The Archegos Chaos: Wall Street’s Most Shocking Event of 2021 …..So Far

By Raed Alkhedr, Regional Head of Research and Analysis at Equiti Group

Since the ease of lockdowns in recent months, there has been a general shift away from tech and media stocks, which profited greatly from the stay-at-home measures.

In the first quarter of 2021, cyclical companies, such as banks, airlines, and industrial firms started recovering as lockdowns loosened around the world, while tech shares faced a bearish outlook, and a margin call was struck on Friday, March 26th.. US banks were able to pull the plug faster than their Swiss and Japanese rivals and dumped these shares. Other banks followed the same pattern later taking the tally to more than $20 billion worth of shares sold. ViacomCBS fell to $48, another 27% lower; Discovery, Baidu, and Tencent also fell rapidly causing massive losses for Credit Suisse and Nomura.

This was the trigger of The Archegos Chaos: Wall Street’s Most Shocking Event of 2021…So Far, that provides valuable learnings to both brokers and traders.

The learning for brokers is to step up their due diligence on their clients before financing them and assess the potential risk from aggressive traders. On the other hand, traders must be aware of leveraged trading and its risks, as misused leverage with greed can cause large losses in a very short period. Traders always need a risk management plan in place and should utilize stop-loss orders in their trades to stay protected from massive drawdowns and large price fluctuations.

An analysis of the build-up to the Archegos Chaos – the plot had already formed.

Archegos is a so-called family office which manages the private wealth of Bill Hwang, who once worked for Tiger Management, another famous hedge fund. One of Archegos’ strategies was primarily focused on trading CFDs (Contract for Differences), a financial instrument where the underlying securities (stocks) are held by banks, but when markets are volatile, the strategy could fall apart.

The first sign of trouble came on March 26 when Goldman Sachs and Morgan Stanley began selling large blocks of shares for a client who had missed a margin call – a demand for more collateral to cover losses on trades that had gone awry. The stocks that were dumped are categorized as “second-tier tech”, and included Chinese search engine Baidu and American media conglomerate ViacomCBS. Their prices crashed under heavy selling pressure with the price of ViacomCBS shares, for instance, falling by more than 33%.

By Sunday, March 28th, news emerged that the client was Archegos.

On Monday, March 29th, Credit Suisse said it was in the process of liquidating the positions of a client that had defaulted on margin calls, and that the related losses would be “material”. Unofficial estimates put these losses at $3bn-4bn. Nomura, a Japanese bank, said that it was on the hook for about $2bn, possibly more if stock prices fell further.

Why would the banks fund an investor with a chequered past?

Banks are desperately searching for profits, and rules drafted after the global financial crisis make it expensive for Wall Street banks to trade on their own account. Previously, hedge funds and so-called family offices could make money from slow-moving, unleveraged asset managers. Such investors mostly buy and sell stocks cheaply on electronic platforms, thus Wall Street banks increasingly rely on fees and commissions from fast-trading hedge funds or family offices that act like hedge funds, like Archegos. Fees on derivatives, such as equity swaps and CFDs, are especially attractive to brokerages. The appeal for the fast-money hedge-fund crowds is that such derivatives allow them to magnify their positions through leverage. They can open larger positions without having to put up more of their own capital upfront and without revealing that they opened those positions.

How did Archegos end up losing so big?

Leverage played a big part. In a CFD, a trader deal with a bank and benefit from price changes without owning the stock. So, if the hedge fund opens a buy order for a CFD share and its stock goes up, the bank pays the difference, and if it goes down, the hedge fund pays the difference. In CFD trading, financial leverage comes into play – leverage is an investment tool that allows investors, in this case Archegos, to gain exposure to the financial markets with a smaller amount of capital, known as margin. This strategy is also known as margin trading, which allows traders to benefit from leverage and open larger positions with the same amount of capital (unleveraged), thus achieving a higher return on equity.

Archegos were offered leverage of 1:5. This means for each $1 a trader puts, the bank provides liquidity of $5. So, for instance, if the $1 margin allows a trader to buy 10 shares, the bank can support the trader with another 40, making the total size of the trade 50 shares. Effectively, Hwang could build large positions by using leverage, and the firm was able to take 5 times the amount they had which was $10bn leveraged up to almost $50bn.

Keeping that in mind, Archegos borrowed extensively to finance big bets on ViacomCBS, Discovery, and Chinese giants Tencent and Baidu. These stocks performed very well at the start of 2021 with ViacomCBS rising from $30 to $100 between January 5th and March 22nd. Discovery’s share price also reached $77 on March 15th, from $36 in early January. As these stocks’ prices went up, it appears that Hwang kept using the money he earned to buy more of these stocks thus increasing the margin required to keep his trades open. However, between March 23 and 24, these stocks crashed to a point and received a margin call – ViacomCBS fell from $100 to $67, a 33% drop in three days. Hwang was unable to keep his financial pledges and refused to cover his margin call forcing the banks to act quickly by dropping the shares they held.

How the officials responded.

On Friday, March 26th Japan’s finance minister said the government is looking into the financial losses incurred by Japan’s Mitsubishi UFJ Financial Group and Nomura and will share information on the matter with the Bank of Japan and overseas authorities.

The U.S. Securities and Exchange Commission (SEC) and the UK’s Financial Conduct Authority (FCA) have also launched preliminary probes into the Archegos meltdown. The SEC declined to comment on Friday, March 26th and the FCA did not immediately respond.

Could Archegos-linked shares bounce back again?

Wall Street is counting the cost of the Archegos meltdown, with pressure piling up on Credit Suisse, while attentions turn to regulatory scrutiny that might result from banks unwinding the fund’s positions. Shares like ViacomCBS and Discovery took the hit and now traders will have to decide whether they will go back into market or not.

ViacomCBS and Discovery are now trading below their median price targets of $55 and $46 respectively, and for some traders, it could be the dip they’re looking for. All these companies have relatively good financial books and just happened to get caught in the Archegos fiasco. Biden’s latest $2 trillion spending plan initiative could also boost the overall confidence in the market, hence pushing the tech industry to the upside. Yet, the lack of more detailed information regarding the Archegos blunder could still bring uncertainty around the duration of the event and therefore investors may be dissuaded from these shares in particular.

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