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Investment Firm’s Collapse Put Unseen Risks on Full Display

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After the implosion of a little-known investment firm saddled banks around the world with billions of dollars in losses last week, one big question is being asked all over Wall Street: How did they let this happen?

The answer may stem from the way Archegos Capital Management, with ample assistance from at least half a dozen banks, made bets on stocks without actually owning them.

Archegos used esoteric financial instruments known as swaps, which get their name from the way they exchange one stream of income for another. In this case, Wall Street banks bought certain stocks Archegos wanted to bet on, and Archegos paid the banks a fee. Then, the banks paid Archegos the stocks’ returns.

These swaps magnified the fund’s buying power, but they also created a two-pronged problem. Archegos was able to build up much more influence over the share prices of a few companies, including ViacomCBS and Discovery, than it could afford on its own. And because there are few regulations about these types of trades, it was under no disclosure obligations.

When those bets soured last week after the shares of some of the companies in question fell, it touched off a miniature crisis: The banks that had let Archegos amass such big holdings furiously sold the stocks to protect their own balance sheets, and the flood of cheap shares pushed the stocks’ prices down even more. And Archegos itself imploded.

The blind-side hit sent a shudder through the financial system and stuck banks with losses that some analysts say could reach $10 billion. And, for a time, it had Wall Street worried that problems could cascade.

“The disclosure system doesn’t cover any of this,” said Dennis Kelleher, chief executive of Better Markets, a Wall Street watchdog group. “These derivatives are designed for synthetic exposure which de facto conceals ownership interests.”

As banks tally up their losses and shareholders smart over the hit to their portfolios, the tactics that Archegos employed will draw the eye of regulators and renew calls for further regulation of swaps and similar financial products, called derivatives.

The Securities and Exchange Commission has said it was monitoring the situation, and Senator Elizabeth Warren, Democrat of Massachusetts, said the meltdown of Archegos had “all the makings of a dangerous situation.”

“We need transparency and strong oversight to ensure that the next hedge fund blowup doesn’t take the economy down with it,” she said in an emailed statement.

Credit…Emile Wamsteker/Bloomberg News

Archegos was actually a family office, set up to manage roughly $10 billion by Bill Hwang, who previously led a hedge fund that was embroiled in an insider-trading case under his leadership. But it used leverage — essentially, trading with borrowed money to amplify its buying power — perhaps as much as eight times its own capital, some Wall Street analysts calculated.

In this case, leverage showed up in the form of swap contracts. In return for a fee, the bank agrees to pay the investor what the investor would have gotten from actually owning a share over a certain period. If a stock rises in price, the bank pays the investor. If it falls, the investor pays the bank.

Archegos focused its bets on the share prices of a relatively small number of companies. They included ViacomCBS, the corporate parent of the country’s most-watched network; the media company Discovery; and a handful of Chinese technology firms. The banks it used to buy swaps held millions of shares in ViacomCBS alone.

Normally, big institutional investors are required by the S.E.C. to publicly disclose their holdings of stock at the end of each quarter. That means investors, lenders and regulators will know when a single entity holds a big ownership stake in a company.

But S.E.C. disclosure rules don’t usually cover swaps, so Archegos didn’t have to report its large holdings. And none of the banks — at least seven that are known to have had relationships with Archegos — saw the full picture of the risk the fund was taking, analysts say.

The use of stock-related derivatives has been rising sharply in recent years. The amount of outstanding equity derivatives — including swaps and a related instrument known as a forward — on stocks listed in the United States has more than doubled from $50 billion at the end of 2015, to more than $110 billion during the first half of 2020, the most recent data available, according to the Bank for International Settlements, an international consortium of central banks.

The use of swaps and other kinds of leverage can supersize gains when investments pay off. But when such bets go wrong, it can quickly wipe out an investor.

That’s what happened last week. Several stocks that Mr. Hwang’s firm had bet on started to fall, and the banks demanded he put up additional money or other assets. Known as “margin,” this is a cushion of cash meant to ensure that the bank doesn’t lose money if the stocks fall. When he was unable to do so, the banks dumped millions of shares of stock they had purchased.

The effect on share prices was profound: ViacomCBS fell 51 percent last week, and Discovery 46 percent. Shareholders in those companies saw the value of their holdings plunge; more than $45 billion in shareholder value was wiped out of those two stocks alone. And banks lost money on any shares whose value had fallen. Kian Abouhossein, a J.P. Morgan analyst, estimated that banks lost $5 billion to $10 billion in their dealings with Mr. Hwang.

Credit Suisse may have lost $3 billion to $4 billion, Mr. Abouhossein estimated. The Japanese bank Nomura Securities has said it is exposed to losses of as much as $2 billion. Morgan Stanley and Goldman Sachs have said they expect minimal losses — meaning it won’t seriously affect their financial results — but for such large entities that could still mean millions of dollars. Mitsubishi UFJ Securities Holdings Company, a unit of the Japanese financial conglomerate, reported a potential loss of around $270 million.

Analysts say the damage was relatively contained, and while the losses have been large for some players, they’re not big enough to pose a threat to the broader financial system.

But the episode will most likely reinvigorate a push to expand the regulation of derivatives, which have been associated with many prominent financial blowups. During the 2008 crisis, the insurance giant AIG nearly collapsed under the weight of unregulated swaps contracts it wrote.

The cascade of problems that began with Archegos was only the latest example of derivatives’ capability to increase unseen risk.

“During the financial crisis of 2008, one of the biggest problems was that many of the banks didn’t know who owed what to whom,” said Tyler Gellasch, a former S.E.C. lawyer who heads the Healthy Markets Association, a group that pushes for market reforms. “And it seems that happened again here.”

Matthew Goldstein contributed reporting.

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