The Breakdown - What the Archegos Arrests Tell Us About the Financial System

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, Arculus, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Friday, April 29th, and today we are talking about the arrest of Bill Huang. Before we get into that, however, a few housekeeping notes. There are two ways to listen to the breakdown. You can listen on the CoinDest Crypto Podcast Network feed, which features the breakdown as well as their other awesome shows, or you can listen to the breakdown-only feed.

Starting point is 00:00:45 The shows both come out the same day with the CoinDesk feed coming out in the afternoon and the breakdown-only feed coming out in the evening. Wherever you listen, if you're enjoying the show, please go subscribe, give it a rating, a review, you know the deal. And if you want to get deeper into the conversation, come join us on the Breakers' Discord. Finally, a disclosure as always, in addition to them being a sponsor of the show, I also work with FtX. So today we are digging into part two of a story we began covering last April, which is the story of Bill Huang and Archegos Capital. It is the story of one financial market participant, but also reflective of much larger questions.

Starting point is 00:01:25 I'll link the previous show in the notes, but let's do a quick recap of Bill Huang. Huang rose to notably as a trader with Tiger Management. Tiger Management was founded by Julian Robertson in 1980 and became one of the premier hedge funds, indeed a firm that would help demonstrate the possibilities of the hedge fund industry. Over the course of its 20 years in business, Tiger Management went from $8 million in assets under management all the way to $22 billion. Around the time of the dot-com bubble, Robertson decided to wind down the fund and shifted to investing in the funds of former employees. These former employees became collectively known as the Tiger Cubs and produced some of the world's best-known hedge funds, Discovery, Lone Pine, Viking, Kuwatu, who is still around and at this point an active crypto investor. Bill Huang's firm was in this group and was a New York-based but Asia-focused fund called Tiger Asia. It built to a peak of $5 billion in assets under management, but that's not really what it's remembered for.

Starting point is 00:02:26 In 2012, Tiger Asia was pursued by the SEC for shorting Chinese Bank, stocks based on insider information, and ultimately Huang paid a settlement of $44 million. In addition to that, there were criminal charges brought by the DOJ against Huang personally. Now, to get a sense of what was actually going on, there were a pair of trading schemes that made about $16.7 million in illicit profits. As per the settlement, the firm committed insider trading by short-selling three Chinese banks based on confidential information. They covered the short positions with private placement shares purchased at a significant discount to public price. Separately, they attempted to manipulate prices in which the fund had short positions by placing

Starting point is 00:03:07 losing trades in an attempt to lower the price of the stocks. Now, I think it's worth noting here the nature of these financial crimes. This is not some disgruntled insider who whispered some inside information. These are complex financial schemes designed to manipulate the price of assets. What's more, they were architected by someone 20-plus years into their career who clearly should have known better. Based on the settlement and the criminal suit, Huang received one year of probation, was barred from having a relationship with broker dealers or managing public money in the U.S. for five years, and was banned from trading in Hong Kong for four years. The U.S. regulatory restrictions placed upon him were formally removed in April of 2020.

Starting point is 00:03:46 Now, to stay in markets but to evade this black mark, Huang founded a family office called Archegos Capital. Family offices can be a lot of different things. including similar to hedge funds. But because they don't trade external investors money, only theoretically family money, they have significantly reduced reporting requirements. At the beginning of Archigos tenor, Huang was not welcomed as a customer at the major investment banks. Indeed, as recently as 2018, Goldman Sachs was on the record saying that he was too risky to do business with. However, over eight years, Archegos built up assets under management from $200 million to $10 billion, which is a crazy rate of return, something like $60, $60,000.000. Something like

Starting point is 00:04:25 63% annualized. And effectively, it got big enough that firms were willing to do business again despite all the previous legal trouble. Fast forward to March 2021, and the whole operation had collapsed. Indeed, when all was said and done, Huang would be the absolute undisputed goat of losing money. Archigos had been taking large position in small-volume stocks, most notably Viacom and a Chinese education company called GSX. In order to avoid raising suspicion, Archegos had been taking these positions using derivatives known as total return swaps. These instruments are contracts with prime brokerages that allow funds to gain exposure to the increase or decrease in a price of a stock without actually holding that stock. So, instead of buying shares in a company, you buy a contract with someone like

Starting point is 00:05:14 Goldman Sachs that says something like they will owe you money if the stock goes up or you will owe them money if the stock goes down, or vice versa in the case of a short position. For the investment, it's a pure play derivative, a zero-sum betting game between counterparties. On the other side of the trade is a bank who hedges by buying the underlying asset. This means that a prime brokerage bank would hold the stock on their own balance sheet and pass through any profit or loss to the owner of the total return swap. Another way of putting this is that when regulators see who owns the company's stock, it's not Archegos who is the originator of the bet on the books. It's the counterparty investor like Goldman Sachs. The other big element of this was leverage.

Starting point is 00:05:52 Based on this type of instrument, Archegos was only required to put up a fraction of the actual capital in question, which meant that they could have a much bigger market impact than they actually had assets under management. Archigoths didn't just hold these derivatives with one prime broker. They held them across multiple banks including Goldman Sachs, Morgan Stanley, UBS, Deutsche Bank, Credit Suisse, and Nomura. It wasn't clear how much these banks were sharing information on Huang's positions, and Archigose certainly wasn't reporting their position sizes to the SEC.

Starting point is 00:06:20 This allowed them to accumulate large positions in low market cap companies without anyone really knowing about it. Here's a really simple Matt Levine description of Archegos's strategy. Starting in about 2020, Archagos investment strategy consisted of buying a whole ton of shares of like 10 stocks, using mostly money borrowed from about a dozen banks. As Archegos kept buying more of these stocks, they went up because generally if you buy a lot of a stock, the price will go up. As the prices went up, Argego's had marked to market profits. The shares it bought earlier, lower prices were worth more so it had made money. Archigos used these profits, leveraged with more money, borrowed from its banks, to buy more

Starting point is 00:06:57 of its favorite stocks. This made the prices go up more, which created more profits, which gave it more money to buy more stocks in what I guess you could call a virtuous cycle. A major problem was that it wasn't clear if Huang had kept good collateral with these banks or if he had been posting the same stocks to multiple banks as collateral. So in late March 2021, these banks reportedly had a meeting to discuss the orderly unwinding of these positions as they discovered just how extensive Archegos' prime brokerage relationships were. The meeting reportedly included an agreement to cut the positions in a coordinated

Starting point is 00:07:30 and careful manner to avoid shocks to the market. However, Goldman Sachs immediately broke ranks and began dumping Archegos' position the next day in huge block trades of 20 to 30 billion at a time. Bloomberg called these trades a series of market roiling trades so large and hurried that investors described them as unprecedented. At first, it wasn't clear what the cause was, but when all was said and done, banks took a huge loss on these positions. Goldman Sachs and Morgan Stanley, because they broke ranks first, got out relatively unscathed, but Nomura ended up reporting a $2.9 billion loss, and Credit Suisse reported a $5.5 billion loss. At the time, Ben Hunt of Epsilon theory speculated that these actions were all very strange. The price drops in Viacom and GSX had begun, but

Starting point is 00:08:18 they seem nowhere near severe enough to liquidate the Archgo's positions if there was anything resembling prudent underwriting going on at the banks. He speculated that the banks may have discovered that Bill Huang was double dipping his collateral, or even that the banks had received a tap on the shoulder from the SEC or the DOJ. And that brings us up to this week when Bill Huang was arrested. Looking for ways to step up your crypto game? Then go with Nexo. For starters, you get free crypto for each purchase or swap. How about earning guaranteed yields? Up to 17, paid out daily. Ideal for you hardcore hoddlers. You don't even need to sell. Instead, borrow instant cash against your assets. Get the most out of your crypto with nexo at nexo.io. That's nexo.i-o.

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Starting point is 00:10:15 Download the FTCS app today and use Referral Code Breakdown to support the show. Bill Huang and Archigo's CFO Patrick Halligan were arrested in their homes on Wednesday. They faced charges of racketeering conspiracy, securities fraud, and wire fraud. Huang has been released with a $100 million bond that's secured by $5 million in cash as well as multiple properties, and federal prosecutors are referring to the scheme as, quote, staggering in its size and brazen in its execution. Huang's lawyers have said that the indictment has absolutely no factual or legal basis, and that their client was, quote, entirely innocent of wrongdoing. Along with the arrest, the indictment from the DOJ and the complaint from the SEC have been unsealed,

Starting point is 00:10:55 and they contain some interesting allegations of what went on at Archagos. One, we got a sense of the numbers. The leverage that Huang used had grown the portfolio from 1.5 billion to 35 billion in a single year. And because of that leverage, the effective size of the firm's stock positions was around 160 billion, which is as big as some of the biggest hedge funds in the world. In June 2020, an archivost employee had asked Huang if the rising price of Viacom was a sign of strength. Huang responded via text message, no, it's a sign of me buying, followed by a laughing emoji. By late March 2021, Archagos had accumulated over 50% of the stake of outstanding shares of GSX, Discovery Class A, and Viacom.

Starting point is 00:11:36 Indeed, the size of its positions was pretty crazy. In GSX, over 70% of outstanding shares. Discovery Class A over 60% of outstanding shares. Viacom, CBS, over 50% of outstanding shares. Tencent Music Entertainment Group over 45% of outstanding shares. And Discovery Class C over 30% of outstanding shares. Again, from Matt Levine, these are comically large numbers. On any given day, Huang represented a significant amount of the trading around these companies as well.

Starting point is 00:12:06 From the complaint, Archegos trading of the equities frequently exceeded 20%, often reached 30%, and even surpassed 40% of certain issuers' daily trading volume. During this period, Archigoths engaged in substantial trading during the last 30 minutes of the trading day, designed to push the stock price of certain issuers in which Archgos was long exposed upward. The indictments contend that none of this was, quote, based on a principled view of the true value of a particular issuer. Finally, during this time, Huang basically sidelined everyone who worked for him in research, more or less ignoring their stock price targets in favor of what he was going for.

Starting point is 00:12:41 So the commentary around the arrest falls into a handful of categories. The first is just confusion and disbelief, and I think this is best summed up by Matt Levine's piece in Bloomberg. Matt asks what the exit strategy was and why a trader of Huang's experience would get himself into a situation where the fund would surely blow up in the first place. After giving you that description that I read before of Huang buying the stock in order to drive the price of the stock up, in order to borrow more money to buy more of the stock to to drive the price of the stock up and so on and so forth, Levine writes, I don't know how to write an ending for this story.

Starting point is 00:13:14 I mean, I know how the story ended in real life and it's the obvious ending. The obvious ending is that if you keep doing this, you end up owning enormous quantity. of your favorite 10 stocks, owing enormous amounts of money to your banks, and having a very slim margin for error. If a slight breeze knocks down the price of one of your stocks, your banks will demand more money in a margin call, and you won't have any cash because you have invested every cent in buying stocks with borrowed money. Your banks will be forced to sell some of your stocks, which will drive their prices down, which will lead to more margin calls and more for sales and more price drops, etc., and what you would certainly call a vicious cycle. And that is, in fact,

Starting point is 00:13:46 exactly what happened. Still, more importantly than the mechanics is this gnawing sense that Levine has that it doesn't make any sense. Quote, the story I laid out above is stupid, and it inevitably ends the way I described. Bill Huang presumably did not want to lose all his money. What was his exit plan? How did he think the story would end? The simple story is so unsatisfying that I have occasionally speculated that he might have had a better plan. One better plan is to do essentially what I laid out above. Buy stocks with borrowed money, push them up, reinvest the profits to push them up some more. But then stop. Call up your banks, withdraw your latest enormous round of mark-to-market profits, and instead of using them to buy more leverage stock positions, use them to buy some gold bars

Starting point is 00:14:28 and bury them in your backyard. Then a slight breeze blows over your stocks. You get margin calls, you say, sorry, I have no money, your stocks crash, your funds equity goes to zero. Your banks lose billions on their loans. You get a lot of negative news articles written about you. You sigh and look chagrined. Eventually everyone moves on and you dig up the gold bars. So Levine is obviously being a bit comical, but I think that his confusion is reflective of a lot of people just trying to understand what the endgame was. A second part of the discussion has been around the fact that much of the legal complaint focuses on things that Huang was doing that simply don't seem illegal. Like buying too much stock. Stimpy Z1 writes, this ridiculous lawsuit is a head scratcher.

Starting point is 00:15:08 None of the complaint cited things are illegal yet. the SEC is sending a message to bilateral clearing primes to shut down institutional leverage. Dirty Texas hedge writes, I haven't dug into the case in detail, but it seems to me the only actual wrong he did was double-pledge collateral. That's definitely fraud, but the rest just seems like he believed his own bullshit question mark. Taking this a bit farther, things like buying stock in the last 30 minutes aren't illegal. In fact, that's an increasingly normal behavior based on the fact that that's when closing prices are set, which matters for index funds and other market actors. Ultimately, this is going to be determined by lawyers, but it's not totally clear what reform

Starting point is 00:15:43 around this case might even look like. A third part of the commentary is about understanding and unmasking just how much systemic risk there still seems to be, and how investment banks conduct business and manage risk. Dan Lauer writes, I spoke with a few people today who all agreed that the excuse being given is bullshit. All the banks talked to each other and broadly knew that Archigos was taking on excessive leverage. Nobody did anything about it because nobody wanted to lose the business. business or fees. Sophie, an analyst at net capital management writes, the Bill Huang news makes it

Starting point is 00:16:13 sound like he's going to take all the blame and the swap desks at the banks are going to get off easy because they lost a bunch of money too. TLDR in the Year of Our Lord 2022, due diligence at banks is just as bad as it's ever been. Oh, and one final thing on this note, people are really losing their minds around the allegation that Archegos just didn't respond to margin calls. Tracy Allaway says, oh, and don't forget, they waited until February 22 to try to suggest switching Archigos to dynamic margining and then failed to do so because their Archiggo's contact wouldn't pick up the phone. Matt Coors writes, the absolute best part about the Bill Huang and Arcoe story is that they avoided margin calls by legit not picking up the phone.

Starting point is 00:16:54 F***ing genius. I think that this last point about risk in the system based on the way existing institutions behave is supremely relevant. If you take a look at where a lot of the focus in the financial system from a regulatory standpoint is, it seems to be things that have nothing to do with this sort of systemic risk. Sure, the Treasury needs to be able to see every $600 transaction that regular people do, but not the accumulation of $160 billion in leverage. And obviously, I bet you know where I'm going next with this. The disparity between how much attention crypto has and commentary there is on its potential to become a systemic risk compared to where systemic risk actually exists today is nuts. And it's not just a matter of emphasis and

Starting point is 00:17:36 proportionality, it's an actual matter of misdiagnosis of problems. Let's use an example that builds off something that Janet Yellen discussed in her recent speech. She talked about a stable coin that had lost its peg due to price volatility in the assets backing it, causing a feedback loop of redemptions and continuing to drive the price down. At a congressional hearing last year, Alexis Goldstein from the Open Market Institute, pointed out that if a hedge fund or a family office was holding a significant amount of a stable coin that had a run like that, that volatility and risk could be transferred to the broader financial system. So let's say something like that happened, that Huang's next fund after he gets out of jail is holding a bunch of a new algorithmic

Starting point is 00:18:12 stable coin. It's also levered to the nines using some new exotic derivative instrument that hasn't been invented yet, that like these previous total return swaps, allow him to operate with near total opacity. He becomes a forseller of other assets because his shiny new stable coin is crashing, and that creates downward price pressure on those other assets which causes further liquidations, et cetera, et cetera, et cetera. In this circumstance, who is at fault? To listen to the way that some parts of Washington discussed crypto, you would think it was only the stable coin. Of course, part of it is a system that allows for leverage and exotic instruments. Part of it is the rules and regulations that allow these types of family funds to operate in total opacity.

Starting point is 00:18:49 And a big-ass part of it is the fund managers who took on too much risk and the wrong risk. Just to put a fine point on this, no one has been blaming Viacom for the Huang mess. So why are we so focused on the underlying asset when we talk about crypto, as opposed to the structures of the institutions and the way that they do business that keeps getting us into these situations over and over again, even today, completely outside the crypto industry? And to take this crypto comparison just one step farther, is there an argument that if this were all crypto assets,

Starting point is 00:19:18 it would have been easier for authorities to track because this is taking place on chain? Honestly, yes, I think there is. It may be that part of why there has been a significant shift in tone among regulators over the past few months is that more and more are coming to an understanding of those inherent properties of transparency and crypto and the ways that they could actually benefit the existing system. Still, I think that ultimately the weight and see for many around this is how much it represents a targeting of one specific person and one specific fund versus a new attitude about going after financial crime. One of the biggest reasons for the discontent in the wake of the global financial

Starting point is 00:19:55 crisis that fueled the early years of crypto was the disillusionment with politics for not actually punishing anyone who would put so much risk into the financial system in the first place. Is this a shift? Only time will tell. For now, I want to say thanks again to my sponsors, nexus.io, Arculus and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. Hey, breakdown listeners, come join CoinDesk's Consensus 2022, the festival for the decentralized world this June 9th through the 12th in Austin, Texas. This is the only festival showcasing and celebrating all sides of blockchain,

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The Breakdown - What the Archegos Arrests Tell Us About the Financial System

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