- Archegos’ use of financial derivatives helped it increase its leverage that triggered a $20 billion liquidation and rattled financial markets last week.
- In 2002, Warren Buffett described derivatives as “financial weapons of mass destruction.”
- Buffett said that derivatives were expanding “unchecked” and that governments had no way to control or monitor the extreme risks posed by them.
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The derivatives instruments that triggered the Archegos Capital Management implosion have for years been scrutinized by regulators and some of Wall Street’s biggest investors, including Warren Buffett.
In Berkshire Hathaway’s 2002 annual report, Buffett called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Archegos’ investments were partially concentrated in derivatives called total-return swaps. The highly leveraged trading strategy also had a role in the fallout of Long-Term Capital Management, a hedge fund that failed in 1998 and ultimately required a bailout from a consortium of Wall Street banks to prevent a financial-market collapse.
In the letter, Buffett described how LTCM used total-return swaps and how the instruments are contracts that can facilitate 100% leverage in various markets, including stocks.
In a total-return swap, one party, usually a bank, puts up all the money for the purchase of a stock, and another party, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes, Buffett explained.
“Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions,” the investor said.
He said highly experienced investors and analysts could encounter major problems analyzing the financial conditions of firms that are heavily involved with derivatives contracts, including total-return swaps. He said that when he and Berkshire Vice Chairman Charlie Munger read through the footnotes detailing the derivatives activities of major banks, the only thing they understood was that they didn’t understand how much risk the institution was running.
“The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear,” Buffett said.
He said that the derivatives businesses were expanding “unchecked” and that central banks and governments had found no effective way to control or even monitor the risks posed by these contracts.
Almost 20 years later, Bill Hwang’s use of derivatives like total-return swaps helped enable him to increase his leverage and ultimately triggered a $20 billion liquidation of his family office. The trades rattled stocks last Friday, as ViacomCBS and Discovery faced their largest daily declines on record. And while some banks like Goldman Sachs and Wells Fargo managed to escape losses by quickly liquidating their exposure to Archegos, others like Nomura and Credit Suisse could face billions in losses from the trades.
Archegos was trading on leverage using total-return swaps, and, according to Forbes, the family office did not disclose its position and subsequent transactions because Securities and Exchange Commission law exempts family offices from disclosing these trades.
The SEC has opened an investigation into Archegos, but it might not lead to any allegations of wrongdoing.