From Archegos to perpetuals
In March of this year, family fund Archegos Capital Management collapsed suddenly and spectacularly. Following not-too-extreme moves in stock prices, the fund's prime brokers sold shares in a hurry, sustaining some losses of some 10 billion dollars. Credit Suisse and Nomura each recorded losses in excess of two billion dollars.
Archegos had entered its positions using cash-settled derivatives: total return swaps and contracts for difference. The fallout from the fund's collapse continues to prompt reflection on systemic risks in the markets for such derivatives.
One connection that has gone unremarked, however, is the prevalence of cash-settled derivatives in crypto markets, in particular perpetual swaps, which have attracted billions of dollars in open interest. Regulators are beginning to take note. There are some connections to be made between the two.
Archegos entered large speculative positions in equities using two cash-settled instruments, total return swaps and contracts for difference. Both instruments create cash flows corresponding to a hypothetical trade, which does not actually take place. A total return swap, for example, is based on a notional exchange of shares for money. Archegos would pay interest to its broker, and receive or make payments corresponding to the shares' price movements. Crucially, although the swap is based on the idea of exchanging shares, all of the flows are settled using only cash.
These T accounts illustrate. Above the line, the notional exchange of money for shares: Archegos enters a long equity, short money position. Its broker does the opposite. This is recorded as a single instrument, the total return swap. This I show as an asset to Archegos, because it is analogous to owning the shares themselves.
But unlike owning shares outright, the long side in a total return swap is responsible for making cash payments when the price of the shares falls. In its failure, Archegos provided an effective demonstration of this: a modest drop in share prices triggered a payment that the fund was quite unable to make. Its brokers in turn liquidated positions in the underlying shares at a loss.
In a different guise, something similar is being implemented using crypto assets in decentralized finance or DeFi markets.
The prototypical instrument is the perpetual swap contract or "perpetual" or even, apparently unironically, just plain "perp." Like the total return swaps used by Archegos, perpetuals are based on a notional exchange of assets for money—crypto for stablecoin in this case. One important difference is that they are traded on an exchange, which establishes prices and manages counterparty risk.
In a perpetual swap, long and short traders enter into positions by transacting with an exchange. The position of the longs is analogous to having bought an asset in exchange for money, and the position of the shorts is analogous to having sold an asset in exchange for money. The exchange acts as an intermediary, facing both longs and shorts, who have no direct exposure to one another.
The exchange's positions net out, its shorts offsetting its longs. But the exchange is left holding the bag if one of its counterparties defaults. This credit risk is managed through margin balances, which traders must hold on deposit, and an insurance fund, which can absorb shortfalls if margin balances are exhausted. These T accounts describe the arrangement:
No funds change hands at the time that the perpetual contract is established. Instead, funds flow between longs and the exchange, and between the exchange and shorts, on a fixed schedule according to the subsequent movement of prices. If the price rises, shorts pay the exchange, which in turn pays longs. If the price falls, longs pay the exchange, which pays shorts. Just as in a total return swap, the flows are the ones that would settle up between the two parties if they had actually conducted the hypothetical exchange, the losing side compensating the winning side. In T accounts, the funding payments look like this:
These payments add to and subtract from traders' margin balances. If balances drop to zero, the exchange can close out customers' positions. Further losses can be paid out of the insurance fund.
Both total return swaps and perpetual swaps replicate the cash flows associated with an exchange, without requiring traders to make the exchange itself. One way to think about such derivatives, which might have appealed to Minsky, is that they remove one settlement constraint (delivery of the underlying instrument), replacing it with another (variation margin or funding payments).
Not having to deliver the underlying instrument economizes on cash, at least as long as price movements are small relative to the price of the asset. This feature can be put to multiple uses: it allowed Archegos to hold large positions against relatively small reserves. Having to actually purchase the shares would have been more costly. Crypto perpetuals on BitMEX or dYdX, similarly, allow big bets funded by small capital positions.
But periodic funding payments have proved to be a double-edged sword: though they can prevent large net positions from accumulating, they also create new short-term cash commitments. Archegos's demise showed the risk. It remains to be seen how crypto perpetuals will hold up.