I wrote about Archegos a few weeks ago but it’s effects are still reverberating. Other than the usual firings, statements of contrition, and juicy insider accounts, the incident has revived the age-old argument between those calling for increased regulation and those believing things are fine just the way they are. I think both sides are missing the point.
Let’s go over the arguments for and against increased regulation and a fresh solution that might just satisfy both sides:
1. The sky could fall, bring on more regulation! These Invisible Whales Could Sink the Economy, Alexis Goldstein, New York Times, 05/18, warns of excessive Archegos-like leverage leading to a systemic financial meltdown. The author is a writer for Americans for Financial Reform, a leftish non-profit and no friend of Wall St. The article urges the SEC to “stiffen regulations and tighten reporting requirements for private funds” and takes the Fed, specifically Chairman Powell, to task for failing to take the Archegos blow-up seriously. Andrew Park, also of the same organization, has called on the SEC to examine whether the family office exemption has caused “regulatory hotspots.”
Regulatory advocates argue that the family office exemption should be repealed and that they should report their holdings on a quarterly basis, just like hedge funds. In short, more public disclosure will reduce systemic risk.
2. Nothing to see here, keep walking! A $6 trillion family office world fights post-Archegos crackdown,” Joe Light, Ben Stupples, Bloomberg, 05/18, chronicles the reaction by some family offices to the fallout related to Archegos. Not surprisingly, the family office industry is mounting a lobbying effort to avoid new disclosure requirements. The Private Investor Coalition, a lobbyist for family offices, argues that the Archegos blow-up has nothing to with the “family office structure.” They also argue that regulators already have the tools necessary to identify possible risks to the system.
Privacy concerns are also cited. Should members of a family office be forced to disclose their exact holdings for everyone and anyone to see, review, and possibly condemn? If their investments are perfectly legal, is it really anyone’s business?
One general comment to start. Although it is certainly tempting to think so, not every unexpected Wall St. event can or will lead to systemic collapse. I discussed this in my last article on Archegos, but it is worth repeating since the Prophets of Doom seem to be out in full force lately. Maybe there are a lot more existential risks than there used to be; maybe not. Whatever the answer, trying to identify and eliminate every possible risk factor and every scary scenario, regardless of probability or cost of mitigation, is a fool’s errand. Is that to say that we shouldn’t at least try? Of course we should, but some perspective is required or we will end up bouncing from one hysteria to the next. After all, if everything is a potential disaster, then nothing is.
With that as background, advocates of increased regulation and reporting assume that the regulators themselves have sufficient knowledge, skill, funding, and manpower to do the job. That’s not necessarily true in the real world and leads to the following question: supplied with sufficient facts and data about Archegos in advance, would regulators have prevented the situation or limited its consequences? Of course, that doesn't mean that we shouldn’t at least try, but the question is worth asking.
In addition, the privacy of family offices must be considered. In today’s sharply polarized environment, it’s not hard to imagine unleashing a tidal wave of internet trolls determined to cancel one’s life and career. Privacy concerns are legitimate and should not be dismissed.
Frankly, I’m not sure whether regulators would be effective or not or whether privacy concerns should outweigh fears of systemic risk. However, the fact that extremely large family offices can hold derivatives positions across numerous brokers without disclosing their composition or size to regulatory bodies (effective or not) defies basic common sense.
Surely there is some middle ground worth considering.
What is the solution?
First, a dose of reality: we’re never going to stop the likes of Bill Hwang and his ilk from trying to manipulate markets and causing widespread losses. He’s not the first, and he won’t be the last. But we can certainly make it much more difficult for them. However, knee-jerk new regulations and reporting requirements will only go so far.
Granted, excessive leverage, the family office exemption, and various “failures of risk management” all contributed to the situation. Given the facts so far, that’s indisputable. But they are not at the core of what ultimately caused this debacle, namely a flawed clearing, trade consolidation, and regulatory regime.
Foes of renewed regulation are half right: we do have existing tools to deal with this right now. The futures industry has provided a model for over 150 years on how to prevent situations like this from exploding and threatening the overall market. Through a unique combination of federal law, mandatory exchange oversight, clearing regulations, and exchange capitalization, as well as consolidated clearing, reporting, position limits, and daily mark-to-market margining, futures exchanges prevent any one investor or institution from taking down the system.
How would this work in practice? To start, establish clearing, reporting, and margining of OTC positions through a centralized clearing corporation or existing exchange clearing house. This would include all equity derivatives, such as the CFD swaps that Archegos executed bilaterally with its prime brokers (which for all intents and purposes were look alike single stock futures).
The infrastructure already exists. Both the CME Group and the Intercontinental Exchange (ICE) have the necessary clearing infrastructures already in place.
What would be the advantages?
More independent and arm’s length risk management, unaffected by the profit motive that apparently clouded the decision process at Archegos’ various prime brokers.
Federally approved volatility based minimum margins for customers’ positions as well as the power to enforce aggregate position limits, solving the issue that each prime broker is unaware of positions at other shops.
Forced liquidation, if required, to preserve the financially integrity of the clearing corporation and reduce systemic risk.
Of course, centralized clearing and position aggregation would be quite a leap from the current system. It won’t happen overnight and maybe it’s even naïve to propose it. However, the alternative -- new regulation and reporting requirements -- will only paper over the problem and will not prevent Archegos-like problems from occurring again.