The stuff Archegos used expires today. Sound like Greek?
Courtesy SEC.gov
Let me explain. A hedge fund blew up. Its counterparties are taking huge hits. There are ramifications. What happens? Maybe nothing. Maybe everything.
First, let’s understand “counterparty.” A counterparty accepts the risk of the opposite of your desired trade. That is, if you want to bet something rises, somebody else will necessarily have to bet it falls by selling a put – a right to sell a stock.
Do you follow? It’s why winning trades are hard. Somebody is always taking a countermanding risk (as ever, market structure matters because you can see the ODDS on which way things go).
And public companies, bets are pervasive. One of these lately punctured the time-space continuum of the market. Hedge fund Archegos (“guiding light” in Greek) gambled on derivatives tied to stocks and lost.
I won’t recapitulate details. Stories abound. What matters is WHY NOW, and what does this event mean to you as public companies and investors?
We wrote about CFDs – Contracts for Difference – in 2012. Total return swaps are a type of CFD. These contracts give funds – I don’t say “hedge funds,” because, reading prospectuses for Blackrock and others, they too can use them – a way to put money on Red 34, but where Red 34 is half the spots on the Roulette wheel.
Why would a counterparty take that bet? Because they too – Goldman Sachs, Morgan Stanley – make bets on the outcomes to offset the risk that Red 34 comes up. Remember, Lloyd Blankfein, erstwhile Goldman Sachs CEO, said in the aftermath of the 2008 debacle, “We’re in the risk-transfer business.”
I think it’s the HOPE of the markets biggest participants that nobody understands this stuff – because everybody would be outraged. I’m not a cynic. I’m looking at the data. Trading unrelated to how your business performs, public companies, pops eyeballs from sockets. Investors, if you don’t know, you’ll be a popped eyeball.
Remember the mortgage-backed securities pandemic? The movie and book The Big Short? Why would banks sell credit default swaps and then bet against the outcome they just sold?
Because you can always offload your risk.
Until you can’t.
Friday was an “until you can’t” moment for the market. I’m surmising based on the available data that hedge funds bet certain stocks in a limited period of time expiring today – Mar 31 – would outperform some benchmark by a defined percentage.
Banks took that bet. Other banks unaware of the size of the bet lent money to the firm making the bet, making it massively larger than anyone comprehended.
To offset risk, banks require collateral. The hedge fund in question put up its portfolio, which the banks shorted – which raised cash and hedged exposure.
I suspect the fund first pledged the SAME collateral to the banks lending money, but then actually assigned it to GS and MS, firms backing swaps.
Here’s the WHY NOW answer. As expirations drew nigh – Mar 31 – it became apparent to the banks selling the swap to the hedge fund and to the hedge fund itself that it was going to fail. Banks holding collateral sold it.
Those with just a pledge held only the bag they’d been left holding. This is why Credit Suisse and Nomura face big losses, it seems to me (it could be some variation on this theme of course).
But that’s not the heart of the problem here.
This is the Suez Canal converging with Wall Street.
If you’ve somehow missed it, a cargo ship longer than the Empire State Building got stuck in the Suez, blocking everything. God freed it. That is, engineers used a combination of the Worm Moon, a super moon and its incumbent high tides, and a lot of tugging. It’s free now. But the damage is done.
In the stock market, as in the Suez Canal, there’s not much liquidity – not much floating things. And a handful of banks serve the bulk of transactions in Treasurys, currencies, bonds, derivatives (like swaps), commodities, equities, ETFs.
Indexes need to true up tracking right now for the quarter. They depend on these banks. Investors want to lock quarterly results. Massive futures obligations are expiring that the same banks back, to true up index-tracking.
What if something just can’t get done? Which thing do they pick to let go?
Maybe they can juggle it all. The Suez couldn’t. Maybe Wall Street can. If not, there’s a CHANCE of severe dislocation for markets between today and Apr 6, when books will be all square.
