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There has been no shortage of coverage surrounding Archegos founder Bill Hwang’s recent fraud and market manipulation conviction – and rightfully so. Largely the result of his recklessness, Archegos’ implosion in 2021 rocked US stock markets and ultimately cost Wall Street banks billions of dollars. But more than three years on from the Archegos scandal, one crucial issue at the heart of the firm’s failure remains starved of the media attention it deserves. And it could wreak havoc in markets once again.

Hwang’s conviction must not signal the end of the industry’s collective post-mortem on the Archegos collapse. It should instead remind firms that serious work must be done to ensure they are insulated against any similar occurrence in the future. After all, while history rarely repeats itself, it often rhymes.

Unanswered questions

As fans of Douglas Adams’ bestselling novel, The Hitchhiker's Guide to the Galaxy, will attest, discovering an answer often provokes a fresh wave of questions. The Archegos collapse was no different. When experts questioned how the firm could collapse so suddenly, three words dominated the discussion: total return swaps. As we now understand, Hwang’s Archegos used this particular derivative contract to take large secretive positions in media firm Viacom CBS and Discovery Inc, among others.

These swaps essentially mimicked stock ownership, allowing Archegos to benefit from price increases but also incur losses when prices drop. Unlike traditional stock purchases, however, these swaps didn't trigger public disclosure requirements. This kept Archegos's leverage hidden from regulators and other institutions. Then, when the firm couldn’t meet hefty margin calls on its highly leveraged positions, the domino effects of forced sales and cascading losses ultimately spelled its demise.

Although total return swaps offer an explanation for the Archegos collapse, they also pose many more questions – most of which remain unanswered. Here are two particularly pressing ones: how many of these swap positions are involved in the trading of much larger companies, and exactly how many funds retain cash equity positions that are used to mislead and disguise trades that are entirely contrary to those positions? If the answer to either of these questions is even remotely significant, the potential impact on markets should a sizeable market downturn cause a stock like Apple’s share price to plummet could be alarming, to say the least.

What is fair disclosure?

The other concerning question raised by Archegos is how can the wider investment community believe what they see on regulatory filings about these companies? There is no small print on a Securities and Exchange Commission filing that reads: “Be warned, there may well be a much larger bet on Apple’s share price falling sharply than you thought.” Indeed, it is hard to say when activity of this nature becomes a disclosable event to the wider market.

There can be little doubt that a massive grey area has been uncovered with regards to what constitutes fair disclosure in the securities-based swaps market. Of course, the prime brokerage arm of any bank has every right to start offloading positions to ensure their clients’ margin calls are met, but when it comes to listed securities on exchanges, there is only so long that critical information can be kept back before what the wider market knows must be made clearer.

Conversations must be had

With so much uncertainty lingering around total return swaps, firms will understandably be keen to do all they can to safeguard themselves against any future market turmoil or regulatory scrutiny unearthed by their use.

As highlighted in a previous analysis we conducted around the implications of the Archegos fallout on markets regulation, point-to-point analysis of the interactions between buy-side players and those at prime brokerage houses is a crucial first step for firms in this context. It offers a way of empowering supervisors and compliance teams to proactively manage what are referred to as ‘interesting situations’, rather than being left to reactively pick up the pieces after the event. It also empowers firms to more easily feed watchdogs a bone should they come sniffing.

Indeed, conversations around the deployment of sophisticated trade reconstruction technology must be had far and wide – as well as promptly. Bill Hwang’s trial may have finally come to an end, but regulatory requirements surrounding the use of total return swaps are only just getting started.

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