Last year’s collapse of the Archegos investment firm came largely without warning; however, a post-mortem of the event finds there were signs of the buildup of risk in regulatory reporting data.

The European Securities and Markets Authority (ESMA) published a study examining the failure of U.S.-based Archegos Capital Management LP in March 2021, which caused more than US$10-billion in losses to its various counterparty banks, and has resulted in fraud charges against the firm and several executives from the U.S. Securities and Exchange Commission (SEC). The allegations have not been proven.

The firm collapsed when stock prices moved against its large, leveraged and highly concentrated trading positions, which were built through total return swaps.

“When the price of the underlying stocks started to decline, the firm was unable to meet variation margins, resulting in the liquidation of the stocks by the counterparty banks,” the paper noted.

In its report, ESMA finds that the risks at Archegos were allowed to accumulate largely undetected, given the firm’s status as a family office, which exempted it from the regulatory reporting requirements imposed on regulated investment fund advisers in the U.S. — and its use of derivatives, which are less transparent to both regulators and other market players, to build its positions.

“Overall, Archegos operations were largely invisible to regulators and market participants,” the report said.

The lack of transparency to its trading partners meant that the firm’s large, concentrated trading exposures weren’t subject to adequate margin requirements — exacerbating the losses faced by its counterparty banks.

At the same time, regulators were largely in the dark too, given the lack of oversight into the firm’s operations.

“While Archegos was legally a family office, it implemented hedge fund–like strategies without being subject to regulatory and reporting requirements at entity level that apply to hedge funds,” the paper said. “Without relevant reporting requirements, regulators did not have the ability to identify risks related to Archegos, including high leverage and concentrated exposures.”

However, the review found that the buildup of the firm’s exposures can be seen in data that must be reported under European rules, known as the European Market Infrastructure Regulation (EMIR) — which require all entities, including family offices, to provide transaction-level reporting of derivatives positions.

Using that data retrospectively, the regulators found they were able to “track the evolution of Archegos’ positions in individual stocks,” and that they could also analyze the mark-to-market value of the portfolio of swaps held by Archegos.

“The data show clearly that Archegos had a highly concentrated portfolio and that any negative change in the price of the underlying stocks could trigger large mark-to-market losses and substantial variation margins,” the research found.

Ultimately, the report concluded that more work is needed to ensure that the risks related to derivatives exposures and leverage are being adequately monitored.

In particular, it said a framework to synthesize different sources of regulatory reporting would provide regulators with better oversight of those risks.

For ESMA, this could include using data collected under the existing EMIR and various other rules “to monitor leverage and concentration risk arising in derivatives markets, and could foster the development of early warning indicators by supervisory authorities to track different types of risk,” it suggested.