Written by Vardaan Kohli, Product Specialist, Cassini
After suffering huge losses from providing excessive leverage to a family office run by an ex-Tiger Management star trader, banks have started to holistically review their risk and balance sheet allocation to Hedge Funds and Family Offices.
Source: Financial Times, Company Disclosures
Archegos had highly concentrated positions in a handful of high growth stocks. Being a family office, accessing leverage via total return swaps, they were able to avoid the strict regulatory disclosure requirements that hedge funds would have had if they held exposure directly.
By not holding the positions as cash securities, it was also able to avoid regulatory margin minimums subject to the US markets.
The stocks had run up multi-fold in the year following the onset of the pandemic; once the market corrected, Archegos faced a liquidity crunch and it’s Prime Brokers (PB) started liquidating the assets to cover the missed Variation Margin(VM) calls.
Archegos’ holdings in these underlying stocks went up in value multi-fold post the pandemic driven market lows; As the stocks corrected and dropped in value, Archegos missed Variation Margin calls to its Prime Brokers forcing them to liquidate the underlying assets at distressed values leading to huge losses.
Prime Brokers run Gap Risk Monitoring on its counterparties to assess where clients margin requirements are below market stress scenarios to avoid exactly such situations. This is looked at alongside qualitative factors such as internal ratings and credit limits to counterparties, the revenue relationship with the counterparty and most importantly how the hypothetical loss measures up against potential revenue. Since the true extent of Archegos’ leverage in the street was hidden from each of its brokers, they would have continued providing excessive leverage individually to capitalize on the financing revenues. Credit Suisse have today (July 29th 2021) published an internal report on exactly what led to the Archegos related losses.
The failures across the board led most of the Banks to overhaul their Risk and Prime Brokerage departments. Regulators have intensified their scrutiny with focus on how huge amounts of hidden leverage was prevalent in a post-2008 world.
With the intensified pressure both internally and externally, the measures Banks are taking are directly impacting the hedge fund industry in the following ways.
Static vs Dynamic Margining: Prime Brokers are reviewing their lending books holistically where they have Initial Margin (IM) for their PB or Synthetic PB clients at fixed level. They are looking to move to dynamic portfolio-based margin models, where risks such as concentration, illiquidity attract higher margin premiums to secure the PB from idiosyncratic losses.
Intraday Margining: Variation margin is meant to cover the day-to-day Mark-to-Market (MTM) losses clients face. In high stress environments, the T+1 margin call with MTM moves from the previous day may be too late. As such, PB’s are incorporating the ability to send out intraday variation margin calls multiple times in the day as market drastically moves against clients to cover their risk.
Prime Broker Margin Replication: Cassini has the capability to replicate margin agreements that clients have with their different brokers. This allows clients to independently verify what their brokers are charging them and have analytics and ability to attribute margin at different levels. Clients can also use this prior to allocating trades to their brokers for where the best margin requirements will be. With the state-of-the-art optimization tools at Cassini, clients can rebalance their trading book holistically across brokers to reduce their margin requirements. They can also carry out what-if scenarios on margin impact of trades on their portfolios.
House vs SIMM: With the upcoming phases of the Uncleared Margin Rules (UMR) – Phase 5 coming into effect Sep 1, 2021, and Phase 6 Sep 1, 2022 – more hedge fund clients are subject to regulatory initial margin on in-scope products. Where these products are traded within Prime Broker agreements, the brokers carry out a review of House v SIMM to call for additional margin. Cassini has in house pre-trade and post-trade SIMM calculation tools. By using in conjunction with PB replication, clients can unlock the black-box margin calculations brokers subject them to.
Variation Margin Forecasting: Cassini gives clients the ability to estimate their future collateral requirement using an analytical approach to calculate Variation Margin over a given time-period within a client specified confidence interval. These calculations can be configured by clients to reflect their collateral and funding management requirements. As PB’s move to intraday Variation Margin calls, the ability for clients to forecast this allows to efficiently manage capital buffers, avoid a forced liquidation scenario, and reduce collateral drag. Along, with the other sets of unique tools, this can allow Clients to competently challenge their brokers.