Bill Hwang, founder of Archegos Capital Management, was charged yesterday with racketeering and securities fraud. How Hwang hid his positions teaches us a lot about how markets work today.
How Total Return Swaps Work
Archegos Capital Management controlled a majority of the shares of several large public companies without making any of the usually required disclosures. It was able to do this because it used a derivative called a total return swap.
A total return swap is pretty much like owning a stock. You get the gains if the stock goes up, you lose money if it goes down.
But you don’t technically own any shares.
Instead, you have a contract with a bank to get the gains and pay the bank for any losses. To hedge its risk, the bank will buy the shares, rather than you buying them.
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Hedge funds like Archegos love this arrangement because it lets them hide positions from the market and exempts them from disclosure requirements. Bankers love it because the swap comes with juicy fees.
These swaps even let you trade on huge margin. And they’re easy to get.
What’s a Few Felonies Between Friends?
But why let a few felony convictions get in the way of a great deal? Credit Suisse booked $16 million in fees from Archegos in 2020, likely leading to fat bonuses for the bankers involved.
How Hedge Funds Can Use Swaps to Hide Short Positions
Hwang used total return swaps to hide bets that stocks would go up. But they could just as easily be used to hide huge short positions.
If a hedge fund wanted to short a stock without anyone knowing how big their exposure is, a swap would be the natural choice. The fund could do numerous swaps with different banks, as Archegos did.
With the hedge fund’s bets split between various banks, no one would know how vulnerable the fund is to a short squeeze.
Had Melvin Capital been smart enough to do this last year, retail traders might never have known how exposed it was to GameStop Corp. shares. But they did know, and they used that knowledge to squeeze Melvin.
You can bet that other funds have learned from Melvin’s mistake.
What Investors Should Know
The bottom line is that it’s extremely easy for hedge funds to hide their positions today. It’s happening every day, and we only heard about Archegos because it blew up.
But you can be sure that other funds are out there hiding massive positions at this very moment.
What trades do you think hedge funds may be hiding? Leave a comment at the bottom and let me know!
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