For the second time in 2021, a hedge fund’s trading strategies have impacted the broader market, as hedge fund/family office Archegos Capital Management had its positions liquidated by its prime brokers and banks, and that resulted in harsh declines in some well-known stocks (Viacom, Discovery, and Baidu). The main reason stocks opened lower on Monday was because markets were concerned that there would be more fallout from the Archegos liquidations.
It is worth noting that Archegos operates as a family office for a former hedge fund analyst. Family offices are generally not regulated.
Given the focus on this issue in the financial noise networks (CNBC, Twitter, Reddit, etc. that I tell all my clients not to get sucked into). I wanted to make sure I covered 1) what happened, 2) why it matters to markets, and 3) what it means for markets/portfolios going forward.
What Happened: Late last week, a hedge fund/family office that was thought to have $5 billion in AUM failed to meet margin calls, and as such its equity holdings were liquidated by its banks and prime brokers, including Credit Suisse, Nomura, Goldman Sachs, and others.
However, because of the use of “Contracts for Differences” (CFDs) owned by Archegos, the total amount of positions that they needed to be liquidated was more than $30 billion. That forced selling in turn caused steep declines in some specific stocks (referenced above) and the broad market on Monday morning.
Why It Matters: Simply put, we do not know if this issue will become systemic and whether it will impact the broad markets beyond a few days. The key problem is we do not know how much more selling is left, how many other banks have exposure to Archegos, or how many other funds have used Contracts for Differences to amass massive equity positions with virtually no underlying equity backing the trades – I will explain what that means below.
The key issue here is the use of Contracts for Differences, which are essentially binary outcome contracts (only two possible outcomes) that allow hedge funds to 1) get massive leverage to an investment, as margin requirements for CFDs can be as low as 2% (both the New York Stock Exchange and FINRA require that all investors keep at least 25%), 2) avoid regulatory exchanges and reporting requirements because these contracts are made behind closed doors (because they are private transactions).
What makes these CFDs concerning is that it is very hard to know what exposure a fund or bank is carrying.
For instance, if I owned a Hedge Fund, I could (theoretically) call a prime broker and enter into a CFD to get $100 million of AAPL stock. To get this exposure, I would only have to put up a small amount of capital ($2 million or $5 million, for example).
Then, I could call a different prime broker and enter the same CFD with them, meaning now I am long $200 million of AAPL with only a small amount of margin posted. None of my creditors would know my total exposure (just my exposure to them).
Additionally, with CFDs, I do not even have to own the stock. I am just entering into a contract that says I receive the profits between the initial price (say AAPL at $120) and the exit price (if AAPL is over $100, I get the difference, if AAPL is under $100, I pay the difference).
On top of that, I can enter a CFD for the stock to appreciate or for the stock to decline (being short the stock, although I do not have to worry about delivering the stock like retail investors have to).
This is why we saw such heavy selling in unrelated names on Friday. When Archegos could not meet the margin calls, the banks sold the liquid assets of Archegos, regardless of whether they were related to any CFD.
Here is the potential major problem: CFDs rely on both the investment firm entering the contract and the bank/prime broker writing the contract to be very proactive about risk management and collateral (kind of like how mortgages rely on the borrower and lender to make responsible choices). We saw how this worked in 2008.
Unfortunately, we all know how that can go sometimes, and in an environment of excess liquidity with very few safe options for investor return, the fear is that this is another canary in the coal mine about excessive risk-taking in markets.
What this Means for Markets Going Forward (i.e. How to Position): As I mentioned, the key concern here is contagion (spread of an economic crisis from one market to another), because it’s very hard to tell exactly how much exposure banks had to Archegos CFDs (or to other firms’ CFDs), because again they are off the exchange and not regulated. As expected, the systemic risk has been downplayed as this being an Archegos specific event. While this entire thing is concerning for anyone that lived through the financial crisis, at this point, there is no evidence to imply this goes deeper, so I do not think the Archegos event means we should de-risk. If anything, we should see some buying opportunities.
To that point, banks got hit on fears of contagion, and I would use any additional declines in the banking sector to buy more (for investors that can handle volatility) because this incident is not altering my Four Pillars of the rally, is not derailing the economic recovery, nor slowing down the rise in Treasury yields.
Beyond tactical positioning and thinking with a longer-term time horizon, I will say that the fact that we have had two hedge fund blowups that have had wider-reaching market implications in the first three months of the year is unsettling. It is especially unsettling for the longer-term future as these blowups are happening when the market is strong and resilient. This begs the question of what might go south if/when we get into an extended period of volatility.
Bottom line, this episode does not make me want to change strategies or reduce exposure unless something changes, but it does remind us that at some point markets will have to deal with the negative side of historic excess liquidity, and that could be a bumpy ride.
If you have any questions, please reach out to me directly.
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
Email: email@example.com | ivoryhill.com
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