Archegos Scam: Explained
A truly simplified, and detailed explainer on the Archegos scam, which could be the next "Lehman Brothers" kinda moment for Investment Banks.
On March 24, 2021, some larger US stocks (blue chips) crashed like crazy. Panic and fear flooded the markets, and all players, big and small, lost money. What caused this? The pure greed of a few in the financial markets, those with the hunger to make more, and more.
This time, it was an investment firm called Archegos (pronounced aar-khe-goes) that took it upon itself to defraud investors. How bad is it? And, how was it able to pull it off in the first place?
Read on.
Once upon a time, there was a boy who wanted to rule the investment world. Across the ocean of opportunity, the boy could see a lush, green mountain of cash. Like all kids, this one was adventurous. He wanted to climb that mountain, and climb it fast!
Little did he know what lay beyond it.
He got into the pro-league, where the biggest and baddest cash-pilers dwelled. It was the Mecca of investment professionals. It was called Wall Street.
On the Street, greed and hunger were the fuels on which ran the cars of ambition. The boy realised that everyone wanted to reach the mountain-top, and were willing to do whatever it takes. So he did too.
Over his 20 odd years in the Street, the boy (Bill Hwang) made a lot of money. With money, came controversies. “In 2012, Hwang pleaded guilty to insider trading of Chinese bank stocks and agreed to pay $44 million to settle charges from the Securities and Exchange Commission.” - CNBC.
In 2013 (not even a year after his ban from the markets), Bill started his own “family-owned office”, to stay in the game.
“How’s that possible, he was banned, right?”
Well, yes. More on that later.
The lust and hunger for more was still there. Over the next 7-8 years, Bill bought huge chunks of shares in top companies. They say that he started with $200mn, and made the fund worth $10bn in this time.
Now, this is not illegal. Buy shares, hold them, make money. But, what’s most interesting with Bill is - no one had any clue, probably not even the companies he had invested in, as to how much he owned. How much he was worth.
How did he do it?
Well, like any other self-respecting Wall Street banker would - he found a loophole he could exploit.
He was not purchasing any stocks from the markets directly. All the large companies he was buying, were not really his “buys.” He did not directly own any.
How? His weapon of choice: total-return-swaps.
Yeah. They are as cool as they sound.
You see, in the stock markets, you can buy or sell things without really buying or selling them. You can bet that a stock will go up or down, without owning them. And, you can bet much more money than you have.
Crazy? Naah. Say you want to bet on Reliance. You think it is going to go up to Rs. 2,500 from current Rs. 2,000 in one year. You have only Rs. 1,00,000 right now. You think that this is a sure shot bet, that there’s nothing that would stop Reliance’s dream run. What do you do?
You call up your friend and ask for a loan from them. They tell you that this is super risky. You convince them somehow to give you Rs. 2,00,000 more at 10% p.a interest.
This is how the before and after scenario looks like:
This is what brokers called trading on leverage. The broker basically extends a loan for the incremental amount (Rs. 2L in our case) and lets the client bet more and more. The more wins you have, the more your broker trusts you (and the more commission or fee he/she earns). This is what we call margin trading.
And, that’s what Hwang did. On a massive scale. Even though he was blacklisted after he pleaded guilty to insider trading, he made a comeback. He made the brokers and banks an offer they could not refuse. He promised them fat commissions.
Everything was going good. Bill even survived the crash of the pandemic. What he could not survive, though, was the biggest margin call in the history of margin calls.
What’s a margin call? Remember those Reliance shares you purchased at Rs. 2,000? What happens when the price goes down below Rs. 2,000? You have to pay the broker the differential amount. It’s the broker or bank’s way of telling you to pay up, or they are going to sell your positions. This ensures that no one goes bellies-up in the markets. When brokers come calling, you better pay!
Bill couldn’t. His bet on a couple of China’s darling startups, Baidu and Fartech, was going drastically down. And then, shit hit the fan.
$33bn was washed off some top US stocks, which “spelt trouble not only for Hwang but also the top banks including Goldman Sachs, Morgan Stanley, Credit Suisse and Nomura which extended billions of dollars in credit to allow Archegos to make highly levered bets on US and Chinese stocks.” - reported a Financial Times article.
The house of cards that Bill had made on borrowed money came crashing down. Why was it triggered suddenly? Because he was not required to pay up the differential amount as and when. He could just settle the difference at the end of the contract term. This is what’s unique about total-return-swaps.
Confused about “total-return-swaps”?
This is how Warren Buffett explains it in his 2002 annual letter (Page-14): “Total-return-swaps are contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B (Bill Hwang in our case), without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes. Total-return swaps of this type make a joke of margin requirements.”
Jargon-heavy? Here you go:
“But didn't the SEC, US’s market regulator, do anything?”
The regulators had no clue. Bill Hwang had set up a “family office,” which meant that he did not have to disclose his shareholding percentage in large companies (usually, regulators require disclosure if stake >5%. In fact, if stake >10%, you are assumed to be an ‘insider’).
All major banks in the US lost money. Millions of dollars of it. Even Goldman Sachs, which had been skeptical till last year to take on Bill’s business, barely survived. Maybe seeing other banks make so much money from one client did not sit well with Goldman. They had to get in on the action.
With their thousand dollar boots and Italian suits, the bankers on Wall Street couldn’t prevent this crisis. What’s sad is that they knew something should be done, but waited till the end to take action.
I guess some people don’t really change, after all. Ambition blinds them. And, they resort to their old gimmicks, as always.
In the Indian context, it’s like Indian banks giving loans to Vijay Malaya. Again.
Crazy, right?
Fun fact: “Archegos” loosely translates to Jesus. The Saviour. The Messiah. I guess this saviour needs some saving now, eh?
Writing his heart out, Shantanu Jain.
Thousands of readers get our daily updates directly on WhatsApp! 👇 Join now!
Side note: Our coffee shot loving friends tried their hands on explaining this. But, I guess the caffeine got to their heads. Can someone share it with them too, maybe? :)