macrocephalopod

We’re going to hear a lot about equity total return swaps over the next couple of days but let me take a second to point out how extremely normal they are and how unsurprising it should be to find out that Archegos was using them.

Some people have a mental model for leveraged longs which is like, you negotiate with your broker to lend you cash, when the cash hits your account you go out an buy stocks with it so you now have eg a 3x long stock position and a -2x loan.

If you are more sophisticated you may imagine this happens in a margin account where the whole thing is streamlined and the loan settlement and stock purchase happen at the same time, but it’s still basically a long stock position plus a loan.

For institutions, most of the time it doesn’t work like this. You will just have a total return swap on the stock, where the bank pays you dividends + price appreciation on one leg and you pay financing + swap fee on the other leg.

Same thing happens with shorts — you won’t actually borrow the stock yourself and go out and sell it, you’ll have a TRS where you pay divs and price appreciation on one leg, and on the other leg you receive the risk free rate and pay borrow cost + swap fee.

All the same constraints apply (eg you can’t short a stock of there’s no borrow) it’s just that all the mechanics happens on the dealer side which is much more straightforward for you, the hedge fund.

The controversial things about Archegos seem to be (a) they may have been deliberately using TRS to avoid disclosure and (b) they were extremely levered (5-6x) and the short side was like ES or NQ futures which were not a particularly good hedge for their long book.