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The U.S. Federal Reserve has warned that existing hedging fund measures “may not be capturing significant risks,” noting the collapse of Archegos Capital as an example of hidden vulnerabilities in the global financial system.
The US Central Bank’s half-yearly report on financial stability found that some asset valuations are “high relative to historical norms” and “may be vulnerable to significant declines in the event of a drop in appetite”.
But the Fed also acknowledged that regulators lack tools to control risk-taking by traders like Bill Hwang, who made big leverage bets on shares through his family office of Archegos.
“The Archegos event illustrates the limited visibility to hedge fund exposures and serves as a reminder that available hedge fund leverage measures may not be capturing significant risks,” said Lael Brainard, the the Fed chairing the central bank’s financial stability committee.
He added: “The potential for material investment problems to affect broader financial conditions underscores the importance of more granular, higher-frequency disclosures.”
The warning about the invisible risks of hedge funds came when the Fed also expressed concern that a worsening global pandemic “could stress the financial system of emerging markets and some European countries.” The impact on emerging countries it could be aggravated if global interest rates “rose sharply,” he added.
In the United States, the central bank said “some businesses and households are still under considerable strain” even as improving the economy, low interest rates and government support have helped businesses and consumers to pay off debts.
The Fed said “banks remain well-capitalized and the leverage of broker-dealers is low.” Existing hedge fund leverage measures are “slightly above their historical averages,” he added, adding that the data “may not capture significant risks from hedge funds or other leveraged funds.”
Hwang’s performance was difficult to control because family offices faced limited disclosure requirements and because he used derivatives known as total return swaps. These instruments allowed Archegos to benefit from increases in individual shares with payments equal to only a fraction of the size of the underlying positions.
Banks that took the other side of the bets tried to cover their risks by buying the underlying shares, but ran into problems when Hwang’s fortune dwindled and he was unable to answer margin calls. Banks abandoned their shares, suffering losses of more than $ 10 billion, including $ 5.4 billion for Credit Suisse and $ 2.9 billion for Nomura.
As a result of the frustrations of U.S. regulators, the biggest losses in the Archegos affair were suffered by bank counters directly overseen by officials from other countries.
U.S. regulators expressed concerns about hidden leverage in financial markets shortly after Archegos exploded. In March, the Financial Stability Supervisory Board, headed by U.S. Treasury Secretary Janet Yellen, restarted the hedge fund oversight group to assess the risks taken by leveraged investment funds.
Gary Gensler, new chairman of the Securities and Exchange Commission, told the House Financial Services Committee this week that he had instructed his staff to consider the new disclosure requirements for full-yield swaps employed by Archegos.
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