Thoughts about Archegos and the Investment Banking Industry
Thoughts about Archegos and the Prime brokerage Industry
As the earnings season for US listed companies approaches, news of the fallout from Archegos (Family office hedge fund) dominated the headlines concurrently. Even as US banks like JPM and BAML are reporting record earnings, other banks such as Nomura and Credit Suisse took significant hits and losses from their Prime brokerage businesses. Matt Levine from Bloomberg and Marc Rubinstein from Net Interest provided exceptional insight to the opaque internal businesses of investment banks and I decided to make some integrated notes based on their unique insights and my personal understanding of the investment banking and prime brokerage businesses.
What constitutes Prime brokerage
1) Agency business - trade execution and fees driven business. Execute buy and sell transactions for clients under street name omnibus accounts. Execute block trades and using algos to split trades into different shapes to conceal institutional buying / selling to ensure best execution based on price and speed of execution. Earn via transaction fees and bid offer spreads.
2) Custody business. Safekeeping of assets. Generally facilitate the client to execute long only portfolios and charge fees based on Asset Under Management. Might provide additional services like securities lending to facilitate client to execute covered short positions, and earn interest revenue.
3) Proprietary trading - Using the bank balance sheet / assets to actively take risk to trade in the market. Securities lending and borrowing are generally OTC and part of the proprietary trading divisions. Banks may choose to employ a market neutral position by executing an opposite trade to the client position to hedge against active risk. This business is generally on the decline after 2008 and Dodd Frank as most of the proprietary traders moved to hedge funds. May adopt a variety of strategies such as flow trading (strategies based on Transaction flows within the bank books), signal trading (scrapping SEC filings and market moving information via algos and automatically execute trades with superior speed and execution), Long shorts, quantitative strategies etc.
4) Securities borrowing and Lending - Fees based business. Assist the client to execute covered short positions by borrowing securities from different counter-parties. May work with index funds (long investors) to lend out their shares, and pay them securities lending revenue to keep their expense ratio low.
5) IPO / private placement Listings - Certain hedge funds may request priority access to highly desirable IPO stocks as part of their investment strategies. Using their relationships, investment banks may try to allocate some of the new IPO stocks directly into the hedge fund books via private placements / IPO allotments allowing hedge funds to have <Dips> on those holdings.
Prime Brokerage Business
Integration of the securities lending, custody, agency business, and IPO allotment businesses. Services hedge funds unique strategies by providing customized services (combination of the above). Prime brokerage incorporate risk management methods such as margin calculations and rehypothecation, segregation of client money and assets, collateral take-down and recalls to ensure they are not overexposed to the risks the hedge funds are taking.
Interaction with Long short funds - Most of the long short positions should not move in the same direction amid market volatility. As investment banks measure risk by price movements and market volatility, there are able to extend higher credit limits against long shorts whereby the portfolios are generally not correlated with market movements.
Interaction with Long only passive ETFs - Certain hedge funds act as market makers to popular index funds. These hedge funds acts as authorized market participant and execute creation / redemption trades via algos based on the basket of securities and earn arbitrage profit off the difference in market prices and ETF wrapper price. These index funds also conduct certain level of securities lending by lending excess shares out to earn some revenue and lower their expense ratios.
Interaction with High Frequency trading funds - Investment banks provide Direct market access services to hedge funds, which is a dumb pipe <superior broadband> business. Certain hedge funds might favor this service as they believe they have superior trade execution compared to the banks, wish to avoid potential conflicts between the investment banks and the fund, and do not really need the bank platforms to execute their trades.
What happened with Archegos (Gaming the system)
As Archegos faced colossal margin calls and is forced to liquidate its entire portfolio, the respective prime brokers conveyed meetings to attempt to organize an orderly sale of the portfolio of stocks. Ironically, in the cut-throat environment of wall street, certain Investment banks moved first to cut their exposure and exacerbated the negative momentum effect, leaving the bag holders to shrivel up and lock in their short term losses. Although I see potential unwarranted undervaluation of the affected stocks from the Archegos forced selling, my limited circle of competence in the entertainment and media industry and minute warchest prompted me to stay in the sidelines for now.
Personal lessons from this debacle
1) Latent risks in concentrated leveraged long portfolios
I see certain parallels in the concentrated leveraged Archegos investment strategy, being run concurrently with the <rocket emoji diamond hands> WSB traders in the reddit space. I have no doubts that there are superiors traders and investors that are able to make outsized profits based on concentrated leveraged long positions. However, the potential horrific downside of losing a 100 billion portfolio in mere days due to random factors and margin calls is unacceptable to me.
Certain astute investors like Warren Buffet (Berkshire), Charlie Munger (Daily Journal) and Bill Ackman (Pershing Square) had exceptional performance by concentrating on a handful of stocks. By skipping the leveraged portion and having access to permanent capital, this allowed them to survive on the bad days. The only safe leverage that I can access is my CPF OA funds. I will make it a rule to only access that when exceptional situations like the Mar 2020 presents itself.
2) Limitations in quantitative risk management models.
It is ironic that despite the comprehensive risk management models employed by the banks, the hedge funds found a way to effectively game the system by limiting the disclosure of information, and adapting their trades execution to get around the reporting and disclosure requirements.
Banking, Insurance and financial stocks have the tendency to do well on most days and suffer huge lumpy hits on rare <black swan> occasions. The profits and revenues may be reported upfront but the true cost and potential losses come years later. Certain banks like Deutshce bank have suffered continual profitability hits in recent years and look way past their prime days. This is a feature and not a bug when investing in such industries.
3) Not all banks are equally common
Most retail investors mainly try to buy cheap banks based on their PB ratios. I used to think along the same lines when I started out investing. As I evolve as an investor, I realized that not all banks are equally common. I personally think I do not have superior insight in the black boxes / loan books of most banks and will be cautious to take concentrated bets on them.
Risk culture
Certain banks prefer lucrative complex deals like UBS and Goldman. They specialize in high margin structured finance products to earn a higher rate of returns on the good days. The true cost of these deals only surfaces years later, in the form of 1MDB bond and derivatives losses, when market conditions changes, and regulatory fines clamp down on the banks
Certain banks like BAML deliberately derisk their lines of business. By adopting a Simplify and Improve strategy to reduce complexity and transit into a lower margin high volume scale business, they managed to avoid regulatory fines and hits compared to the others
Diversified LOB and access to cheap capital (JPM and BAML)
These banks have access to relatively permanent and cheap capital from retail banking deposits.
An overinflated deposit base from QE00 bolstered the pool of
money that can be allocated to retail and commercial lending. By having diversified lines of business, the hit in commercial lending business
(from uncertain market conditions) is offset by the huge tail wind from IPO listing and trading revenue business. Similarly, if there is sour market sentiment that is affecting trading / listing revenue, the retail banking and commercial lending divisions can buffer the loss in revenue in the form of more stable recurring loans.
Credit provision losses and lending practices
As unregulated fintechs make their way to consumer lending and algo driven lending approval processes, I am wary about the way they employ regulatory arbitrage. By skimping on the regulatory capital required from traditional banks, they attempt to attract consumer deposits cheaply and lend them out at a higher interest rate. Although I believe that the direction to automated lending and approval is the right one, I do not know if the credit provisions are sufficient and estimates of losses are sound. In the bad days, a <bank run> of these undercapitalized platforms can be dangerous.
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