Pressure mounts on financial regulators to address Archegos debacle

Regulators in DC are starting to feel the pressure to address the fallout from Archegos Capital, the faltering family firm that could inflict up to $10 billion in losses on some of the world’s largest banks.

“We need transparency and strong oversight to ensure that the next hedge fund blowup doesn’t take the economy down with it,” Sen. Elizabeth Warren (D-Mass.) said in a statement provided to Yahoo Finance. Warren called on regulators to increase scrutiny on hedge funds and derivatives, among other things.

Bloomberg reported that the Securities and Exchange Commission and the Financial Industry Regulatory Authority phoned banks on Monday to learn more about the abrupt liquidation of over $20 billion in stocks linked to Archegos.

The episode raises questions about regulation of large investment firms managing family wealth, in addition to disclosure requirements surrounding derivative products like total return swaps and contracts-for-difference.

“I don’t think either of those issues would have been on Washington’s to-do list without the market turmoil caused by this incident,” Compass Point analyst Isaac Boltansky told Yahoo Finance.

Although Nomura disclosed that it could be impacted by as much as $2 billion, Credit Suisse has yet to quantify the hit it expects to take.

JPMorgan’s global investment banks team now projects industry-wide losses in the range of $5 billion to $10 billion, significantly more than its initial estimate of $2.5 billion to $5 billion.

“We are still puzzled why [Credit Suisse] and Nomura have been unable to unwind all their positions at this point,” the JPMorgan analysts wrote Tuesday.

Disclosure of stock holdings

Bad bets at Archegos pushed lenders to initiate a margin call, in which the borrower is asked to put up more cash or collateral to cover its losses.

Steep sell-offs late last week in Archegos-linked stocks like ViacomCBS (VIAC), Discovery Inc. (DISCA), and Baidu (9888.HK) suggested that a fire sale was happening.

It wasn’t until when Credit Suisse and Nomura disclosed over the weekend the possibility of sustaining material losses in its relationship with the hedge fund, which was later identified as Archegos.

One challenge for regulators is the obscurity by which Bill Hwang, a former equity analyst at Tiger Management who founded Archegos, was able to amass leveraged positions in those stocks.

Investors owning more than 5% in a U.S-listed company must disclose those holdings, per Section 13 of the Securities Exchange Act.

But Archegos took on total return swaps that entitled the fund to the earnings of its targeted stocks without actually owning the stocks themselves. The fund also may have used contracts-for-difference, a type of short-term derivative that allows traders to bet on the entry and closing prices of a given stock.

But because both derivatives do not involve actually owning the shares themselves, Archegos was not required to disclose those positions. In other words, Hwang was able to build a highly leveraged position (which JPMorgan estimates to be about 5 to 8 times) with little detection.

‘Gamification’ of markets

Former SEC lawyer Tyler Gellasch is advocating for fixing Section 13 to include equity derivatives and short positions.

The public interest in the Archegos episode could spur policymakers to look into even broader reform. Raymond James’ Ed Mills and Michael Rose argue that the Democratic-led Congress may see a bolstered case for a financial transaction tax.

“The forced deleveraging of Archego will keep the ‘gamification’ of markets a continued focus of Congress and federal financial regulators,” Raymond James wrote Monday.

The Financial Stability Oversight Council, a cohort of eight federal regulators and three state regulators among its members, could take up the issue in a meeting scheduled for Wednesday.

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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