Warren Buffett warned about the financial instruments that triggered the Archegos implosion 18 years ago

REUTERS/Rick Wilking/File Photo

• Archegos' use of financial derivatives helped it to increase its leverage that triggered a $20 billion liquidation and rattled financial markets.
• 18 years ago, Warren Buffett warned that derivatives are "financial weapons of mass destruction."
• In a 2002 Berkshire report, Buffett said derivatives were expanding "unchecked" and governments had no way to control or monitor the extreme risks posed by them.
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The derivatives instruments that triggered the Archegos Capital Management implosion have faced scrutiny for years from regulators and some of Wall Street's biggest investors, including Warren Buffett.

In the Berkshire Hathaway 2002 Annual Report, Buffett called derivatives "financial weapons of mass destruction carrying dangers that, while now latent, are potentially lethal."

Archegos Capital Management's investments were partially concentrated in derivatives called a total return swaps. The highly leveraged trading strategy also had a role in the fallout of Long-Term Capital Management (LTCM), a hedge-fundthat failed in 1998 and ultimately required a bailout from a consortium of Wall Street banks in order to prevent a widespread financial-market collapse.

In the letter, Buffett describes how LTCM used total-return swaps and how the instruments are contracts that can facilitate 100% leverage in various markets, including stocks.

In a total-return swap, one party, usually a bank, puts up all the money for the purchase of a stock and another party, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes, Buffett explained.

"Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions," the investor said.

He described how highly experienced investors and analysts can encounter major problems analyzing the financial conditions of firms that are heavily involved with derivatives contracts, including total-return swaps. He said that when he and Berkshire vice chairman Charlie Munger read through the footnotes detailing the derivatives activities of major banks, the only thing they understood was that they didn't understand how much risk the institution was running.

"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear," the legendary investor said.

He warned that the derivatives businesses were expanding "unchecked," and central banks and governments have found no effective way to control, or even monitor the risks posed by these contracts.

Almost 20 years later, Bill Hwang's use of derivatives like total return swaps helped enable him to increase his leverage and ultimately triggered a $20 billion of his family office. The trades rattled stocks last Friday, with ViacomCBS and Discovery facing their largest daily declines on record. And while some banks like Goldman Sachs and Wells Fargo managed to escape potential losses by quickly liquidating their exposure to Archegos, others like Nomura and Credit Suisse are facing billions in potential losses from the trades.

Archegos Capital was trading on leverage using total return swaps and according to Forbes, the family office did not disclose their position and subsequent transactions, because current SEC law exempts family offices from disclosing these trades.

The SEC has now opened an investigation into Archegos, but the probe may not lead to any allegations of wrongdoing.

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