By Wei Sun
This blog post was published as an op-ed in Asia Times Financial on April 25, 2021.
While the capital management operation’s downfall may not end up being a “Lehman 2.0,” bankers and financial regulators aren’t naïve enough to think they were the only firm taking such a risky path.
The default by Archegos Capital Management on its margin calls on March 26 sent frissons of fear through global financial markets.
It evoked a sinking sense of déjà vu among investors – a financial firm being brought down by its involvement in highly leveraged, opaque financial instruments, with counterparts rushing for the exits and a couple being hit by the door on the way out.
While many do not expect Archegos to be a “Lehman 2.0,” it would be a brave – and foolish – banker or financial regulator who thinks that Archegos was the only firm to participate in such risky transactions.
With investors searching desperately for yield in an environment of prolonged low interest rates and easy liquidity, Archegos – meaning “leader” or “pioneer” in Greek – may well be the first such domino to fall, as markets become more volatile amid concerns over rising US yields.
Details of the Archegos failure are well-documented. It had purchased complex swaps known as contracts-for-difference (CFDs), brokered by the world’s major banks. These transactions entail buyers placing directional bets on the prices of securities for a fee, without actually purchasing or selling the underlying instruments.
The buyer would realize gains or losses from a portfolio of stocks or other assets – when the price of a security goes up, the seller pays the buyer the difference, and vice versa.
In the Archegos case, the payments appeared to have been correlated to a basket of shares whose prices tanked. CFDs also allow investors to take “leveraged bets,” that is, borrow money from the banks at a fraction of the cost of the underlying asset, of around 10 to 20 percent.
Family offices like Archegos have the potential to become systemically important, if they aren’t already. Let’s consider the data. Some 7,300 family offices around the world were estimated to manage $5.9 trillion for individuals or families worth $9.4 trillion back in 2019.
Put in context, the market capitalization of the benchmark Dow Jones Industrial Average is $10.3 trillion presently, and the pool of capital held by hedge funds globally was around $3.8 trillion at the end of 2020.
Archegos, reportedly with net assets of between $10-20 billion, may have had actual exposures of between $50-100 billion, and is estimated to have directly cost some of the world’s largest banks some $10 billion, with Credit Suisse and Nomura collectively losing almost $7 billion.
A financial firm is considered to be of systemic importance if its disorderly failure disrupts the functioning of the financial system, as a result of its size, substitutability, or interconnectedness, and has serious negative consequences for the real economy.
Often, we tend to think of large financial institutions as being more systemic, given their indisputable role in intermediating financial resources.
However, the Archegos incident is yet another reminder that interlinkages between a small distressed entity and the wider financial system, including the biggest banks and their networks, carry major financial stability implications because of direct spillovers to the balance sheets of other financial institutions and indirect contagion or “collateral damage.”
With greater global financial deepening and integration, the existence of borrowing-lending relationships, common business structures, capital market transactions, and investor herd behavior can strengthen such interlinkages.
So how would the spillovers from a shock to a systemic financial institution be manifested? Using this particular example, the trading losses from the Archegos default severely hurt the balance sheets of some of its prime brokers.
Although the probabilities of default of the latter’s own creditors remained relatively stable in this case, a sharp increase – as happened during the global financial crisis – would have required those creditors to make additional provisions to comply with the relevant financial regulations or accounting rules.
Those creditors could be subsequently constrained from undertaking some of their business activities, resulting in lower revenues or even losses overall. Moreover, the spillovers would likely not have stopped there, as the original shock would have been transmitted through multiple orders of inter-institutional relationships, causing wider collateral damage.
While the Archegos event was still unfolding, we stress tested the credit losses of Credit Suisse and Nomura and their networks for hypothetical scenarios. Assuming that the shocks to the two institutions ended up being of similar (albeit rather extreme) size to those experienced by Asian banks during the Asian financial crisis, Nomura could have exported almost $7 billion in collateral damage to other Japanese financial institutions, in addition to the potential losses of its own creditors.
Separately, the direct creditors of Credit Suisse, both at home and abroad, would have been most affected, racking up expected losses of close to 2.8 percent of Swiss GDP.
Asian financial systems continue to be exposed to systemic risks that may be beyond their control and outside their purview in an increasingly interconnected global financial system.
In this regard, the only defense may be that financial supervisors and regulators must ensure that their financial institutions remain well buffered, adopt strong risk management practices, and eschew risky, non-transparent transactions.
The region’s major financial institutions appear to have dodged the Archegos bullet and seem resilient to any further nasty surprises from Credit Suisse and Nomura. But, they might not be so lucky next time.
After all, the Iliad tells of how a young Nestor of Gerenia was able to bring down the giant, Ereuthalion of Arcadia, in ancient Greek mythology.
Ong and Sun are the authors of the paper The Failure of Archegos Capital Management: Estimating Potential Spillovers to ASEAN+3 Financial Systems