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Total Return Swap

Total Return Swaps are contracts brokered by big investment banks that allow a user to take on the profits and losses of an index or a basket of stocks or other assets in exchange for a fee.

Swaps allow investors to take huge positions while posting limited funds upfront, in essence, borrowing from the bank, also called the financing leg in a TRS:

This total return swap provided non-fully funded investors the ability to finance required equity exposures while at the same time increasing these positions through leverage. In an equity TRS, the derivative contract exchanges the cashflows of the total return index with a benchmark interest rate (EURIBOR, LIBOR, etc) plus a spread to compensate the seller of the TRS for funding the purchase of the equity index.

That’s exactly what Archegos was doing with prestigious banks such as Credit Suisse, Morgan Stanley, or Nomura.

The firm’s positions were either in big, concentrated positions in companies’ shares or held in total return swaps. Using total return swaps instead of simply buying shares of companies provided two main benefits for Archegos.

The use of these types of derivatives helped enable the firm to increase its leverage, in essence owning more of a stock or a basket of stocks than its cash would have otherwise allowed it to. In addition, these total return swaps allow investors like Mr. Hwang, the owner of Archegos to maintain their anonymity while owning huge derivatives positions.

The types of swaps used by Archegos and hundreds of other firms are among the most controversial products in investment banking. Proponents say these types of derivatives contracts increase market access and improve liquidity. Critics have said they increase leverage past the point of acceptable, adding risks to other investors in the whole market. Archegos had assets of around $10 billion but held positions worth more than $50 billion at the beginning of the year.

 

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