FINRA Proposes Stringent Rules for Hedge Funds’ Favorite Tool – Swaps
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FINRA Proposes Stringent Rules for Hedge Funds’ Favorite Tool – Swaps

Recent trading activity has landed some banks in hot water. Now, FINRA is trying to take action - but will they?
Neither the author, Tim Fries, nor this website, The Tokenist, provide financial advice. Please consult our website policy prior to making financial decisions.

In the arms race between traders and regulators, monumental slippage in the form of Hwang’s devastating total return swaps shines light on existing vulnerabilities. FINRA has set its sights on fixing it.

The Benefits of Financial Anomalies

In a world of decentralized finance defined by smart contracts running on a blockchain, the weak points come from poor coding that’s “hotfixed”. The same holds true for hierarchical, centralized finance. However, the latter system is much slower to release remedial ‘patches’.

Sometimes, the opaqueness that leads to vulnerabilities is a feature, not a bug. Only when publicly exposed and embarrassed do regulators and legislators attend to patch things up. The GameStop short squeeze was one such event, resulting in a series of congressional hearings addressing:

  • The illegal (yet ongoing) issue of naked short selling that tends to generate failed-to-deliver (FTD) stocks.
  • Payment for order flow (PFOF) as an inherently conflicted relationship between brokerages and market makers—which is why it is banned in the UK and Canada.

While GME/AMC achieved global notoriety status, another event managed to overshadow it in terms of losses suffered. After the CEO of Archegos Capital and previously convicted trader, Bill Hwang, leveraged billions on Chinese tech stock at a high entry point, he did not only wipe out his own wealth but that of the world’s largest banks. They are still recovering from a massive $50 billion credit exposure.  

Outside of the mere foolishness of those bets, Hwang exposed a financial mechanism not widely known—total return swaps. In other words, instead of Hwang going the usual route—borrowing to buy stocks for his account—he made his prime brokers buy the stock shares first, then bought them himself through a swap.

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Total Return Swaps Explained

As its name implies, this financial vehicle is a contract with the banks making the trader take both losses and profits from a trade. In return, banks receive a fee. In the case of Bill Hwang’s bets on Chinese tech stocks, he effectively borrowed from the banks to make such huge positions without shoring them up with cash.

Hedge fund managers like Bill Hwang are fans of total return swaps (TRS) because they receive massive financial exposure (funds invested in a contract) without owning them legally. Instead, the banks hold the ownership. Moreover, because TRS are derivatives, they gain value from an underlying asset, which makes them a security-based swap if used for a single security contract:

“Total Return Swaps: Under the proposed interpretive guidance, a Total Return Swap, or TRS, on a single security, loan, or narrow-based security index generally would be a security-based swap. Where counterparties embed interest-rate optionality or a non-securities component into the TRS (e.g., the price of oil, a currency hedge), it would be a mixed swap.”

This leads us to the patching up aspect. FINRA, the government-authorized agency in charge of protecting investors, had filed a draft at the end of last month, to be reviewed by the Securities and Exchange Commission (SEC).

FINRA In Charge of Hotfixing Hwang’s Exploit

Consisting of 276 pages, the FINRA draft proposes a number of tweaks to the current process related to security-based swaps (SBS). Standing from the crowd is one on page 167, requiring contractual members to keep a precise record of the fronted cash for the securities borrowed—which is called the Initial Margin Requirement:

“Proposed FINRA Rule 4240(b)(2), entitled “Initial Margin Computation,” would require that, as of the close of business on each business day, the member compute the Initial Margin Requirement for each Uncleared SBS Account equal to the sum of the Initial Margin Requirements on the Uncleared SBS and securities positions in that Uncleared SBS Account.”

In effect, this and other tweaks would serve as warning bells to regulatory bodies if someone were to engage in Hwang-like massive swaps.

“FINRA believes that differentiation as to initial margin requirements among these different types of SBS is appropriate and necessary given the unique characteristics and risks posed by different SBS products.”

Interestingly, the notion that SBS pose “unique characteristics and risks” is not news for the SEC. Two years ago, the SEC proposed rules to mitigate such risk, which had failed to catch Hwang in their net.

Hedge fund managers are increasing their crypto exposure by the day. They certainly didn’t miss the recent Bitcoin dip opportunity. Do you think crypto swaps are next on the menu? Let us know in the comments below.

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