When Archegos Capital Management hit several investment banks with $10bn of losses earlier this year, it risked a wider financial collapse.
Now hedge funds’ growing involvement in cryptocurrency could carry even greater systemic risks, according to former Wall Street traders.
Archegos risks were hidden
Archegos went broke in March after losing out on risky, leveraged bets on a number of US equities.
Its failure triggered dramatic share price falls at the two banks most exposed to the bankrupt fund: Credit Suisse shares lost as much as 28 percent following the Archegos collapse, while Nomura shares dropped 22 percent.
Archegos’ use of total return swaps to bet on stock prices had made it difficult for the investment banks’ prime brokerage arms to understand the full extent of the fund’s positions and its overall leverage. As a result, they underestimated their own individual exposures to the fund.
Archegos “highlighted the opacity of risky exposures”
Alexis Goldstein, a former investment bank derivatives expert and now director of financial policy at the Open Markets Institute, a US think tank, believes the inadequacy of US regulations also helped contribute to the collapse.
“Apart from long options, no derivatives are required to be reported on the Securities and Exchange Commission’s Form 13F, which meant that banks and regulators alike were in the dark about Archegos’ positions until its implosion,” she said.
Form 13F is a quarterly report, including all equity holdings, that institutional investment managers with at least $100 million in assets under management have to file with the SEC.
Goldstein’s comments were part of written testimony delivered yesterday to the US House of Representatives Committee on Financial Services.
In May, the US central bank wrote about Archegos in its semi-annual Financial Stability report.
The Archegos event had “highlighted the opacity of risky exposures and the need for greater transparency at hedge funds and other leveraged financial entities that can transmit stress to the financial system,” the Federal Reserve said.
Hedge funds, banks and VCs increase crypto exposure
According to Goldstein, hedge funds’ rapidly increasing presence in the cryptocurrency markets is a similar blind spot for regulators, as well as for the banks acting as prime brokers to these funds.
“Should a substantial portion of the hedge fund market move into cryptocurrency, extreme volatility in crypto could spread to other financial markets,” she said in her remarks to the congressional committee.
Over a fifth of all hedge funds are now investing in cryptocurrency, PwC said in a recent survey, while more than 85 percent of those funds intend to deploy more capital into the asset class by the end of 2021.
“Large too-big-to-fail banks and Silicon Valley venture capital firms are also a growing presence in crypto”
“The lack of reporting by private funds on their cryptocurrency positions will make it difficult for regulators to determine if this market creates systemic risk concerns,” Goldstein said.
According to the Open Market Institute’s director, other financial institutions are also rapidly increasing their exposure to cryptocurrency.
“In addition to hedge funds, large too-big-to-fail banks and Silicon Valley venture capital firms are also a growing presence in crypto,” Goldstein said yesterday during the committee hearing.
“Venture capital (VC) firms have already invested $17 billion in crypto firms so far this year, which is more than three times what they invested in all of 2020,” she said.
Hedge fund crypto leverage amplifies the risks
According to Goldstein, easy access to leverage in cryptocurrency amplifies the possible systemic risks.
“If hedge funds get further into crypto they don’t care about direction, they’ll go long, they’ll go short, they can use leverage,” she said.
“There are lots of cryptocurrency exchanges, like FTX, Binance and others, that allow people to use insane amounts of leverage, and hedge funds are the perfect client to use that sort of leverage,” Goldstein went on.
“So what happens is a huge number of hedge funds who have prime broker relationships with too-big-to-fail banks all happen to be in similar crypto positions, whether it’s long or short. And if there’s massive volatility in the market, they may have to sell some of their other assets.”
“This may lead to margin calls in their non-crypto assets, which could lead to forced liquidations and redound to the banks themselves in the form of counterparty risk,” she said.
Goldstein went on to compare current market conditions in cryptocurrency with those in the credit markets before the 2008 financial crisis.
“As someone who worked at Merrill Lynch prior to the 2008 financial crisis and on over-the-counter equity derivatives trading desks before the introduction of the Dodd Frank Act, when there was no regulation and all the trading was essentially opaque, the cryptocurrency markets remind me of that time,” she said.
The 2010 Dodd Frank Act sought to rein in banks’ proprietary trading activities and to force greater transparency on the derivatives market. It also mandated the central clearing of standardised derivatives.
In her statement to the congressional committee, Goldstein called for the formalised reporting of crypto trades by hedge funds to give regulators a consistent, standardised view into the footprint of private funds in cryptocurrency.
Big Short star sees repeat of 2008 crash
In June Michael Burry, the hedge fund manager who profited from the 2008 financial crash by betting against structured credit instruments, said a repeat of 2008 could occur in the cryptocurrency markets. Burry blamed hidden leverage for the growing risks.
“When crypto falls from trillions, or meme stocks fall from tens of billions, #MainStreet losses will approach the size of countries. History ain’t changed,” he wrote in a series of since-deleted tweets.
“If you don’t know how much leverage is in crypto, you don’t know anything about crypto, no matter how much else you think you know,” Burry said.
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