US Securities and Exchange Commission chair Gary Gensler highlighted the role derivatives such as total return swaps have played in financial market blow-ups over the past three decades as he vowed to reduce risk further in these markets at the International Swaps and Derivatives Association’s annual general meeting last Wednesday.
Both Long-Term Capital Management and Archegos Capital Management (the notorious investment firms that collapsed in 1998 and 2021, respectively) used total return swaps, Gensler noted, as they leveraged market bets that ultimately brought about their demise. Insurer AIG, meanwhile, used another type of security-based swap – credit derivatives referencing sub-prime mortgages – that led to it needing a US$180bn government bailout in 2008.
Derivatives markets have undergone significant regulatory changes since the 2008 financial crisis, including mandatory central clearing of many products and increased trade reporting. But Gensler signalled further measures were needed “to shine [a] light on these markets before any future such tremors arise".
“On occasion, security-based swaps have moved from the corners of the market to front and centre,” Gensler said, adding that those experiences had helped inform how he thinks about these derivatives today.
“While we have adopted many reforms to the security-based swap market, we have work to do to further fulfil our obligations under [the] Dodd-Frank [Act] and update rules for this marketplace. Thus, we are embarking on yet another ‘new era'.”
Archegos, the family office run by former hedge fund manager Bill Hwang, used total return swaps to take large, concentrated bets on a handful of companies. Banks that allowed Hwang to use derivatives to leverage his positions suffered over US$10bn in losses when those bets soured. The US Department of Justice recently arrested Hwang and charged him and his chief financial officer with fraud.
Gensler said LTCM, which required a Federal Reserve-orchestrated bailout when it racked up massive losses in 1998, had over US$1trn of derivatives contracts, many of which were total return swaps. Today, the total return swap market is huge, Gensler said, with about US$500bn in volume across 70,000 daily trades occurring in the early days of April.
The SEC has already taking measures to bolster the integrity of security-based swaps markets, Gensler said, and the regulator is consulting on further proposals.
“I believe that we have the opportunity to reduce risk, increase transparency, and strengthen the integrity of the derivatives market,” he said.