There are plenty of unanswered questions following the recent meltdown of family office Archegos Capital Management—and plenty of compliance lessons to be learned.

Archegos is a hedge fund operated by billionaire Bill Hwang that reportedly lost $8 billion in less than two weeks in March. The firm had taken highly leveraged positions in several blue-chip stocks, including ViacomCBS. When ViacomCBS lost nearly half its value, Archegos’s risky bets backfired. The massive stock sell-off that followed caused billions in losses for some of Archegos’s largest lenders, most prominently Credit Suisse, which reported it lost $4.7 billion. In the aftermath, the bank launched an investigation and fired its chief risk and compliance officer.

Todd Cipperman, managing partner of Cipperman Compliance Services and former general counsel for a mutual fund firm, said banking regulators are sure to scrutinize what happened at Archegos.

“I think they’ll be asking, ‘Why was he able to get so much money?’” Cipperman said of Hwang.

The head of the Senate Banking Committee, Sen. Sherrod Brown (D-Ohio), released a letter Thursday in which he posed a series of questions to Credit Suisse regarding its role in the Archegos meltdown.

“I am troubled, but not surprised, by the news reports that Archegos entered into risky derivatives transactions facilitated by major investment banks, resulting in panicked selling of stocks worth tens of billions of dollars and those banks collectively losing nearly $10 billion,” wrote Brown.

“To protect the integrity of the commodity markets, the [CFTC] must be aware of and able to monitor the activities of large family offices. In order to do this the Commission should have basic information about family offices that are operating commodity pools. The qualifications of persons operating family offices should be no less than for persons operating other exempt and non-exempt pools.”

CFTC Commissioner Dan Berkovitz

Brown asked Credit Suisse about its know your customer (KYC) processes and how those were applied to Archegos and Hwang; about the bank’s evaluation of family offices for services, particularly for extension of credit; and about “how collateral, including initial margin and variation margin, is maintained for transactions with those clients.”

He inquired about how the bank’s family office clients are onboarded and how often periodic reviews of family offices are undertaken.

And he pressed Credit Suisse to explain its role in Archegos’s margin call on ViacomCBS stock, as well as its “participation in, or consideration of, any coordination with other banks to sell, or to refrain from selling, stocks related to Archegos transactions.”

Federal banking regulators are likely to be asking similar questions as the dust settles.

Regulatory change coming?

As a so-called “family office,” Archegos is exempt from reporting requirements from both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The exemption was carved out with the idea that wealthy families, managing their own money, did not present a risk to retail investors.

But billionaires like Hwang have used this exemption to inject huge amounts of money—and risk—into the markets without regulators knowing anything about it. Relationships between these family offices and large banks are also less transparent as a result. Even the banks lending money to Archegos and Hwang would have had little insight into his relationships with other lenders or the extent of his positions in particular stocks.

According to the Wall Street Journal, Hwang managed about $10 billion of his own money through Archegos but was leveraged for as much as $30 billion, which he borrowed from several large banks. Archegos took big, concentrated positions in companies in total return swaps, which allowed him to take huge positions while posting limited funds upfront, the newspaper reported.

Both the SEC and CFTC have begun exploring whether to revisit the family office exemption. The SEC has reportedly launched a preliminary investigation into the Archegos matter, while CFTC Commissioner Dan Berkovitz called for family offices to be regulated by the agency.

Berkovitz said under the Trump administration, the CFTC loosened notice requirements for family offices and also exempted those working for family offices from disclosing previous disqualifications.

“To protect the integrity of the commodity markets, the Commission must be aware of and able to monitor the activities of large family offices,” he wrote in a statement April 1. “In order to do this the Commission should have basic information about family offices that are operating commodity pools. The qualifications of persons operating family offices should be no less than for persons operating other exempt and non-exempt pools.”

Compliance takeaways

Boris Liberman, partner with Lowenstein Sandler’s Investment Management practice, said the first thing compliance officers should do in reaction to the Archegos fallout is ensure they know what’s in their firm’s trading documents—”not guess, not approximately know,” he said. It’s vitally important for buy-side entities to know exactly what they have in their trading agreements with dealers, as well as what rights the dealers have with respect to their assets when things go wrong.

Liberman says firms can’t rely on relationships and hope things will be solved when serious problems arise. The documents will rule.

It would also be wise to consider updating those documents. In some cases, relationships between investment firms and broker-dealers that are years old are still supported by outdated paperwork.

“Sometimes, as the relationship you have with the dealer changes, but the legal trading agreements have not caught up to that,” he said. “It’s always an evolving relationship, and you need to be mindful that the documents need to change as the relationship changes. You may start trading instruments with different liquidity profile or different markets, so that even if your old agreements may technically support such activity, you will need to revisit to negotiate new terms.”

Another way to manage risk is with a diversified set of dealer counterparties. It is important to understand how dealers’ sensitivities change with respect to trading instruments and trading activity and how global regulations impact them, he said. Such understanding will help to better diversify your dealer roster across asset classes.

Understanding documents and diversifying dealers “will go a long way to better understanding the risks and consequences that could arise from a particular type of trading,” Liberman said.

Cipperman says the fallout from Archegos may very well mean registered hedge funds can expect to receive more scrutiny about their credit practices during examinations by the SEC.

“This is going to be a real challenge for registered hedge funds,” he said. “It’s a classic case of unintended consequences. Credit has gotten tighter, and it’s likely to get even more tight. Is that a good reason to restrict credit for the rest of the hedge fund industry? You’d be penalizing the good guys who are doing the right thing.”

Cipperman also advised compliance officers at a firm using derivatives to “take a good look at your risk. It’s an issue, so get on it.”