Macaskill on Markets: Who needs margins? Synthetic equity lending pumps up risk
Jon Macaskill
A dramatic but little appreciated rise in the volume of equity total return swaps is being accompanied by an erosion in the margins charged by bank prime finance desks to clients such as hedge funds.
The addition of hidden leverage via swaps comes as equity derivatives are turbocharging bank trading profits and generating fierce competition for the title of number one in equities revenue between the top three firms: Goldman Sachs, JP Morgan and Morgan Stanley.
The stealthy supply of leverage via synthetic stock lending could increase the risk to dealers in a major market downturn, according to an upcoming report from Jonathan Wallen, assistant professor at Harvard Business School, and Lina Lu of the Federal Reserve Bank of Boston.
“The dealer banks do a lot of secured lending and our particular concern is the growth of their activities in the equity market, because equities are poor collateral but it is very profitable to provide funding for equity lending. Total return swaps are a huge and growing market and the haircuts there are very tight – sub 5%,” Wallen said in an interview.
This effective leverage of more than 20 times contrasts with traditional secured lending against stocks via prime brokers, where margins are often between 15% and 25%.
Wallen and Lu late last year published a detailed review of the activity of trading desks at the five biggest US dealers. They found that Bank of America, Citigroup, Goldman Sachs, JP Morgan and Morgan Stanley in aggregate generated large profits with limited market risk in their study period between 2014 and 2023.
The profitability of equity businesses, such as prime finance and derivatives trading, was a surprise to the authors. This prompted work on a follow-up report using Federal Reserve and Bank of England data that will be published in a month or so.
“The large US dealer banks are synthetically lending against about US$2trn of equity collateral and synthetically borrowing against US$1.7trn of equity collateral (as of June 2025). We are more worried about the lending side because of negative tail risk in the equity market,” Wallen said.
“During the Covid crisis, the large US dealer banks collected about US$300bn of variation margin from counterparties over the course of three weeks and this was more than posted initial margin. Since then, synthetic lending through derivatives in the equity market has more than doubled.
“I worry that the recent historical data on which VAR [value at risk] and margin requirements are based do not have equity market returns like those in the 2000 dotcom bust. For a sufficiently large negative equity market shock, dealer banks may be exposed due to counterparties unable to meet variation margin calls and insufficient initial margins.”
This time it's different?
Bankers highlight recent improvements in derivatives technology and caution against a focus on absolute margin levels that vary with credit judgments.
There is no question that the increasing dominance of fund giants such as Balyasny, Citadel, Millennium and Point72 is exerting downward pressure on synthetic equity margins, however.
“Large hedge funds have concentrated massively, so of course they will negotiate down the margin that they are paying every day, but there is real-time cross-margining now and collateral can be moved intraday when it used to be T+2,” said one equity derivatives veteran.
“The hedge funds are quite diversified with a lot of different pods, so the risks look good on the surface. And more important is the technology, as the market for collateral has evolved so much.”
The pod-shop approach to hedge fund risk management may well help to manage exposure in the next downturn, though with big funds accounting for more than 30% of US equity trading there is an obvious threat to overall liquidity from any position cutting.
The race for number one
A more paradoxical risk may come from hubris created by the success of equity trading businesses at the biggest US banks and their fierce competition for bragging rights. Goldman reported a record US$16.5bn of equities revenue for 2025 and took the number one slot among dealers, citing prime finance and derivatives for its outperformance.
That didn’t sit well with Morgan Stanley chief executive Ted Pick, whose elevation to the top job in 2024 was in part due to his success establishing a global lead in equities revenue for a number of years.
Pick seemed to be trying to manifest a return to the equities gold medal podium during Morgan Stanley’s earnings call in January. Coming a close second to Goldman with its own record US$15.6bn of 2025 equities revenue clearly wasn’t a disaster for the bank.
But Pick promised better days ahead. He hailed progress in derivatives, which he admitted had been a relative weakness for Morgan Stanley. “A lot of that has now been erased, so we actually are coming across now as a derivatives house as well for clients,” Pick said on the call.
Archegos anniversary
This month marks the fifth anniversary of the collapse of Archegos Capital Management. The failure of the fund cost the bank counterparties to its equity total return swaps around US$10bn and led to the forced sale of Credit Suisse to UBS.
Credit Suisse had cut its swap margins for Archegos from 15%–25% to 7.5% before the collapse, according to a legal review, though the bank’s eventual US$5.5bn loss was also due to spectacularly sloppy risk management as the fund headed towards implosion.
Goldman, and to a lesser extent Morgan Stanley, dodged the worst of that disaster with adroit selling, but a broader future market slump could test total return swap exposure for even the biggest equities dealers.
