Meltdowns, Margin Calls, and a Risk-Oriented Mindset
The collapse of Archegos (the family office that recently imploded, generating substantial losses for at least two of its prime brokers) was notable given the size of the positions, the amount of money involved, and the speed with which it all fell apart. While there will be many detailed post-mortem analyses of what happened, we offer our perspective as experts on risk management, and insights into how risk management systems can help other firms avoid such disasters.
The whole is not the sum of the parts
This is perhaps glaringly obvious after the fact, but it is critical to note that if a firm does not have all of its positions modeled on the same risk platform, it cannot know its total risk. To anyone who has been following the Archegos story, it is now obvious that one’s total return swaps may be overlooked in determining equity concentrations, but that is just one example of the many ways that risk exposures and leverage can be mis-measured when risk analyses are scattered across disparate systems.
A firm that measures risk for different types of positions on different systems has no clear picture of its true exposures. Equities, ETFs, options, interest rates, inflation, credit spreads, swaps, FX, volatility, and so on, are all related. A firm may have offsetting positions that actually reduce risk, but may also have exposures and leverage that will have larger than anticipated effects under certain conditions. The importance of modeling all types of positions on the same risk platform applies equally to prime brokers, banks, hedge funds, family offices (which can look like hedge funds) and other financial entities on the sell-side or buy-side.
Institutional Risk Management – A large Monte Carlo “experiment”
A prime broker or clearing firm with a large, diverse set of clients is, in a sense, conducting its own grand Monte Carlo experiment in which every day is a new random shock and each client constitutes a random risk factor. And like water seeking the cracks, eventually the “simulation” will uncover any shortcomings in the risk management. Except, of course, that these simulations are real, and so are the outcomes.
Better to uncover these weaknesses in the virtual world.
Maintaining the Guardrails
On the topic of margin calls, it is fair to say that no one likes them – not prime brokers, not clearing houses and not buy-side firms. But while requiring customers to maintain the appropriate level of collateral is clearly necessary, it may not be sufficient to protect prime brokers against an account blowing up. Better to anticipate and warn against a potential significant margin call than have to deal with the fall-out from unrecoverable losses that result when positions are liquidated in volatile markets (remember, margin calls are rarely necessary when markets are calm).
While this is obvious, there is an aspect of the margin requirement that may provide a false sense of security and contribute to the problem. Even though clients may “rail against the margin guardrails,” those clients have an a prioriexpectation that their prime broker is maintaining a sufficiently high level of risk oversight – one that is greater (more sophisticated) than what the client may be maintaining internally. In the client’s mind, “if there is no margin call, I must have a safe level of risk”. So if a prime broker’s oversight is lacking, a client may unintentionally blow through prudent limits and suffer a potentially catastrophic loss.
The guardrails serve both a concrete function and act as a signal, and it is important for brokers to generate clear signals based on the best information possible.
When is Diversification Risky?
Everyone involved in the investment and risk management business has been well educated about the benefits of diversification in reducing risk. So, here’s a riddle: when is diversification risky?
As noted above, a firm that does not have all of its positions modeled on the same risk management system cannot know its total risk. Similarly, if a firm’s risk management processes are “diversified” across multiple platforms running in different time zones, and risk is only measured at the end of the day (what does “end of day” mean when markets trade after hours and exposures are global?) the firm is actually creating risk for itself. Markets move intraday and overnight. A firm that waits until 5 pm local time to measure risk and then only in a specific region, can wake up the next morning in a very bad place.
Each blow-up or crisis has its own unique story. Archegos has its set of circumstances, as did the Long-Term Capital Management meltdown in 1998, the financial crisis of 2008, Black Monday (a lifetime ago, in 1987), and others. So, it is not possible to predict the conditions that will precipitate the next crash or blow-up in our industry. But strong risk management tools and practices, and a culture that views risk management as critical to business success can help sell-side and buy-side firms alike to avoid creating dangerous conditions. Strong risk management allows you to take the corners, but apply the brakes when approaching the cliff’s edge.
Broker-dealers understand the importance of producing accurate margin calculations for their clients’ accounts, but they need to know more than just how much margin each client must post; they need to know why the margin system came up with a given result.
In times of stress in the markets, not only does volatility increase for individual assets, cross-asset correlations can increase dramatically as well. This results in a “double whammy” for a typical portfolio because the portfolio’s volatility increases due to both effects.