NEW YORK • The forced liquidation of more than US$20 billion (S$27 billion) in holdings linked to Mr Bill Hwang's investment firm is drawing attention to the covert financial instruments he used to build large stakes in companies.
Much of the leverage used by Mr Hwang's Archegos Capital Management was provided by banks including Nomura Holdings and Credit Suisse through swaps or so-called contracts-for-difference (CFDs), according to people with direct knowledge of the deals. It means Archegos may never actually have owned most of the underlying securities - if any at all.
While investors with more than a 5 per cent stake in a US-listed firm usually have to disclose their holdings and subsequent transactions, that is not the case with positions built through the type of derivatives Archegos apparently used. The products, which are transacted off exchanges, allow managers like Mr Hwang to amass exposure to publicly traded firms without having to declare it.
Archegos' swift unwinding has reverberated worldwide, after banks like Goldman Sachs and Morgan Stanley forced Mr Hwang's firm to sell billions of dollars in investments accumulated through highly leveraged bets. The sell-off roiled stocks from Baidu to ViacomCBS, and prompted Nomura and Credit Suisse to say they face potentially significant losses on their exposure.
One reason for the widening fallout is the borrowed funds that investors use to magnify their bets: a margin call occurs when the market goes against a large, leveraged position, forcing the hedge fund to deposit more cash or securities with its broker to cover any losses. Archegos was probably required to deposit only a small percentage of the total value of trades.
The chain of events set off by this massive unwinding is yet another reminder of the role that hedge funds play in global capital markets. A hedge fund short squeeze during a Reddit-fuelled frenzy for GameStop shares earlier this year spurred a US$6 billion loss for Melvin Capital and sparked scrutiny in the US.
The idea that one firm can quietly amass outsized positions through the use of derivatives could set off another wave of criticism directed against loosely regulated firms that have the power to destabilise markets.
While the margin calls last Friday triggered losses of as much as 40 per cent in some shares, there was no sign of contagion in markets broadly on Monday. Contrast that with 2008, when Ireland's then richest man used derivatives to build a position so large in Anglo Irish Bank it eventually contributed to the country's international bailout. In 2015, New York-based FXCM needed rescuing because of losses at its British affiliate resulting from the unexpected de-pegging of the Swiss franc.
Much about Mr Hwang's trades remains unclear, but market participants estimate his assets had grown to anywhere from US$5 billion to US$10 billion in recent years and total positions may have topped US$50 billion.
"This is a challenging time for the family office of Archegos Capital Management, our partners and employees," Archegos spokesman Karen Kessler said on Monday in an e-mailed statement. "All plans are being discussed as Mr Hwang and the team determine the best path forward."
CFDs and swaps are among bespoke derivatives that investors trade privately among themselves, or over the counter, instead of through public exchanges. Such opacity helped to worsen the 2008 financial crisis and regulators have introduced rules governing the assets since then.
Over-the-counter equity derivatives occupy one of the smallest corners of this opaque market. Swaps and forwards linked to stocks had a gross market value of US$282 billion at end-June 2020, according to data from the Bank for International Settlements. That compared with US$10.3 trillion for swaps linked to interest rates and US$2.4 trillion for swaps and forwards linked to currencies.
Regulators have clamped down on CFDs because of concern that the derivatives are too complex and risky for retail investors, with the European Securities and Markets Authority in 2018 restricting their distribution to individuals and capping leverage. In the US, CFDs are largely banned for amateur traders.
Banks still favour them because they can make a large profit without needing to set aside as much capital versus trading actual securities, another consequence of regulation imposed in the aftermath of the global financial crisis. Among hedge funds, equity swaps and CFDs grew in popularity because they are exempt from stamp duty in high-tax jurisdictions such as the United Kingdom.
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