied by shortcomings in risk management, meant that when it went down it inflicted billions of dollars in losses on the banks that had lent it the money to trade the TRS.

It had been using TRS to make leveraged bets in the equities market. Using only a small portion of its own money, and getting its bankers to fund the balance, Archegos was able to make huge bets on equities. The key for the banks was collateral. As long as Archegos had pledged collateral to cover its bets, the lending banks felt they were covered. For Archegos, this was easy … they just pledged the shares they had bought with the TRS. If Archegos ran into trouble on the TRS, the banks in theory would just sell off these shares to recover the money they were owed. Clearly most of these derivatives trades don’t go wrong and banks make money on fees and commissions funding them.

The role of prime brokers

Four major banks were acting as prime brokers for Archegos. Prime brokers are more common in the US than they are in the rest of the world. The broker not only executes the derivatives trades but also funds the trade and receives fees for doing so. Most of the funded trades are backed by securities – as was the case with Archegos. They had pledged the equities they bought as collateral. But it seems that as some of the banks’ clients generated more business, they were less stringent on collateral requirements.

In Archegos’ case, it used multiple prime brokers and was able to take advantage of this to increase its funding. The net result was a highly leveraged trading firm whose overall credit risk no one seemed to be monitoring. Archegos used all of this credit to build up huge TRS positions on a variety of corporations. When prices of their shares started to fall, the prime brokers did what they were supposed to do, they sold the collateral, i.e. they sold the shares that Archegos had pledged for the TRS. And as anyone who’s traded with leverage will know, when you’re that highly leveraged, the price falls don’t need to be that big for it to erode your capital. The prime brokers kept selling and Archegos went down.

Risk management failure

Archegos was a failure of risk management. All aspects of it: credit risk, market risk and operational risk. It was lax risk management that allowed the build-up of such leveraged positions by Archegos. The family office model, the lack of oversight by the prime brokers, the fact that notional positions were built up across multiple prime brokers, and the fact that it was the shares underlying the TRS that were being used as collateral;  all of this allowed the build-up of highly leveraged positions, apparently without much oversight.

The regulatory framework written after the 2008 financial crisis was designed to prevent such gaps in risk management. In the US, the regulation that should have prevented the build-up of such leverage was the Dodd-Frank Act of 2010. But the implementation of some of its most important parts have been delayed multiple times, with many saying that had the Securities and Exchange Commission fully implemented the rules much of the loss could have been prevented.

Could the Archegos collapse have been prevented with proper risk management?

The failure of risk management was central to the Archegos collapse, and the lack of enforcement of regulation was central to the risk management failures. A centralised view of legal entity exposures, clean and validated risk and time-series data, and accurate pricing are all critical to effective risk management. Clearly, boards of directors and regulators in the form of National Competent Authorities always learn from the latest event that fell through the cracks of governance, oversight and risk management. While Archegos won’t be the last financial firm to fail, it should be the last to fail because of this particular combination of factors