An Archegos lesson: for market transparency, cash financing beats equity swaps every time

Regulators and most market participants care about transparency, risk management and liquidity. The Archegos story is another example of why bilateral equity swaps, also called Total Return Swaps (TRS), are a subpar option when it comes to achieving these goals. The better choices are cash financing in the form of margin and securities loans, or cleared TRS. It’s long overdue that regulators fix this problem.

The Archegos losses are a case of unhedged bank exposure against a counterparty that built up large, opaque positions with a number of firms. The same margin call implosion that occurred last week could happen in the cash markets too, with margin calls on positions going the wrong way leading to forced sales. But TRS have different characteristics from cash leverage that make them less useful for the public and harder to manage when something goes wrong.

There is no effective transparency in the equity TRS market. Banks and brokers report their exposures to regulators in a variety of ways but that says nothing for market participants knowing the size of exposures at each bank on a security level basis or collective industry exposure. And while some regulatory reporting is daily, other reports may be delayed by a week, month or quarter. Outside of a bank, we don’t think there is really a way to know what’s going on in the TRS market on a daily basis.

On the other hand, equity cash financing in the form of margin loans and securities loans lead to a cash equity purchase or sale made on an exchange. This lets the market know when positions are being built up in real-time and requires regulatory reporting for impacted entities. (Archegos didn’t file regulatory holdings so that’s a moot point in this case, but still important for the broader market). The same argument could be made about cleared equity TRS, but the only project in the works so far is on LSEG in Europe. It may take a bit before that reaches the US.

For the people responsible for GameStop hearings and similar inquiries, the transparency benefits of cash positions over TRS should be front and center. More reporting on short selling? Sure, why not. But instead of asking for more reporting on short selling, why not ask for transparency on the larger opaque market of bilateral equity TRS business. An inquiry into why the equity TRS business has boomed, and how that liquidity could be shifted back to physical markets, would be a US House Financial Services Committee hearing worth watching.

Risk management
In a TRS, the bank is the counterparty and may face losses if its open positions lose money. For a long TRS, that would mean that the bank would pay out in the event that a stock price rises without an offsetting hedge. What happened with Archegos was the opposite: the stock price dropped, banks went to collect margin but the counterparty did not or could not pay. The banks had to sell the hedges to recover their cash, pushing the market prices down. Given news reports that Archegos was a $10 billion family office and stock sales to make up its margin call totaled $19 billion, the suggestion is that the fund is bankrupt. Nomura and Credit Suisse are already said to be looking at combined losses of around $6 billion with possible industry losses of up to $10 billion.

The situation would have been a bit different if the banks had lent cash to Archegos instead of making a paper commitment, but not the end result of the margin call or forced sales. The actual purchases would have happened in the cash markets, thereby adding liquidity and helping spur stock prices upwards (there may have been some bank hedges for the bilateral TRS that helped the market but there’s nothing like margin-driven cash buying). But cash is still owned by a fund for either a cash or derivative position if the trade moves against it, and banks will sell holdings to recoup any losses.

Although banks may have faced the same end-result in either case, the cash buying and selling would have been seen by regulators and industry self-regulatory bodies. NASDAQ could have seen some crazy buying in Viacom (VIAC) and informed the SEC, FINRA or both. Industry risk management is effective, and regulators could have investigated the situation before the bubble burst.

Market liquidity
Cash buys and sells are made on public markets, which builds market liquidity and price discovery. If we’ve heard one thing from regulators over the years, it’s that they support liquidity in the interest of regular investors and retirement savers. This is who the market ultimately needs to work for. If you want more market liquidity, you trade cash. TRS takes this liquidity away except for any needed cash hedges. Otherwise though, the TRS doesn’t replace liquidity in cash markets. (Note: a reader asked if we are implying that banks don’t hedge their TRS positions. Not so – we have always found that banks hedge their TRS through a combination of cash trades, listed derivatives and other TRS. There should be no doubt about that.)

Further, margin loans made to buy stocks need to be financed, leading to equity repo or other financing transactions with their own supply and demand dynamics. Equity swaps lead to nothing except what should be a hedge against risk. A lack of demand or over demand for equity repo can serve as an additional risk management and pricing tool for brokers when making a margin loan.

The same arguments can apply on the short side. Securities loans and short sales fuel market liquidity and drive price discovery. Bilateral TRS trades sit on a bank’s book. Securities loans rates are transparent for any market participant worth their salt. Even we know loan rates on a daily basis and we are consultants, not even traders! TRS prices are entirely opaque.

The TRS market has boomed thanks to Basel III/IV and Dodd-Frank rules that preference this product over equivalent cash transactions on the long and short side. Banks will trade what it in their best interest to trade, and regulators have set it up that TRS is, in many cases, the better trade from a balance sheet cost perspective. Hopefully Archegos will be a wake up call that this state of affairs, and the continued growth of equity TRS financing at the expense of the physical markets, should be redirected for the benefit of the investing public.

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