5/13/22, 1:15 AM Archegos debacle reveals hidden risk of banks’ lucrative swaps business | Financial Times

Derivatives
Archegos debacle reveals hidden risk of banks’ lucrative swaps business
Derivatives that blew up Hwang family office were growing source of revenue for Wall Street

Global banks earned an estimated $11bn in revenue from synthetic equity financing including total return swaps in 2019, double the
level of 2012 © FT montage

Robert Armstrong in New York APRIL 1 2021

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The Archegos Capital debacle has exposed the hidden risks of the lucrative but opaque
equity derivatives business through which banks empower hedge funds to make
outsize bets on stocks and related assets.

The soured wagers made by Bill Hwang’s family office have triggered significant losses
at Credit Suisse and Nomura, underscoring how these tools can cause a chain reaction
that cascades across financial markets.

Archegos was able to take on tens of billions of dollars of exposure to stocks including
ViacomCBS through total return swaps, a type of “synthetic” financing that is popular
with hedge funds since it allows them to make very large bets without buying the
shares or disclosing their positions as they would if they owned the stock outright.
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The lack of transparency means firms such as Archegos can enter into similar swaps
with several lenders, which are not privy to the investor’s overall exposure,
magnifying the risk to hedge funds and banks if the positions backfire.

Global banks earned an estimated $11bn in revenue in 2019 from synthetic equity
financing including total return swaps, double the level of 2012, according to
Finadium, a consultancy.

The business, which has grown rapidly since the financial crisis, accounts for more
than half of banks’ total equity financing revenue, Finadium calculates — more than
traditional margin lending and lending out shares for shorting combined. Synthetic
financing continued to take share from other forms of equity financing in the first half
of this year.

Banks earn steady income streams on total return swaps through the regular fees
investors such as hedge funds pay to enter into the agreement. The investor is then
paid by the bank if the stock, or other related assets including indices, rises in value.
The bank also provides investors with any dividends that come with holding the stock.

The bank offsets its exposure by either owning the underlying shares, taking the
opposite position with other clients with an opposing view, or buying a hedge from
another financial institution. 
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5/13/22, 1:15 AM Archegos debacle reveals hidden risk of banks’ lucrative swaps business | Financial Times

If the stock falls, the investor has to post regular payments, ranging from daily to
quarterly, to make the bank whole.

“Since most swaps are executed on large notional amounts . . . this could put the total
return payer (typically a commercial or investment bank) at risk of a hedge fund’s
default if the fund is not sufficiently capitalised,” according to Deloitte.

This is exactly the situation Archegos faced when several of its positions cratered,
leaving the banks to sell off the hedges — the stocks — in a great rush. The situation
was made more severe because Archegos had entered into swap agreements with
multiple banks.

Because equity total return swaps are

bespoke or “over the counter” contracts
Though the big banks between two parties, they are not cleared and
have pages and pages of reported through an exchange. Nor are
disclosure related to investors required to report their synthetic
derivatives, they are equity exposure to the US Securities and
typically at a level so Exchange Commission, as they would if they
high that you don’t get had the same amount of exposure through a
close to seeing cash holding.

information about The industry is required to report most swaps

exposure to individual deals to a data warehouse that provides
counterparties/securities authorities with information on derivatives,
Dave Zion of Zion Research Group but rules covering equity total return swaps
do not come into force until later this year.

“We have a fundamental problem in the

reporting of holdings of synthetic equity that is not secret and is not new,” said Tyler
Gellasch, a former SEC official and executive director of Healthy Markets, an advocacy
group.

“If there are five different banks providing financing to a single client, each bank may
not know it, and may instead think it can sell its exposure to another bank if they run
into trouble — but they can’t, because those banks are already exposed.”

The growth in the equity total return swap market “developed as a natural outcome of
Basel and Dodd-Frank rules that often favour [total return agreements] over cash
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5/13/22, 1:15 AM Archegos debacle reveals hidden risk of banks’ lucrative swaps business | Financial Times
equity financing”, said Josh Galper, managing principal of Finadium, referring to the
international and US reforms that followed the financial crisis.

For the banks, providing synthetic equity exposure is an attractive business because
when clients’ positions are consolidated against one another, it requires less
regulatory capital than traditional margin lending.

“Capital ratios, liquidity ratios and the ability to net down trades can make total
return swaps more advantageous” than other forms of equity finance, Galper said.

Banks’ disclosures make equity total return swap exposure hard for outsiders to
measure.

“Though the big banks have pages and pages of disclosure related to derivatives, they
are typically at a level so high that you don’t get close to seeing information about
exposure to individual counterparties/securities,” said Dave Zion of Zion Research
Group, which specialises in accounting.

“The information on concentration of credit risk tends to be at an industry level and it

will focus on net derivative receivables”, whereas gross numbers can be more
revealing when it comes to exposure to market risk, he said.

Some banks treat equity total return swaps as collateralised loans for accounting
purposes, according to Nick Dunbar of Risky Finance, a consultancy specialising in
bank disclosures. “They don’t get booked by the derivative trading desk of the bank, so
they don’t appear in the Basel III filings” of risk-weighted assets, leverage and credit
risk that all global banks are required to make.

The lack of disclosures means that the equity total return swap business, which is
generally a source of steady profits for banks, conceals rare but severe risks. One
banker on an international bank’s equity derivatives desk said “it was very hard to
know who owns what”, and as such equity total return swaps are “a classic case of
picking up nickels in front of a steamroller”.

“You can pick up those nickels all day. That steamroller moves pretty slowly. But if
you trip, boy, do you get run over,” he said.

This story has been amended to clarify the reporting requirements concerning total
return swaps and the frequency of margin payments.

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