Losses that triggered the liquidation of positions approaching $30 billion in value bring to light complicated financial instruments used by European investors that are effectively banned in the U.S. but could still have spillover effects domestically.
So-called contracts-for-difference were at the center of some of the massive wrong-way bets made by Bill Hwang’s Archegos Capital Management, according to reports.
According to Bloomberg News, contracts-for-difference, or CFDs, were at the heart of some of the “unprecedented” trades executed by the former protégé of hedge-fund titan Julian Robertson. Robertson founded the prominent investment firm Tiger Management in 1980 and his investment scions are referred to affectionately as Tiger Cubs.
CFDs are a kind of derivative instrument that allow traders to place a directional bet on the price of a security without actually buying or selling the underlying instrument, Julius de Kempenaer, senior technical analyst at StockCharts.com, explained to MarketWatch via email.
“It works much like a futures contract on, say, an index. The buyer and the seller agree on the price of a transaction sometime in the future. At the end-date, or earlier if they decide to unwind the position beforehand, only the difference between the actual and the agreed price will be settled.”
“If the price went up the seller pays the buyer the difference, and vice versa,” the analyst wrote.
The StockCharts.com analyst explained that CFDs are leveraged bets, where investors can use borrowed money at a fraction of the cost of the underlying asset, “typically around 10-20% depending on the volatility of the underlying market.”
“This means that you can get a position worth $1 million and only need $200,000 in margin. That allows building big positions very rapidly without a lot of market impact,” he said.
Margin is the amount of money a trader must initially pony up as collateral when taking positions, and a margin call occurs when the market goes against such leveraged bets, forcing the investor to deposit more cash or securities to cover losses.
On top of the leverage, sources reported that Hwang may have been able to obscure his investment fund’s exposures by using multiple banks to execute the firm’s trades.
Credit Suisse Group AG and Nomura Holdings Inc. said they could incur substantial losses related to major liquidation trades but didn’t name Archegos.
Big banks hedge their exposures to such CFD bets by buying at least a part of the actual shares in the market.
CFDs aren’t legal in the U.S. but their usage in other regions, particularly Europe, may be something that regulators weigh as they monitor this margin-call situation, Amy Lynch, a former SEC regulator and president of FrontLine Compliance, told MarketWatch in a Monday-afternoon interview.
“Extremely risky,” is how she characterized CFDs.
“It’s kind of like being able to go into a naked position,” she said, referring to naked bets where investors use derivatives to gain exposure to an investment without owning the underlying asset.
Lynch said that firms like Nomura and Credit Suisse “can handle these amounts of losses,” but said it is still enough of a worry in the market that “they should revisit their internal controls and practices around these instruments.”
On Monday, the market appeared to shake off the event, with the Dow Jones Industrial Average
finishing at a record high, while the S&P 500 index
finished virtually unchanged and the Nasdaq Composite Index
ended the session modestly lower.