We provide some background on equity swaps between hedge funds and banks in light of the recent deterioration in some individual stocks.
There has been extreme volatility in some individual stocks over the past few days, with companies such as Viacom VIAC dropping from a chart level of $100 to $40 last week. As you may know, this was largely attributed to trading activity from the offshore hedge fund Archegos, which had gained leveraged exposure toward various stocks through contracts known as total return equity swaps. While this does not have much of an effect on our technical research right now, we felt it was an especially interesting market event and may certainly warrant questions from clients, especially for those holding any of the securities that have been affected. Therefore, we wanted to provide some broad background on total return equity swaps and how they led to such massive price deteriorations.
These contracts are very similar to a contract for difference (CFD), which is defined as a financial derivative trade that has the difference in the opening and closing of that trade settled in cash, without the transaction of any actual securities or shares of stock (source: investopedia.com). CFDs also use leveraged exposure, allowing the investor to gain a large position in a particular stock while only being required to provide enough capital for a fraction of that investment. CFDs are illegal in the U.S., however, equity swaps are not. Although similar to CFDs, an equity swap contract between an investor and a bank has a defined timeframe, while a CFD does not.
These swaps are significant as they allow hedge funds to take large positions in securities without having that position actually reported. As an example, say a hedge fund wants to go long XYZ stock for $200 million. They can enter into an equity swap with a bank to gain leveraged exposure, which may only require a $5 million investment to be put upfront. The hypothetical equity swap contract states that the hedge fund is long $200 million initial investment in XYZ at $100 a share for three months. If the share price moves higher over the next three months, the hedge fund gets paid the profit. If the share price moves lower over the next three months, the hedge fund has to pay the bank for the loss at the end of the three months. This can occur without anyone other than the hedge fund or bank knowing, which also allows the hedge fund to enter into the same contract with multiple banks.
This occurred with Archegos, as they had multiple equity swaps on the same companies spread out across various banks. As long as the share price went up, they were paid for their exposure, but when the share price of some of their positions went down, the banks then called on Archegos to pay for their losses on heavily leveraged positions. When they were unable to cover their losses, the banks were forced to liquidate all of the hedge fund’s exposure through block trades, causing the massive sell-off in some individual stocks over the past week. Unfortunately for most investors, they were not aware of the actual monetary exposure behind these securities until it was too late.
While many broad market indices have seen declines in the past few days, significant drawdowns have been generally limited to those names actually involved in the Archegos equity swaps. However, this is the second time in 2021 that we have seen the unraveling of heavily leveraged positions from hedge funds affect the broader market, and we are only in the first quarter of the year. This will certainly be important to monitor for further developments or regulation adjustments moving forward.
