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Wednesday, March 31, 2021
Some Reflections on the Archegos Incident
ANBOUND

The recent international market's focus was on the fallout of the hedge fund Archegos. Many China Concept Stocks saw their share prices fall by about 30% last week after Goldman Sachs and other financiers forcibly liquidated their holdings in the highly leveraged Archegos, the previous week after it was unable to cover margin payments. Analyses now estimate the size of its unwinding at about USD 20 billion, resulting in a market value loss of more than USD 30 billion. International financial institutions, including Nomura, Credit Suisse, and Wells Fargo, have each suffered billions of dollars in losses. In particular, the massive selling on March 26 shocked the market, causing losses of USD 10 billion in a single day and making up the "black swan" event of the year.

Judging from the market performance, the U.S. stock market has now absorbed the expected losses of large investment banks and has not caused systemic risks. Given that Archegos' trading volume is not large enough and the credit risk transmission chain is short, involving only the investment banks that provide financing, it is not likely to trigger a massive sell-off in the short term. However, in the opinion of ANBOUND researchers, the problems exposed by the high leverage trading of hedge funds may not be completely over. In the case of rising interest rates and inflation expectations, the trend of the U.S. market has shown a tendency to change. This situation will expose a series of problems, which will have a huge impact on the international capital market in the case of excessive liquidity.

The Archegos debacle is widely seen as the result of heavily leveraged bets against the market. Archegos is estimated to have about USD 10 billion of its own money under management, but it is highly leveraged by banks. Some analysts believe that its position is worth more than USD 50 billion. Its manager, Bill Hwang, has been aggressively investing in stocks at four to five times leverage without having to disclose it, so the outside world has no idea how much risk it is exposed to. None of these private placements, named after family offices, need to be registered with the U.S. Securities and Exchange Commission. This means that Archegos, despite managing billions of dollars of assets, has faced little direct regulatory scrutiny. In a 2021 report, Ernst & Young estimated that there were already more of its family offices worldwide than private equity and venture capital combined. As of 2019, its family offices managed nearly USD 6 trillion in assets globally. That amount of capital, though not all of it at risk, is also a huge uncertainty. The problems exposed this time are likely to be the tip of the iceberg. The risks in this regulatory blind spot will be the source of concern and panic in the markets.

The main cause of this high leverage investment is still the Federal Reserve's monetary easing policy. The flood of dollar liquidity has pushed the prices of risky assets, such as U.S. stocks, to record highs. This makes investors more inclined to "borrow money" and speculate in capital markets. According to the latest American Association of Individual Investors' confidence survey, nearly 51% of retail investors believe the stock market will rise in the near term, higher than the historical average of 38%. Expectations that the market will continue to rise inevitably lead some investors to take risks, such as over-leveraging, which helps to amplify gains but can also backfire and lead to losses. Many investors leverage their positions through options, and the volume of equity options traded rose 85% last year compared with 2017, according to Trade Alert. At the moment, as the renowned U.S. short-seller Ray Dalio said, hedge funds have accumulated a lot of risk exposure and it could cause a "selling stampede" once the market turns, which is the most feared situation in the U.S. stock market. That fear is a reflection of the fragility of confidence in the market, and Archegos' collapse could prompt more investors to reassess risk and adjust accordingly, affecting valuations and prices. Such a market correction could put more activist investors to further exposure.

The highly leveraged trading of hedge funds is attracting the attention of regulators. The U.S. Securities and Exchange Commission is holding an emergency meeting to discuss the issues. Regulators are concerned not only about the regulatory problems caused by Archegos, but also about the potential credit risks and other threats faced by the investment banks that provide credit to Archegos. Regulators in the U.K., Switzerland, and Japan also said they would be watching the situation closely. In this case, it could lead to the problem of "too big to fail", which could trigger a chain reaction if regulators start to rein in the risks involved and push for artificial "deleveraging"; and if regulators step in to bail out the market, it will further exacerbate highly leveraged investments and add to the accumulation of risk.

In fact, the current optimistic outlook for the U.S. economy is causing a great divergence in inflation expectations. Although the capital market remains in a fragile equilibrium state, through the gradual collapse of technology stocks and stocks involved in the phenomenon of "investment concentration", the equilibrium of the market has begun to reverse. The implosion of aggressive hedge funds means that the equilibrium of the overall market is being upset. Under the influence of the "panic taper", the U.S. capital markets will be more volatile in the future.

The market trend is gradually changing amidst of the rising U.S. Treasury yields. The Fed officials have recently stressed their commitment to getting inflation back to its policy target or pre-pandemic level. This means that last year's "zero interest rate" environment will gradually change, pushing up the interest rates represented by Treasury yields. This trend will expose highly leveraged, risky investors to unwitting risk, and Archegos may be the first to be put at risk. Once the liquidity reverses in the future, it could be disastrous for investors accustomed to a low-interest-rate, high-growth market environment.

Final analysis conclusion:

In the short term, the Archegos incident is likely to have limited impact. That said, in the current market and monetary environment, the risks of such highly leveraged investments are accumulating. As inflation expectations and interest rates begin to rise, the risks of highly leveraged investments will continue to be exposed in the future, bringing more risks to the market.

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