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A Credit Suisse sign hangs outside of its Manhattan offices on March 29, 2021, in New York City. The investment bank, which had reportedly lent money to Archegos Capital Management, now faces billions of dollars in losses after the hedge fund's collapse.Spencer Platt/Getty Images

The worst has been avoided, with Archegos Capital Management’s collapse failing to send markets into a tailspin, but a record level of debt continues to fuel daily trading activity – which means the fund’s implosion won’t be the last.

Archegos, which managed US$10-billion of client money, collapsed last week after getting hit with margin calls, which are requests from its lenders to repay the money borrowed to fund trading positions. Investment banks Nomura and Credit Suisse , which had reportedly lent money to the hedge fund, now face billions of dollars in losses.

It is the second major disruption fuelled by margin trading in as many months. In February, retail trading platform Robinhood was forced to raise US$3.4-billion in emergency capital after its clients borrowed excessive amounts of money to trade volatile stocks such as GameStop .

BMO exposure ‘immaterial’ in Archegos case: Bank

When Robinhood’s clearing house – which supports its loans – asked the company to put up extra capital as a cushion against potential losses, the firm couldn’t at first, and chaos nearly ensued.

Both scenarios were resolved without a broader fallout, but a record US$814-billion has been borrowed to fund trading positions, according to the Financial Industry Regulatory Authority in the United States. All that debt makes financial markets highly susceptible to sharp corrections.

Much like Archegos, which was founded by money manager Bill Hwang, many hedge funds try to juice their returns by borrowing money to invest. When the bets pay off, the gains can be prolific. When they don’t, they can backfire quickly, forcing panic selling. If the fund is big enough, the sales can send the broader market spiralling amid a vacuum of misinformation.

“Leverage has created a large number of fortunes,” said George Ball, chief executive officer of Houston-based Sanders Morris Harris, a money manager. “Leverage has also created almost an equivalent number of economic debacles.”

Mr. Ball has called on the Federal Reserve, which oversees financial regulation in the U.S., to protect against systemic shocks by raising the minimum cash requirements for margin trades. As it stands, individual investors are technically limited to a 50-per-cent margin position on a trade, but institutional investors have much more leeway. Archegos was trading on a debt-to-cash ratio of 8 to 1, according to reports.

At these levels, the margin for error is so slim that veteran investors can quickly find themselves in trouble.

Coming out of the 2008 global financial crisis, the U.S. made it a priority to tackle “shadow banking,” which includes margin lending, and set up a task force comprised of all its market regulators, known as the Financial Stability Oversight Council, to address the issue.

In early 2016, the FSOC specifically warned about growing levels of debt being employed by hedge funds. “Forced sales by hedge funds could cause a sharp change in asset prices, leading to further selling, substantial losses, or funding problems for other firms with similar holdings,” the council warned. The 1998 failure of Long-Term Capital Management, then the world’s largest hedge fund, is proof.

But at the time, the FSOC said there wasn’t enough detailed information on hedge-fund positions to adequately assess the risk, because some of their trades can be hidden using techniques such as total return swaps. Through these arrangements, a fund will get the economic exposure to a portfolio of stocks, but doesn’t actually own the individual shares. Archegos is reported to have used these positions extensively.

However, the FSOC’s efforts were ultimately abandoned after Donald Trump was elected president in late 2016. Meanwhile, the use of margin in financial markets has only increased since, in part because underlying interest rates are so low that traders can borrow cheaply.

Archegos’s implosion may prompt investment banks and prime brokerages to reassess their willingness to lend all on their own, but there are calls for the market institutions, including the Fed, to reset the ground rules for the entire market.

“The Fed has two highly complementary functions,” said Gregg Gelzinis, associate director of economic policy at the Center for American Progress, referring to its control over monetary policy and financial regulation. “While it’s definitely good from a labour market standpoint to have low interest rates … that just puts more pressure on their financial regulation.”

As it stands, though, central banks have largely focused on unemployment, accepting higher leverage as a necessary consequence. Now is the time to rethink that, he argued. “It’s important for financial regulators to lean against the wind,” Mr. Gelzinis said.

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