By all measures, the week of March 22, 2021, began as a hopeful week on Wall Street—the third wave of the COVID-19 pandemic had largely subsided, workers were returning to the office, and financial markets were at all-time highs. By the end of the week, however, the decline of just a few media and technology stocks, precipitating the default of a single hedge fund, led to losses of epic proportions across multiple prime brokers. Ultimately, Wall Street brokers incurred losses of over $10 billion due to the implosion of Archegos Capital Management, which had significant and highly leveraged exposure to only a handful of positions. Since the Archegos default, financial institutions across the globe have sought to evaluate their risk functions and insulate themselves from the type of concentrated credit risk the event had exposed. This article, prepared by the attorneys tasked with reviewing and evaluating the nearly $5.5 billion in losses incurred at Credit Suisse, discusses the key lessons learned from Archegos’s downfall, and the steps financial institutions should take to protect themselves from similar credit risk exposure in the future.
Archegos was a family office founded in 2013 by Sung Kook “Bill” Hwang. Archegos, formerly “Tiger Asia,” was one of a group of hedge funds started by alumni of Tiger Management (so-called “Tiger Cubs”), one of the largest and most successful hedge funds of the 1990s. Following Archegos’s defaults— and its ensuing loss of $20 billion in assets under management—Hwang has been characterized as “the greatest trader you’d never heard of.” Compared to his cohort on Wall Street, Hwang cut an unusual figure. A reported pillar of his church for years, Hwang founded the Grace & Mercy Foundation, gave millions of dollars to mostly Christian causes, hosting Scripture readings at his foundation offices in Midtown Manhattan, and “invest[ing] according to the word of God and the power of the Holy Spirit.”1
Hwang’s early successes were largely due to an aggressive trading strategy, which attracted regulatory attention in 2012, when Tiger Asia and Hwang settled insider trading allegations with the U.S. Securities and Exchange Commission, and also pled guilty to wire fraud with the U.S. Department of Justice. Tiger Asia then returned its outside capital to investors and rebranded as Archegos, a family office with roughly $500 million in assets. In December 2013, Hwang was ordered to pay a penalty of HK $45 million (approximately USD $5.8 million) to 1,800 local and overseas investors affected by Tiger Asia’s insider trading. In October 2014, a Hong Kong tribunal banned Hwang and Archegos from trading securities in Hong Kong for four years.
Despite his prior run-ins with the SEC and DOJ, Wall Street continued to do business with Hwang and Archegos, largely due to the fund’s prior and continued success. Hwang’s investment strategy focused on making highly-concentrated and highly-levered bets on single-name stocks in the financial services, telecommunications, and technology sectors, predominantly in the form of single-name equity swaps. His aggressive strategy had long appeared to be paying off. In just four years, Archegos’s net asset value (“NAV”) grew from the initial $500 million in 2012 to $3.9 billion in 2016. By the end of 2020, Archegos’s NAV reached $9.8 billion. By mid-March 2021, it grew to approximately $16 billion, and, just prior to Archegos’s defaults, its NAV totaled approximately $20 billion.
Despite his prior run-ins with the SEC and DOJ, Wall Street continued to do business with Hwang and Archegos.
A large and growing NAV is generally a very positive sign, but Archegos’s overwhelmingly upward trajectory included periods of steep declines; the historic volatility of the portfolio should have underscored the importance of properly margining these positions, as the risk of loss grew commensurate with the growing value of the positions. In Credit Suisse’s case, Archegos’s positions were severely under-margined, in large part because Archegos’s swap portfolio was “statically” margined, as opposed to “dynamically” margined. Dynamic margining means that the initial margin on swaps (the margin cushion taken by brokers to account for the risk of loss upon a counterparty’s bankruptcy or failure to pay) changes over time, factoring in various portfolio characteristics, such as volatility, position concentration, or directional bias. By contrast, static margining means that initial margins are calculated based on the notional value of the swap at inception, and remain static in dollar terms over the life of the swap; thus, as the value of positions increases, the initial margin as a percentage of the total position erodes.
As a result, while the value of Archegos’s positions increased exponentially in March 2021, the initial margin posted on those positions at Credit Suisse eroded precipitously in parallel. The failure to employ dynamic margining with respect to Archegos’s swap portfolio—and the resulting insufficient margin amounts—was the single largest contributor to the ultimate losses.
By the end of the week of March 22, 2021, Archegos had defaulted on margin calls from, among others, Goldman Sachs, Morgan Stanley, Credit Suisse, Nomura, and UBS. The overall losses, of over $10 billion, raised significant questions as to how some of the world’s most sophisticated and successful financial institutions incurred such enormous exposures to Archegos’s positions, and whether adequate risk-reducing mechanisms were in place to mitigate those losses. Predictably, the answers to these questions are complicated. Many factors contributed to the losses, including Archegos’s own actions and the lack of transparency surrounding family offices and their finances. Notably, the Archegos incident has reportedly prompted scrutiny and potential regulatory crackdown from the SEC regarding family offices.
Overall losses, of over $10 billion, raised significant questions as to how some of the world’s most sophisticated and successful financial institutions incurred such enormous exposures to Archegos’s positions.
Transparency notwithstanding, there were multiple and mounting red flags that were readily apparent. The failure to properly deal with those red flags led to Credit Suisse’s significant losses, as detailed in the report commissioned by a Special Committee of the Credit Suisse Group Board of Directors (the “Report”), which we prepared. The Report was the culmination of a comprehensive, three-month investigation, which included over 80 interviews of current and former Credit Suisse employees and the collection of more than 10 million documents and other data. It serves as a cautionary tale for risk teams everywhere, and, importantly, provides a roadmap for changes the banking sector can make to improve risk management and culture to prevent similar losses from occurring in the future.
The report commissioned by a Special Committee of the Credit Suisse Group Board of Directors provides a roadmap for changes the banking sector can make to improve risk management and culture to prevent similar losses from occurring in the future.
The Report details lessons learned from the Archegos default, broadly falling under three categories of missteps that are applicable to financial firms across the industry:
While much has been said—and continues to be litigated—about the likelihood that Archegos deceived its prime brokers as to the true extent of its positions, there was a fundamental failure to recognize the mounting risk of Archegos’s portfolio, which ought to have prompted business and Risk personnel to mitigate those risks to the full extent possible, which they failed to do.
First, on the business side, senior managers across Wall Street had access to information showing that Archegos’s risks were mounting but did not prioritize reducing Archegos risk. Preliminarily, these firms should never have taken on this quantum of risk to Archegos, a family office with a checkered regulatory past that lacked mature internal risk processes and was dominated by a single decision-maker. Given that risk, however, the first line at each institution, at a minimum, should have ensured that its positions were properly margined. Instead, as was the case at Credit Suisse, it appears firms may have been overly focused on revenue generation and not losing Archegos’s business to competitors.
It appears firms may have been overly focused on revenue generation, risk personnel failed to keep the business in check.
Similarly, Risk personnel failed to keep the business in check. At Credit Suisse, for example, risk personnel failed to adequately police Archegos’ limit breaches, failed to escalate non-public information from Archegos revealing that it had additional concentrated exposure to the same single-name positions across Wall Street, and failed to monitor the idiosyncratic risk in Archegos’s concentrated portfolio with customized analyses, instead relying on a standard suite of scenario analyses that were ill-suited to Archegos’s concentrated portfolio.
Perhaps the most important lesson for the banking sector is that a culture of strong risk discipline is crucial to avoiding a similar situation. This includes underscoring to business employees their responsibilities as the first line of defense, enforcing risk limits, clearly defining the roles of in-business Risk functions (versus Risk functions with access to non-public information), and emphasizing customized risk analysis where a portfolio’s risks are non-standard.
Perhaps the most important lesson for the banking sector is that a culture of strong risk discipline is crucial to avoiding a similar situation.
In instilling such a risk culture, senior managers across Wall Street have to be prepared to have difficult conversations, to challenge the business when it takes on outsized risk, and to instruct their first and second lines of defense to take commensurate risk-mitigating actions. Instead, senior managers across Wall Street too often seek to avoid confrontation, adopting a lackadaisical and overly business-friendly attitude.
Senior managers across Wall Street too often avoid confrontation, adopting a lackadaisical and overly business-friendly attitude
For example, in Credit Suisse’s case, the bank created a Counterparty Oversight Committee (“CPOC”) following a prior hedge fund default, intended to be a forum to evaluate counterparty risk in relation to the revenue generated by the counterparty. The Committee, which gathered together senior managers from the business and Risk, was precisely the place to address Archegos’s outsized and growing risk profile. Yet, while Credit Suisse’s counterparty risk to Archegos was discussed at two CPOC meetings, one in September 2020 and another in March 2021, senior managers failed to adopt concrete action items and firm deadlines to address the evident risks. For example, after the September CPOC meeting, the only action item for Archegos was for Risk to “notify of any changes with the counterparty and revisit the counterparty at a future meeting,” with no fixed timetable. At the March meeting, CPOC concluded that Archegos should be moved to dynamic margining by a target date of April 2021 and, if there was no traction by March 15 on that front, to request an additional $250 million in margin from Archegos.
While more concrete, the action items and timelines determined at the March meeting were woefully inadequate. Indeed, the $250 million figure was a seemingly arbitrary amount, representing less than one-fifth of the approximately $1.27 billion in additional margin that would have been required as a day-one step up under the dynamic margining proposal sent to Archegos just two weeks earlier—which was itself overly accommodative. Moreover, there was no evidence that any senior executive at CPOC escalated any of the alarming information shared with the Committee, including the fact that, in March 2021, Archegos’s gross portfolio value had skyrocketed to $21 billion and was highly concentrated, illiquid, and grossly under-margined.
These specific failings at Credit Suisse point to an important lesson for all investment banks. Creating the right risk architecture is not remotely sufficient. It is critical to create a strong risk culture so that the senior managers on risk committees are not only empowered to critically evaluate counterparty risk and escalate matters of concern to executive management or the Board of Directors, but that they do so. The members of such committees must understand that they are expected to impose concrete remediation action items and deadlines commensurate with that risk. They must also understand that they will be held accountable for these decisions.
It is critical to create a strong risk culture so that the senior managers on risk committees are not only empowered to evaluate counterparty risk and escalate matters of concern to management or the Board of Directors, but that they do so.
Wall Street firms must also be wary of cutting corners when it comes to sufficiently staffing their Risk teams or investing in the necessary technology to appropriately monitor risk. At Credit Suisse, for example, the various Risk teams had inadequate staffing at all levels to sufficiently manage and address the risks posed by Archegos (and other hedge fund clients). As employees left the in-business Risk function, they were replaced with less experienced personnel, which one witness referred to as the “juniorization” of the team. Junior employees became responsible for an ever-increasing number of clients, and senior employees reported wearing so many hats, receiving so many reports, and being inundated with so much data that it was difficult for them to digest all of the information and discharge their responsibilities effectively.
On the business side, there was an unwillingness to invest in necessary risk technology. For example, there was a relatively inexpensive technology fix that had been proposed to correct for bullet swap margin erosion, but the business never funded it. Additionally, and more importantly, the business failed to prioritize the technological investment necessary to bring dynamic margining capability to swaps held by all clients—an investment that not only would have prevented bullet swap erosion, but also would have allowed add-ons for concentration, bias, and volatility in a client’s portfolio.
On the business side, there was an unwillingness to invest in necessary risk management technology.
Moreover, Credit Suisse’s risk-related systems and infrastructure could not adequately support the Risk function to quickly and accurately assess risk at any given time. For example, potential exposure (“PE”) is a critical measure used to estimate the potential loss related to a counterparty’s credit risk. After Credit Suisse’s calculation methodology for PE changed, Risk personnel developed concerns about the validity of PE numbers and the underlying methodology, causing employees to generally discount PE limit breaches—including Archegos’s persistent breaches— as accurate or meaningful reflections of risk. Further, the various Risk Committees only had access to data that were four to six weeks old. As a consequence, Risk was unaware of, and unable to fully appreciate in real time, the magnitude and pace of the exponential growth in Archegos’s positions and the attendant risk, even accounting for the outsized risk that Credit Suisse was sufficiently aware of, as discussed above.
There are multiple hard lessons here for the banking sector. Too often companies rely on outdated software and archaic technology, investment banks included. Sufficient funding for modern risk systems is critical for any bank seeking to improve its risk function. Similarly, in any cost-cutting exercise, control functions which do not clearly contribute to the bottom line are often disproportionately impacted. Yet, as Archegos reveals, it can be catastrophic when investment banks fail to sufficiently invest in experienced and capable risk managers, and ensure that they are not spread too thin so that they can meaningfully fulfill all such roles and responsibilities.
Sufficient funding for modern risk systems is critical for any bank seeking to improve its risk function.
While no one could have fully predicted what was going to happen that pivotal week of March 22, 2021, certain steps could have been taken to mitigate the risk posed by Archegos. As much as possible, financial institutions should equip and empower their risk functions to be able to avoid similar situations in the future, and should instill a strong culture of risk discipline so as to underscore the importance of risk measures firm-wide. While the bottom-line is always an important consideration, the Archegos debacle is a prime example of how prioritizing profit in the short-term—especially at the expense of risk—is a recipe for disaster in the long-term.
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