Explainer-Why Archegos Capital Was In U.S. Regulators' Blind Spot

U.S. authorities on Wednesday charged Archegos Capital Management owner Bill Hwang with racketeering, fraud and market manipulation over the meltdown of his New York family office which left global banks nursing roughly $10 billion in losses.

Despite managing $36 billion in invested capital, according to the regulators, Archegos was subject to little direct regulatory scrutiny because it operated as a family office and used certain types of lightly regulated swaps to avoid other reporting rules.

WHAT IS A FAMILY OFFICE?

Family offices are entities established by wealthy families to manage their money and provide related services to family members, such as tax and estate planning, as well as managing philanthropic ventures. Globally, family offices managed nearly $6 trillion in assets as of 2019, according to market research firm Campden Research.

ARE THEY REGULATED?

Single family offices generally are not regulated. Most family offices historically did not have to register with the U.S. Securities and Exchange Commission (SEC) because the 1940 Investment Advisers Act exempted firms that advised 15 or fewer clients.

The 2010 Dodd-Frank Act passed in the wake of the 2007-2009 financial crisis repealed that exemption to ensure hedge funds and other private fund advisers that may have fewer than 15 clients had to register with the agency. But the act in turn created a new exemption for certain family offices.

As a result, any company that provides investment advice about securities to family members and is wholly owned and exclusively controlled by family members or entities is exempted from the Advisers Act, according to the SEC.

On Wednesday, the SEC confirmed that Archegos was exempt from registration as an investment adviser. That meant Hwang's aggregate positions - and in turn his full risk exposure - were not visible to regulators or to the individual banks that were trading with him.

WHAT TRADES DID HWANG USE?

According to the SEC, Archegos generally pursued "a long/short" equity strategy, taking long exposures in single stocks, and hedging those through short exposures via exchange-traded funds other customized baskets of stocks, and in some cases limited short exposures to individual stocks.

"Its long positions tended to be both highly leveraged and highly concentrated," the SEC said, noting that his leverage at some points reached 1000%.

However, the "vast majority" of Hwang's exposure was via a type of equity derivative written by his bank counterparties, in which they bought the underlying shares but promised Hwang a yield based on those shares' performance.

Those derivatives gave Hwang exposure to individual stocks without owning them, allowing him to circumvent an SEC rule that requires individuals who buy 5% or more of a company's stock to publicly report the holding. To date, holders of those types of security-based "swaps" did not have to report them.

The SEC said Hwang's use of the swaps was "a deliberate strategy ... to limit the visibility of market participants and Counterparties into the extent of Archegos's aggregate holdings."

The SEC is working to fix that regulatory loophole.