This article first appeared in Forum, The Edge Malaysia Weekly, on April 26, 2021 – May 02, 2021.
“The three blow-ups seem isolated and not systemic — mere fender-benders. However, with the high-speed superhighways that contemporary financial markets are in, such fender benders have the potential of creating huge pile-ups. Like the coal miners of old, who used canaries as an early warning signal for toxic gases underground, policymakers would be well advised to take note of these blow-ups as early warning signals.”
Within a space of about three months, there have been at least three serious financial blow-ups. Like fissures forming before an eruption, these blow-ups, though isolated, could be the early warning for policymakers and financial markets.
The first was GameStop, the events surrounding which led to at least one hedge fund being nearly obliterated. Here, individual retail investors using the Reddit platform ganged up against a hedge fund known to be shorting GameStop stocks. As the retail investors orchestrated a broad-based purchase of the stock, the hedge fund behind the short position capitulated, with losses estimated at US$6 billion.
The second case was that of Greensill Capital, a UK-based financier. Established in 2011 as a supply chain financier, it quickly became a behemoth built on debt. Though Greensill Capital was supposedly a fintech concern, its supply chain financing (SCF) was nothing but good old factoring.
Using technology and operating on thin margins, Greensill Capital was really a “shadow bank” with little regulatory oversight. It appears that more than just SCF, it was also providing “funding against expected future invoices”, clearly stretching its luck.
The company borrowed from investment banks like Credit Suisse, Nomura and Goldman Sachs to fund its SCF and its customer base was highly concentrated. Its main customer, GFG Alliance, a UK-based steel producer, reportedly accounted for the majority of the financing it provided.
What initiated Greensill Capital’s collapse was the refusal of its main insurer to continue providing insurance on its working capital financing. Without the insurance, the banks were not willing to continue funding and Credit Suisse, its main financier, froze US$10 billion of funding it had provided.
In early March, Greensill Capital, hit by payment delays from GFG Alliance, was pushed into bankruptcy when it defaulted on a relatively small scheduled payment to Credit Suisse. A multibillion-dollar institution was tripped up by a small scheduled repayment. Such is the inflexibility that comes with being highly geared.
The third and probably the most egregious, was the blow-up of Archegos, a US$50 billion edifice built on leverage that crumbled to non-existence within a matter of days.
Established as a family office in 2013, it was neither a bank nor a hedge fund, and so escaped regulation. Archegos, it appears, took billion-dollar bets on a few stocks through derivatives like CFDs (contracts for differences) and equity total return swaps. In exchange for a small fee, these instruments effectively enable one to “own” the underlying stock.
Simply put, with equity total return swaps, one receives cash flow equivalent to the sum of dividends and capital gains or losses of the underlying stock for a given period, in exchange for the premium. The inherent leverage that such instruments provides meant that Archegos could build massive equity exposure, reportedly in excess of US$50 billion, on a very small capital base.
The counterparties to these transactions were again investment banks like Credit Suisse. It turns out that the use of such equity derivatives was beneficial in several ways to both parties in terms of regulation and compliance. For the likes of Archegos, it not only escaped the need to disclose its large positions but also saved costs on stamp duty exemptions, since the stocks were not owned directly.
For banks, there was the added advantage of not having to report and set aside capital as these derivative instruments were not covered under Basel III reporting requirements for capital adequacy.
Archegos’ extremely successful seven-year run came to an abrupt end because of a single stock, ViacomCBS Inc, which announced a secondary stock offering, resulting in a 9% fall in its price. As Archegos had exposure to about 29% of Viacom’s outstanding stock, it unravelled when margin calls on the equity swaps could not be met.
An obvious question that arises from all three events is, how could someone take such large risks? Surely the people behind these institutions and at the banks were rational and knowledgeable. So, what gives?
The key to understanding such behaviour lies in recognising the perverse incentive that arises with situations of excessive leverage. When a firm is highly leveraged, management is incentivised to take on risks as most of the money at stake is externally sourced borrowed money.
Failure would mean external debt holders stand to lose much more than equity holders, but success would mean huge profits to equity holders but the same interest rates to debtors. This skewed returns payoff is what causes the perverse excessive risk-taking behaviour.
Such incentives of leverage, together with the ability to take advantage of regulatory loopholes, meant that the build-up of risks could go unnoticed. In addition to credit risk, all three cases had serious concentration risk. Clearly, regulators missed them, given the loopholes.
A key underlying lesson is that debt builds vulnerability. Financial markets become more fragile and prone to accidents because leverage magnifies fluctuations. Thus, a small setback in Viacom shares was enough to wipe out Archegos, a US$50 billion entity.
This same build-up in vulnerability and magnification applies at the macro level too. Like the companies here, highly leveraged nations become that much more susceptible to shocks, both internal and external.
There is a huge social cost to excessive leverage and risk-taking. Thus far, the three blow-ups seem isolated and not systemic — mere fender benders. However, with the high-speed superhighways that contemporary financial markets are in, such fender benders have the potential of creating huge pile-ups.
Like the coal miners of old, who used canaries as early warning signals for toxic gases underground, policymakers would be well advised to take note of these blow-ups as early warning signals.
By Prof. Dr. Obiyathulla Ismath Bacha
Image by George McCaa, U.S. Bureau of Mines