Outreach Blog

Thursday, September 28, 2023

Untold Stories of Market Manipulation: Archegos Capital

How Securities Lenders Unraveled the $100 billion Pump and Dump Scheme


Author: Ed Blount

By Ed Blount and Dan Hammond

 

“In a matter of days, the companies at the center of Archegos’s trading scheme lost more than $100 billion in market capitalization, Archegos owed billions of dollars more than it had on hand, and Archegos collapsed.”
U.S. Federal Bureau of Investigation[1]

This blog tells the untold story of how securities lenders in March 2021 became more than simply a source of liquidity to markets. Lenders organized their de facto market posse when their securities lending agents and custodians set in motion the chain of contractions that brought down Archegos’ massive fraud. It was their automated ceiling on total credit extension – share inventory buffers -- that led, in a very short time, to traders’ discovery, surveillance, and opposition to the manipulation. 

With a dataset of more than 225 million securities loans, we evaluated how the market responded to the Archegos’ manipulations. According to the SEC charges, the "relevant period" of the manipulation covered fewer than 150 days. During that time, more than 175,000 loans were made of equities for CBS Viacom (VIAC). We have chosen that issue as an example for our study. 

Collateral values will climb with security prices but the constant on float – the issued and outstanding share count – is a major constraint on leverage.

From 30 thousand feet, it seems that the market worked its mechanisms very well. The GME squeeze on Melvin Capital was fresh in VIAC traders’ minds. They didn’t need social media to focus on the prospect of another squeeze. As the VIAC share price climbed past $60, those traders who had shorted at $30, e.g., targeting $10, were forced to double their bets in collateral margin calls.

Yet, the irrational price rise kept going. When VIAC hit $90, the funding markets were saturated. Credit limits and inventory buffers exhausted the markets’ ability to sustain the VIAC price bubble. One week after Archegos failed its margin call, the funding market for VIAC collapsed. The share price bottomed at $40, and creditor losses on VIAC collateral fire sales were reported at $10 billion. 

The Resilience of the Securities Finance Infrastructure

The constraining role of inventory buffers is illustrated in the chart above. For more details on the alleged manipulations, please read here and here.

Institutional securities lenders, by making their huge portfolios available to short sellers who opposed the VIAC bubble, and lending agents, by their controls on VIAC inventory, provided the counterbalance to excess leverage in VIAC. Risk capital committed to funding short sales of CBS Viacom (VIAC) doubled in three months, as service providers efficiently arranged, cleared and settled the hedges of Archegos creditors, along with those of VIAC market makers and derivatives dealers. 

Inventory buffers placed a ceiling on the number of shares on loan at a critical time in the CBS Viacom price bubble.[2] Borrowing fees surged at first and, in so doing, tipped off traders to the squeeze potential. Since squeezes on short sellers are engineered with shares not cash, the growing scarcity of available VIAC shares was an indicator of a stressed market. The “smart money” and tactical arbitrage shorts ramped up their block trades as the price approached $100. VIAC spiraled to $40 when Archegos couldn’t support the price bubble any longer.

The lending agents’ buffers forced a scramble among short sellers to avoid recalls at the same time that borrowing fees and margin calls for additional collateral were rising. Lending agents raised their fees for the now-hard-to-borrow VIAC shares. Long-term, strategic short sellers closed out positions, realized their losses, and returned borrowed shares when the cost of carrying the loan became exorbitant.

Capital started to flood the short side of the VIAC market, and the role of the securities financing market became crucial to systemic stability. As agents put limits on the number of shares available for lending (units) in the aggregate, new loans and returns had to balance out roughly. Every new agency loan had to come from shares being returned by someone else. 

VIAC’s share price bubbled up as increasing demand from short sellers raised the borrowing fees and collateral margin for new loans. Inventory buffers were strained when larger shorts entered the trading pits. And Archegos finally imploded when creditors opposed further credit extensions.

All this was evident to well-informed observers in the securities financing markets.

 

The Accumulation Period

In the run-up to the crisis, the SEC complaint alleged that Archegos adopted a risky strategy of buying huge, leverage-fueled positions in small-cap stocks with limited liquidity. From December, 2020 to early February 2021, the SEC reported that Archegos’ executives were enrolling new prime broker/swap counterparties in order to extend their credit limits, while their traders were manipulating the market with repetitive, ascending limit orders that inflated the price of CBS Viacom (VIAC ). The increasing stock price also had the effect of expanding the credit balances in the Archegos portfolio, enabling even more accumulations. 

According to the SEC Complaint, “Archegos effected this scheme by dominating the market for its Top 10 Holdings, as well as by ‘setting the tone’ (i.e., engaging in large premarket trading), bidding up prices by entering incrementally higher limit orders throughout the trading day, and ‘marking the close’ (i.e., engaging in large trading in the last 30 minutes of the trading day) and by other non-economic trading, all with the goal of artificially inflating the share prices of its Top 10 Holdings.”[3]

Archegos’ traders magnified their use of leverage by concentrating the firm’s portfolio in just ten derivative swap positions, which were each duplicated to different degrees with the credit from eight prime broker/swap counterparties.  Never would these firms have financed price manipulation, one must assume, had not the Archegos management group repeatedly lied to the credit risk managers of their brokers. 

During late January, the headlines in the financial media were dominated by the retail short squeeze of GME.[4]  Very quietly, Archegos grew more than tenfold to $35 billion in assets under management.

 

The Surveillance Period

In mid-February, 2021, Archegos’ trading and share positions accounted for most of the market liquidity and free float in VIAC, stretching the limits of Archegos’ ability to deceive Wall Street. At one point, a risk manager at a prime broker asked if the large VIAC long positions disclosed to the SEC by other prime brokers under Regulation 13(d) had resulted from their buys of VIAC shares as hedges for controlling the balance sheet risks from Archegos’ single-name swaps. 

The more astute media analysts and their trading desks saw that the price of VIAC was hyper-inflated and started to make larger bets against Archegos. Short sellers’ trade sizes grew dramatically. The average value of new short positions (securities borrowed for settlement) in the Surveillance Period grew from $7.07 million to $10.1 million, an increase of 42.9%.

The average age of outstanding loans declined from 60 days to 22 days, for a decrease of 63%, driven by many very old loans being returned as shorts cut their losses. 

When combined with almost two-thirds shorter tenures, the larger average ticket size created a far more active shorting market at the same time that Archegos was being reined in by its credit limits. The turbulent VIAC activity drew capital to oppose the rogue traders like a market posse.[5]

 

The Opposition Period

By mid-March, 2021, traders were building new and larger short positions, as shown by the decline in loan tenures. The pressure from these sales was magnified by a corporate event: On March 22, 2021, VIAC announced an additional stock offering in an attempt to cash in on their recent price momentum. 

The offering received a lukewarm reception.[6] In particular, Archegos was seen to neglect to participate, possibly due to a lack of cash reserves.  This was the ultimate signal to the market makers that the game was up.  A downturn in the value of VIAC and, consequently, of its highly leveraged equity bets resulted in a crisis of liquidity at the fund. Then, the scramble to unwind the swaps and seize the collateral began among the banks that had provided financing for the trades.

 

[1] U.S. Department of Justice, “Four Charged in Connection with Multibillion-Dollar Collapse of Archegos Capital Management,” Wednesday, April 27, 2022, https://www.justice.gov/opa/pr/four-charged-connection-multibillion-dollar-collapse-archegos-capital-management

[2] The number of new units (shares on loan) averaged 40% above the previous quarters’ volume.

[3] See Complaint, ECF No. 1, SEC v. Sung Kook (Bill) Hwang, No. 1:22-cv-3402 (S.D.N.Y. Apr. 27, 2022).

[5]Blount, Edmon W. “The Bear Market Posse, or Counterparty Risk Management during the Recent Turmoil.” RMA Journal, 1 Sept. 2008, https://cms.rmau.org/uploadedFiles/Credit_Risk/Library/RMA_Journal/Market_Risk_Topics/The%20Bear%20Market%20Posse,%20or%20Counterparty%20Risk%20Management%20During%20the%20Rece.pdf .

[6]Golum, Rob, et al. “ViacomCBS (VIAC) Stock Sinks After Announcing $3 Billion Share Offering.” Bloomberg.com, 22 March 2021, https://www.bloomberg.com/news/articles/2021-03-22/viacomcbs-sinks-after-announcing-3-billion-share-offering#xj4y7vzkg  . Accessed 13 September 2023.

 

 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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