In 2021, when an opaque family office with $36bn in assets at its peak collapsed, it sent much larger shockwaves through Wall Street than anyone had anticipated.
Archegos had secretly been able to build up a portfolio of outsized bets concentrated on a handful of companies. A complex set of leveraged derivatives and no reporting requirements meant that the fund, run by Bill Hwang, was able to hide the size of these positions from the broader market.
Even the prime brokers that lent Hwang money — so that the now convicted fraudster could execute the bets — were none the wiser. When it collapsed, fewer than 10 banks had racked up more than $50bn of credit exposure to Archegos.
The impact on the broader financial market is one example of the risks regulators and investors say is posed by “hidden leverage”. These are pockets of hard-to-detect debt which build up in lightly-regulated areas such as family offices — private wealth-management companies for rich individuals — and hedge funds for a variety of reasons.
“There are pockets of leverage that we don’t know exist, we don’t know how large they are. They’re hidden from us . . . and leverage, improperly managed, can amplify shocks,” says John Schindler, secretary-general of the Financial Stability Board.
If you’re highly levered and exposed to a particular asset “you might have to make margin for collateral, which means you might have to sell that asset, or you might have to sell some safe assets that you kept in reserve,” he says. “Either way, you could start dynamics that shift prices in a significant way.”
A number of financial institutions, such as family offices and hedge funds, have little to no reporting requirements. And even when they are required to report details of their holdings, the use of complex derivatives can make it difficult for an authority to measure leverage. “And there could be just fraudulent or lying forms of leverage,” Schindler adds.
The leverage we can see “is only the tip of the iceberg”, says the chief investment officer at one credit hedge fund.
The unravelling of these bets has exacerbated market downturns from the 2008 global financial crisis, stress in the UK gilt market following then prime minister Liz Truss’ ill-fated “mini” budget in 2022, and the commodity price turmoil following Russia’s full-scale invasion of Ukraine earlier that year.
Archegos used total return swaps agreed with banks to capture the volatility of a stock, winning or losing money if its price rose or fell, while the banks actually owned the shares. In effect, it was betting with borrowed money.
When the value of the shares it owned slumped, the firm had to conduct a fire sale as its lenders demanded it put up more cash to cover the falling value of collateral. Archegos defaulted on its margin calls, the banks unwound their position. The share prices of holdings, such as Chinese technology company Baidu, crashed.
But whether the build up of difficult to detect debt is now a systemic accident waiting to happen is a point of contention between regulators, public bodies and investors.
Although you have pockets of levered investments “here and there . . . the interconnectedness with the banking system is much more limited, and the leverage globally is lower [than it has been],” says Cécile Lévi, head of private debt at Tikehau Capital.
In response to a FSB consultation on leverage in “non-bank financial intermediation” BlackRock observed: “The insolvency of a single fund or margin calls faced by an individual market participant are not in themselves examples of systemic risk . . . unless the impact is severe for a critical institution or core market.”
But critics point to the rapid growth of the lightly regulated parts of the economy — such as hedge funds, family offices and private debt funds — which often conceal these pockets of debt as an area which could pose a systemic risk.
While insurance companies, pension and investment funds hold the majority of non-bank financial assets, “more than 90 per cent of on balance sheet financial leverage is in so-called other financial intermediaries . . . such as broker-dealers, hedge funds, finance companies, holding companies and securitisation vehicles”, the FSB says.
In 2024 the global hedge fund industry managed $4.5tn in total, with total assets increasing by $401.4bn on the previous year and up 56 per cent since 2015, according to data from the research company HFR.
Identifying one particular area of risk posed by hedge funds, the European Securities and Markets Authority published a report earlier this year, that found that a group of funds with just €12bn in assets were using 18 times leverage to place bets worth €210bn on markets.
Hedge funds’ positions in the US Treasury market had grown so large that the Bank of England placed the sector’s borrowing under greater regulatory scrutiny, labelling them a risk to financial stability.
However, the chief financial officer of a large European asset manager said that the increasing presence of these type of funds just means the leverage is “more dispersed”.
“When it was on a bank balance sheet, you could arguably see it more easily and measure it. But it didn’t make it safer to have it there.”
Family offices have also boomed in size and popularity, with Deloitte estimating that the more than 8,000 strong sector manages $3.1tn of assets globally. It expects the number of funds to rise to 11,000 by 2030, and the total assets under management to $5.4tn.
The Securities Industry and Financial Markets Association argues that even though the industry is growing, “a situation like Archegos is significantly less likely to occur today” because of the enhanced reporting requirements for uncleared swaps put in place in 2022 by the US Securities and Exchange Commission and Commodity Futures Trading Commission.
Similarly, the International Swaps and Derivatives Association argues that “such reporting would have allowed regulators to detect the build-up of risky positions.”
Private credit has also expanded rapidly to fill the space left by banks with assets of about $2.1tn, according to the IMF’s 2024 Global Financial Stability Report, which warned that the sector had “never experienced a severe economic downturn at its current size and scope” and that with “limited prudential oversight, the vulnerabilities of the private credit industry could become systemic.”
Regulators, however, are struggling to make their mind up about whether hidden leverage is an accident waiting to happen.
“Maybe everybody’s perfectly resilient to this, but I don’t know,” says the FSB’s Schindler. “Everybody’s trying to protect their investors’ money, their money. But maybe there’s a shock they haven’t conceived. Maybe there’s something they’re not testing for.”
