Everyone is talking about the swift tumble of Archegos Capital Management and subsequent plummet of Credit Suisse and Nomura stock prices. There’s no doubt these prime brokers will eventually bounce back, so isn’t the ensuing panic of investors misplaced?
In what has been described as the “dumbest financial story of 2021,” Archegos, a hedge fund (turned family office) run by convicted insider-trader Bill Hwang, performed a multibillion-dollar belly flop on Monday. Some of the fund’s prime brokers, namely Goldman Sachs and Morgan Stanley, successfully limited their losses by acting expeditiously, while others (including Credit Suisse and Nomura) were left with a bill in the billions.
This event sparked a selloff of financials, hinting at investors’ fears of a spillover to the whole financial sector. The concern that hedge funds can have so much influence over their prime brokers, however, is overblown. In fact, the risk of a prime broker shock negatively affecting their hedge fund clients is much larger than any potential risk of a hedge fund adversely affecting its prime broker.
For those who don’t know, hedge funds are intricately linked to their prime brokers. Typically, prime brokers are large investment banks (like Goldman Sachs and Credit Suisse) that provide hedge funds with financing and numerous other services, including securities lending, custodial services, and even dog walking.
According to the aggregate SEC data, around 50% of hedge fund financing comes from its prime broker (or brokers), with around 35% of total financing extended on an overnight basis. This means that a lion’s share of a hedge fund’s funding can be recalled with merely 24 hours’ notice.
Contractually, the prime broker–hedge fund relationship disproportionately favors the prime broker. Hedge funds are usually overcollateralized, which means that the value of the collateral they post to execute leveraged trades exceeds the original amount borrowed. If collateral value decreases, a hedge fund receives a margin call, meaning that more collateral must immediately be provided or else its position is liquidated. In the case of Archegos, the hedge fund defaulted on its margin calls, leading to Goldman Sachs’s and Morgan Stanley’s rapid unwinding of Archegos’s positions.
Aggregate SEC data suggest that, on average, the ratio of the value of collateral to borrowing is around 130%, though it varies over time and by prime broker, client, and type of securities traded.
For example, looking at data from regulatory reports filed by banks in the U.S., we can see that Goldman hedge fund clients posted collateral that was, on average, over three times that of their exposure to derivatives not traded on a centralized exchange, known as over-the-counter, or OTC, derivatives. In contrast, other clients, such as corporates or government entities, are frequently undercollateralized.
It’s pretty clear here that prime brokers dictate the terms of the game. In fact, the top 10 prime brokers capture over 75% of the entire prime brokerage industry.
In contrast, out of over 9,000 hedge funds reporting to the SEC, the 100 largest control only around 30% of total assets under management. Most hedge funds are relatively small (with assets of less than $150 million) and have little bargaining power, leaving them largely at the mercy of their prime brokers.
The most poignant example of this was the 2008 collapse of Lehman Brothers, which brought down over half of its hedge fund clients. However, research shows that even this extreme shock could have been mitigated by a simple diversification strategy. Indeed, Lehman clients with multiple prime brokers managed to survive that ordeal.
While, admittedly, in 2008 having multiple prime brokers was rare, the Lehman experience has made it common practice today. The fact that hedge funds have managed to adapt to their unequal relationship with their prime brokers and manage their counterparty risks highlights a clear failure of individual banks’ risk management (we’re looking at you, Credit Suisse and Nomura).
Given that Archegos is a family office, it does not need to disclose any information to the public. However, examining the last available public documentation from 2012 of Tiger Asia Management (headed by Hwang pre-Archegos), we can see that it used nine different prime brokers.
Assuming that Hwang maintained a relationship with most of these banks, it appears that he was managing his counterparty risk well. Some of the banks, however, were not.
Although we don’t have the details, it is easy to deduce that both Credit Suisse and Nomura probably extended Archegos too much leverage, neglecting to ask for sufficient collateral in return. Why was this allowed to happen?
The answer could have something to do with the allure of the juicy commissions such a big fund could bring in. It could also be true that Credit Suisse and Nomura accept less collateral as they’re relatively small players in the hypercompetitive prime brokerage industry. What is important to note, however, is that good risk management, as demonstrated by Goldman (one of the last prime brokers to begin dealing with Hwang again after his 2012 scandal), is rewarded by the stock market.
But even if a prime broker does suffer some losses owing to a hedge fund’s actions, an individual fund is highly unlikely to do life-threatening damage to a large investment bank. In contrast, a shock to a systemically important bank could ripple through the entire financial system.
Such an event is the kind of real, undiversifiable risk regulators should keep their eyes on, not idiosyncratic quasi-threats like the one Archegos poses.
Valeri Sokolovski is an assistant professor of finance at HEC Montreal.
Magnus Dahlquist is the Peter Wallenberg professor of finance at the Stockholm School of Economics.
Erik Sverdrup is a postdoctoral researcher at Stanford Graduate School of Business.
