Large losses from “simple” equity derivatives - Archegos and total return swaps.

By Marcel Bessent

In a trading update provided by Credit Suisse earlier today (6th April 2021), the bank announced “a charge of CHF 4.4 billion in respect of the failure by a US-based hedge fund to meet its margin commitments”. It also announced that the CEO of the investment bank as well as the Chief Risk and Compliance Officer will step down from their roles.

News reports last week identified Credit Suisse as one of a number of global investment banks nursing large losses from derivative trades with New York based Archegos Capital Management, the family investment office of Bill Hwang. It is understood that the losses stem from a relatively vanilla equity derivative called total return swaps entered into between Archegos and the banks. It is reported in the press that the banks collectively allowed Archegos to amass tens of billions of dollars of exposure in various listed shares.

An equity total return swap is a synthetic way of owning a share with a fraction of the capital necessary if the stock was purchased outright. The swap pays out the difference between the share price at maturity relative to some price (known as the strike price) agreed at the start of the contract. The value of the contract mimics exactly the value of an outright purchase of the shares but without committing the same level of capital to the investment.

Most contracts are struck at a price which means that at inception the contract has a value close to zero (after fees). This means that the fund does not have to post large amounts of cash to enter into the swaps, only a relatively small initial margin amount is posted to the swap provider. By only committing a small percentage of the capital that would be needed to buy the stock outright, the fund can synthetically make investments far in excess of what would be possible in a cash purchase of the same assets. By providing the fund with the potential for magnified gains when their investment strategies are successful, the swaps providers – in this case, the investment banks – allow the fund to become highly leveraged.

As the price of the stock underpinning the contract changes so does the value of a total return swap. If a fund enters into a synthetic long position on a particular stock via a swap and the stock price moves higher, then the value of the contract moves in favour of the fund. Conversely, if the stock price were to drop, then the value of the swap would turn negative for the fund. In such a scenario, the mark to market loss becomes a debt to the bank and the fund would need to transfer the equivalent cash amount (known as a variation margin) to the investment bank to cover the exposure. This is known as a collateral call.

For a fund that is highly leveraged with relatively little spare cash relative to the size of its investments, collateral calls can quickly become a death spiral. Even small changes in the value of the assets underpinning the contracts, can have an outsized impact on the cash position of the fund. It appears that the unwillingness or inability of Archegos to make collateral calls when its investments started to sour sparked last weeks’ risk management debacle.

In theory, the risk from these swaps should be fairly straight forward to manage. The swaps are known as a “delta 1” type derivative, as the value of the contracts changes on a one-to-one basis with the underlying stock price. This means that if the bank buys the underlying shares in the same quantities as the swap contract then they have hedged any changes in the value of the swap. The problems arise when the counterparty to the swap defaults and effectively disappears, leaving the bank holding the shares as a hedge to a derivative which no longer exists.

Swaps are “over the counter” transactions between the fund and the bank. They are not cleared on any central exchange and so there is no publicly available reporting of positions. This in turn means there is no transparency on how many of these contracts a fund may have entered into with other banks.

Ordinarily, a bank may think that the risk is has to such a default is manageable and that it would be able to off load the shares without significant financial loss. Banks with large share buying and selling businesses with access to many institutional clients willing to buy large blocks of shares, at a relative discount to the market, can be lulled into a false sense of comfort regarding the true risk exposure. What one bank may think is a risk idiosyncratic to itself can quickly transpires into a systemic failure across the sector. What some banks thought would have been a limited exercise of selling a few shares into a liquid market appears to have become a stampede as others in the same position attempted simultaneously to off load many billions worth of exposure in just a few individual stocks.

The news today from Credit Suisse follows the announcements last week from the credit agencies Moddy’s and Fitch that they had changed their ratings outlook from stable to negative on both Credit Suisse AG and Nomura Holdings Inc – another investment bank caught up in the Archegos rout. The news is a sobering reminder that even “relatively vanilla” derivatives have the potential to be costly when poorly risk managed. In an echo of the central lesson from the Great Recession of a decade ago; leverage in times of distress can quickly escalate an innocuous risk into a career ending calamity. Risk managers at some of the banks involved appear to have understood this. Others have not fared so well.