Understanding Archegos

Credit Suisse suffered losses of close to US$5.5 billion from the default of Archegos Capital Management. It identifies management failure and a focus on short-term profit at the heart of what went wrong

The market value of Archegos Capital Management’s investment holdings plummeted during the week of 22 March 2021, driven by a price slide in a number of single-name tech stocks, particularly ViacomCBS, in which Archegos had a large and heavily leveraged position. This triggered a chain reaction that resulted ultimately in the company’s default.?

A 170-page report by a Credit Suisse (CS) Group Special Committee makes candid and at times highly critical observations about the engagements of the investment bank, and specifically its prime services division, with Archegos in the lead up to the hedge fund’s closure.

The report, seen by Securities Finance Times, was published on 29 July 2021 and presents the findings of a CS Group Special Committee, on behalf of its board of directors, into the circumstances that led to Archegos’ collapse and the large financial losses and reputational damage sustained by the investment bank (subsequently referred to as the ‘Special Committee report’).

This event resulted in combined losses of more than US$10 billion for the prime services divisions of global investment banks, including CS, Morgan Stanley, Nomura, and UBS.?

Other investment banks, including Deutsche Bank, Goldman Sachs and Wells Fargo, are known to have had trading relationships with the hedge fund, but claim to have unwound their exposures with minimal financial loss.

This event has prompted buy and sell-side firms across the investment industry to reassess how they manage counterparty risk and market risk — and how they will structure their securities financing and liquidity management strategies in times ahead.?

One large UK-based asset management firm told SFT that, following concerns raised by the GameStop short squeeze and the Archegos default, it had conducted a root and branch internal review of the risk controls associated with its investment processes, including the role that securities lending should play in its future business strategy.?

CS suffered around US$5.5 billion in losses following the default of Archegos Capital Management, which the report describes as the family office of Sung Kook “Bill” Hwang, a former hedge fund manager located in New York.?

To investigate its losses, and to provide a foundation for remedial action, the bank appointed a review committee consisting of four directors, working alongside its law firm Paul, Weiss, Rifkind, Wharton and Garrison, and a team of expert advisers.?

The research was conducted over a three-month period and was based on interviews with 80 current and former CS employees, along with access to a large pool of CS documents and other data. This is the first in a series of articles in SFT that will analyse the collapse of Archegos, how counterparties and service providers managed their relationships with the hedge fund, and lessons we can draw for the future.

Fundamental failure

Central to the losses sustained by CS as a result of the Archegos default, the investigation identifies “a fundamental failure of management and controls in CS’ investment bank and, specifically, its prime services business”. This business, the report concluded, was focused on generating short-term profits and failed to control — indeed, it actively enabled — Archegos’ “voracious risk taking”.

The internal investigation points to warning signals that were dismissed or ignored, including Archegos’ repeated limit breaches which, it says, provided indication that the buy-side firm’s “concentrated, volatile and heavily under-margined” swap positions posed a threat to CS. However, the CS business, from its risk managers to the global head of equities, failed to act on these warnings, despite attempts by some individuals within the organisation to ensure that appropriate action was taken.

On the basis of these findings, the Special Committee report is critical of CS’ risk culture, particularly a prime services business that had a “lackadaisical attitude” to risk discipline and risk systems that flagged up acute risks but were then ignored systematically by business and risk managers.?

It also identifies a “cultural unwillingness” to enter into challenging discussions or to escalate issues that presented grave economic and reputational risk to the organisation.

The Archegos relationship

Tiger Asia (as Archegos Capital Management was initially known) became a CS client for cash equities trading in 2003. It later became a prime services client in 2005 when it started trading in equity swaps, conducting most of its business activities through CS prime services in New York. As Tiger Asia, it invested primarily through long-short equity and long-only equity strategies, with a focus on Asian securities.?

The investment bank’s relationship with Archegos was primarily through its prime services division and specifically its prime brokerage (PB) and prime financing sub-units. PB handled the fund manager’s cash securities trading (traditional securities finance, custody and clearing), while prime financing handled its synthetic trading (derivatives, including swaps, and other types of synthetic position).

Significantly, the Special Committee report makes it clear that both prime brokerage and prime financing are “intended to be low-risk businesses” (original emphasis). Counterparty risk, it notes, should be evaluated and then offset through effective margin management. Market risk should be evaluated and then offset through effective hedging (p 5).

In managing its relationships with buy-side clients, CS indicates that it operates multiple lines of risk defence. The business unit, in this case the prime services division, provides the first layer of defence, with each business employee directly responsible for protecting the bank against losses. Prime services maintains an in-house risk management unit named Prime Services Risk (PSR) that, among other duties, sets margin rates and manages other risk controls in dialogue with traders and clients.

A bank-level risk division, Credit Risk Management (CRM), provides a second line of defence, responsible for evaluating credit risk across all of the investment bank’s business lines while acting independently of any individual business unit. This includes conducting annual counterparty risk reviews, assigning an internal credit rating to the counterparty, and setting counterparty trading limits for the prime services division and other business units.

Warning signals

Concerns were developing within the investment industry about aspects of Tiger Asia’s conduct and integrity well before the Archegos default in early 2021.?

Specifically, in 2012, Tiger Asia and Hwang paid to settle a charge with the US Securities and Exchange Commission (SEC) relating to insider trading allegations. Around the same time, it pleaded guilty to the US Department of Justice (DoJ) in connection to wire fraud charges. Following these events, CS reports that Tiger Asia returned assets to its external investors and relaunched as Archegos, a family office for the Hwang family with close to US$500 million in assets.

In 2014, Hwang and Archegos were banned for four years from trading in Hong Kong. Subsequently, Archegos moved its trading strategy with CS primarily to US equities, including US American Depositary Receipts (ADRs) of Asian issuers.?

The Special Committee inquiry concluded that CS continued to conduct business with Archegos throughout these regulatory and criminal investigations. Significantly, it found no evidence that CS directed additional monitoring or scrutiny to Tiger Asia or Hwang’s activities as a result of red flags raised by these events (p 4).

When the prime services division, at the request of the CS Compliance team, conducted a reputational risk review of Archegos in 2015, it dismissed the settlements with SEC, the guilty plea to the US DoJ and the HK trading ban as “isolated, one-time events”. It advised that CS should continue trading with the hedge fund based on the latter’s “strong market performance” and “self-proclaimed ‘best in class’ infrastructure and compliance (as represented by Archegos to CS)”.

When the Hong Kong trading ban on Archegos was lifted in 2018, CS prime services indicated its interest to resume trading with the fund manager in Asia. Prior to doing so, CS conducted a second reputational risk assessment on the client. This arrived at similar conclusions to the assessment conducted in 2015, according to the Special Committee report, thereby providing the green light for prime services to resume trading with Archegos in the APAC region.?

Although CS’ compliance division raised concerns at this time about retaining Hwang as a client, “its concerns were allayed without any in-depth evaluation of the potential reputational risk to CS” and no limitations were placed on CS’ business relationships with Archegos as a result of these reputational reviews, says the subsequent investigation.

Margin management

The Special Committee report concludes that the Archegos scenario raises questions about the competence of business and risk managers that had “all the information required” to recognise the size and urgency of Archegos risks but failed on multiple occasions to take decisive action.

This is not a case where CS business and risk staff engaged in fraudulent practices or acted with ill intent, says this report. It was also not the result of a risk architecture which failed to identify critical risk. On the contrary, “the Archegos risks were identified and were conspicuous”, it said.

One prominent example was the margin strategy that the prime services division applied in its relationship with Archegos.

Archegos’ portfolio with CS’ prime brokerage division was dynamically margined, thereby accommodating market movements, volatility, concentration and controls for bias into the margin requirements requested by the prime broker.?

In contrast, Archegos’ swap trades, which were handled by CS’ prime financing division, were statically margined — initial margin (IM) was calculated on the basis of the notional value of the swap contract at inception and remained static in USD terms over the lifecycle of the swap.?

The result was that as CS’ exposure to its counterparty grew larger – with changes in the value, concentration and long-short bias of Archegos’ portfolio – so the margin it held for the prime financing book became increasingly inadequate to cover this exposure.

In 2017, changes in Archegos’ PB portfolio prompted CS to issue a request for additional margin. However, Archegos asked for this request to be dropped on the grounds that its short swaps portfolio held with CS’ prime financing unit offset its long-biased prime brokerage portfolio. Since the netted exposure was close to market neutral, Archegos made the case that the 10 per cent directional bias add on (‘net bias add on’), which triggered the request for the margin call, should not be applied.

CS agreed to drop its request for additional margin, providing that Archegos’ combined portfolio bias did not exceed 75 per cent either long or short.?

Over the next few years, Archegos’ portfolio did periodically breach the 75 per cent threshold, but CS, in each instance, granted a grace period, sometimes stretching to five months, to bring this back below the threshold. “The business appears to have relied on Archegos’ assurances that it would reduce the bias, and Archegos generally did, though this dynamic repeated several times over the next few years, reflecting the business’ accommodative approach to Archegos,” said the Special Committee report (p 8).

In a separate communication, Archegos asked CS during 2019 to lower its swap margins. Archegos made the case that other prime brokers were offering lower margin rates than CS and they also allowed Archegos to cross-margin swaps and cash equities — enabling these to be covered by a single margin call — a service that CS did not extend to Archegos (p 8-9).?

Subsequently, CS agreed to the client’s request to post lower margin for its prime financing portfolio. In doing so, CS still had contractual protection in place – including a right to terminate swaps on a daily basis and to change IM amounts at its discretion. However, the Special Committee inquiry concluded that the contractual protection the bank had negotiated with Archegos was “illusory”, since the business had no intention of invoking these safeguards for fear of antagonising the client (p 14). Moreover, it found that the decision to reduce margin requirements prompted Archegos to significantly increase its swap exposure with CS.?

During 2020, CS’ risk exposure to Archegos rose substantially — and by the end of February, a small short bias in Archegos’ aggregate portfolio had been displaced by a net long bias of more than 35 per cent. With this development, the justification that previously existed for removing the ‘net bias add on’ — that the swaps portfolio was balancing out the PB portfolio — no longer existed. However, CS did not re-impose the bias add-ons and require Archegos to post additional margin.

Significantly, when the prime finance team reduced the swap margin as described above, Archegos began to relocate long swap contracts from the prime brokerage unit (where this activity had previously been held) to the prime financing business at the lower margin rate. According to the Special Committee report, Archegos’ swap exposure mushroomed to US$9.5 billion, three-quarters of which was long. Archegos’ swap exposure in prime financing, at US$7.1billion, represented 74 per cent of its gross portfolio value held with CS — and this was margined at 5.9 per cent, in contrast to a 15 per cent margin rate on the PB book (p 11).?

During the Spring of 2020, Archegos was regularly breaching its potential exposure limits, according to the Special Committee report. In April 2020, its potential exposure was more than 10 times its ￡20 million limit and the weak performance of the fund had caused its NAV to drop from US$3.5 billion in February to close to US$2 billion in April (p 12).

Notwithstanding, the prime services business team confirmed that it remained comfortable with the margin framework applied to Archegos’ business across prime brokerage and prime financing portfolios when asked to do so by the CRM team.

By August, its potential exposure had stretched to US$530 million against a US$20 million limit. “Because potential exposure (PE) limit breaches are intended to be rare and consequential events, Archegos was included on a list of PE offenders sent to the Credit Control Group, a division of CRM,” says the investigation report. It also continued to raise alarms owing to regular scenario exposure breaches.

Further analysis of the events leading up to Archegos’ default, along with the response of counterparties and service partners, will follow in the next part of this article.

Primary conclusions

It is likely that Archegos deceived Credit Suisse and obfuscated the true extent of its positions, which Archegos amassed in the midst of an unprecedented pandemic (p 23).

So say the findings of the CS Special Committee report on Archegos Capital Management. This said, the Special Committee judged that the prime services business team and CS’ risk management division had “ample information” well before the events of the week of 22 March 2021, when Archegos defaulted, that should have triggered action to at least partially mitigate the risks that the hedge fund posed to CS.?

Expanding on these findings, the Special Committee concluded that the prime services business mismanaged the Archegos situation at multiple levels. Senior staff had information that Archegos’ risks were mounting, including reports sent to co-heads of prime services and the head of equities. The business either ignored these risks or lacked the competence to appreciate their significance, it says – but, either way, “the business was focused on increasing Archegos’ revenues with CS, even at the expense of increasing the risk to CS far in excess of applicable limits”.

This problem was compounded, says the report, because neither CS co-head believed he “owned” the prime financing US swaps business from a management standpoint and neither actively managed the corresponding risks. Both co-heads were “double hatted”, with multiple responsibilities and overrun with management information which undermined the overall management of the business (p 24).

The report adds that traders absolved themselves of responsibility for credit risk, neglected to conduct pre-trade credit checks and relied almost entirely on risk opinion from Prime Services Risk (PSR).?

Only one committee, the investment bank’s Counterparty Oversight Committee (CPOC) [discussed in further detail in the next part of this article], considered the Archegos situation in detail, but this was silo-based in its operation, where each member focused only on counterparties directly relevant to their own business. Significantly, the report finds that this did not offer adequate challenge and professional scepticism regarding the risk mitigation measures adopted by the prime services business.

Specifically, the report finds that mismanagement of the Archegos situation by the prime services business was “manifest from start to finish”. It concludes that the business should not have taken on such a large, concentrated, illiquid exposure to Archegos as a counterparty, especially in light of the client’s own large and unconcentrated underlying market risk.

Moreover, given that CS was taking on significant risk through its prime services relationship with Archegos, it was incumbent on the business to make sure that the hedge fund was posting sufficient margin to safeguard CS in the event of its default. The Special Committee finds that the business failed to exercise its contractual rights – for example the right to request additional margin at 3-days’ notice – and to engage Archegos in “difficult conversations”. Instead, it focused on engaging on terms that would not endanger its future business relationship with the hedge fund.

In evaluating limit breaches, the Special Committee concludes that the prime services business tended to side with Archegos. In 2019, the business argued on the fund manager’s behalf to lower its standard margin level on swaps to 7.5 per cent, from an average of 20 per cent, because the swaps portfolio had a significant short bias and this offset the long bias in Archegos’ prime brokerage portfolio.?

Less than 12 months later, when Archegos’ swaps portfolio developed a substantial long bias and this justification no longer applied, the prime services business failed to restore the fund manager’s margins to standard margin levels (of 15-25 per cent). By September 2020, the average margin rate on Archegos’ swaps portfolio, now holding a significant long bias, was less than 6 per cent (p 25).

At the same time, the risk management team failed to impose deadlines for the client to eliminate limit breaches. While CRM had non-public information indicating that Archegos had concentrated exposure with other prime brokers to the same single name positions that it held with CS, the CRM failed to push for additional disclosure from the client to assess the extent of this risk and to mitigate it.

By February 2021, one month before its default, Archegos had a portfolio that was among the most concentrated, leveraged and volatile of all CS hedge fund clients, according to the Special Committee report. It also had the largest notional exposure of all the bank’s prime financing clients and with the largest margin breaches.

At its heart, “CS failed to address a culture that encouraged excessive risk-taking and injudicious cost cutting, as well as a complex and siloed organisational structure that impeded the swift identification, understanding and escalation of risk”. (p 30)

While the Special Committee report is heavily critical and demonstrates deeply rooted failures in CS’ risk management and business culture, its detailed analysis provides an important starting point for remedial action.

SFT will discuss these findings more fully in the next part of this article.