The U.S. Securities and Exchange Commission was supposed to be able to spot a whale like Bill Hwang by now. As the financial world knows, it didn’t. Will the agency be able to catch the next one?

The collapse of Hwang’s Archegos Capital Management represents one of the most spectacular failures of risk-management and oversight in recent memory. For the SEC, it caps a decade of foot-dragging on protections that were meant to avert, or at least minimize, just such a blowup.

Archegos highlights a pair of regulatory blind spots that Washington has long neglected: The firm’s heavy use of swaps to place undisclosed bets and its status as a private family office. With the pending arrival of new SEC chief Gary Gensler, the debacle adds to the already formidable challenges the agency faces.

The SEC’s issues with swaps date back to the aftermath of the 2008 crisis when Congress passed the Dodd-Frank Act. The law directed it to set up databases that would track complex derivatives transactions in real time -- meaning the regulator could have had details on Hwang’s huge bets at its fingertips. Eleven years later, the agency hasn’t completed the task.

“The SEC has never activated the Dodd-Frank security-based swap safeguards,” said Elise Bean, who as a top aide to Senator Carl Levin investigated JPMorgan Chase & Co.’s London Whale scandal. “If a hedge fund, family office, or big trading outfit exceeds the security-based swap reporting thresholds the SEC says ought to apply, the SEC won’t know it.”

The SEC’s lack of insight into Hwang’s trading was compounded by a decision it made in 2011 on family offices. Congress required them to be exempt from new rules imposed on hedge funds, but left it up to the agency to define what constitutes a family office.

After intense lobbying by wealthy investors, the regulator settled on a label that effectively insulates firms that manage the assets of a few rich clients from SEC inspections. That means the booming industry -- at least half of the estimated 10,000 family offices were formed in the past two decades -- is dodging routine oversight.

An SEC spokeswoman declined to comment.

Lawmaker Scrutiny

The agency is sure to come under scrutiny as lawmakers and the Biden administration review the Archegos blowup. While the implosion didn’t undermine financial stability, the billions of dollars in losses announced by Credit Suisse Group AG and Nomura Holdings Inc. show the dangers of lightly regulated investment firms making huge wagers with loads of borrowed money. The episode also raises fresh questions about a post-crisis regulatory framework set up by the Federal Reserve and other global watchdogs that was designed to keep a much tighter leash on banks’ risk-taking.

This week, the SEC dispatched two top officials to brief congressional aides on the latest developments. The regulators were grilled about the agency’s ability to monitor Hwang’s swap positions and its oversight of family offices, according to notes of the meeting reviewed by Bloomberg News. The SEC officials conceded the regulator knows little about family offices’ trading activity, the notes show.

Swaps, which played a major role in igniting the 2008 turmoil, were traded privately over the phone by banks and unregulated until Dodd-Frank. The Commodity Futures Trading Commission got most of the new policing duties, but the SEC took on contracts tied to less than 10 securities. Those “security-based swaps” are among the products that Archegos traded.

By 2019, the SEC finally completed the entire package of rules, including those on the surveillance database, so it could begin monitoring swaps. But industry doesn’t have to comply with key requirements until this November.

Several government officials privately said the agency’s lack of information has posed challenges in reviewing New York-based Archegos. The firm entered into contracts on individual stocks with a number of banks that were likely ignorant to the full extent of risk that was building up. In theory, the SEC could have seen a more complete picture if the surveillance databases were up and running.

Acting SEC Chairman Allison Herren Lee has pushed internally to make sure the agency meets the November deadline for being able to keep tabs on the market, a person familiar with the matter said. Still, much of the fallout from Archegos will land on Gensler, who’s scheduled to get a Senate confirmation vote this month. He implemented swaps rules for the CFTC when he ran the agency during the Obama administration -- a job that was mostly done when he left in January 2014.

Oversight Gaps

During the Dodd-Frank debate, Gensler opposed lawmakers’ decision to give the SEC a small portion of the swaps market, arguing unsuccessfully that oversight should be under one agency to prevent gaps that Wall Street could exploit, according to a former CFTC aide.

Current and former CFTC officials said they were surprised that the SEC punted for so long on swaps. The agency has had three leaders since it was first directed to set up an oversight regime – Democratic appointees Mary Schapiro and Mary Jo White and Jay Clayton, named by former President Donald Trump.

The rules “got the back-burner treatment,” said Tyler Gellasch, a former counsel at the agency.

Frustration over the slow progress reached a crescendo in September 2015 when three SEC commissioners -- Democrat Luis Aguilar and Republicans Dan Gallagher and Michael Piwowar -- issued statements blasting the inaction.

“We strongly believe that the commission must finish its work in this area, especially given that the CFTC completed its rules almost two years ago,” the Republicans said. “The lack of final rules has created a void that impacts Main Street as much as Wall Street.”

Powerful Tool

One of the delayed regulations was for “swaps data repositories” run by outside firms where banks and other swap dealers would report their transactions. The goal, described by Schapiro in 2010, was to give regulators a powerful new tool to spot market manipulation and systemic risks.

About five years later the SEC approved a final plan for how the massive data tombs would operate. But even then, nothing happened because the agency hadn’t finished separate rules that would determine which firms needed to report trades and how often. That process was finished under Clayton in 2019, though there are still no repositories where trades can be recorded.

The SEC’s effort on family offices was the opposite of the swaps rules: It was finished less than a year after Dodd-Frank passed.

A group called the Private Investor Coalition was formed in 2009 to advocate on the issue and it hired several top law firms to lobby the SEC. They pushed for a broad definition for family offices, arguing that the firms should be exempt from agency oversight because they don’t manage money for outside clients and had long policed themselves successfully.

In the end, the SEC put in place an exemption that wasn’t as gaping as some family offices had urged, but that still provided a runway for the industry’s explosive growth. Since Dodd-Frank’s approval, several hedge fund titans, including Stanley Druckenmiller and George Soros, have converted their firms to family offices.

‘Too Big’

The SEC believes it was following Congress’s intent when it wrote the rule, according to a person familiar with the agency’s thinking. The watchdog’s focus is protecting smaller investors, not rich people who handle their own investments, people who worked on the regulation noted.

Dan Berkovitz, a Democratic CFTC commissioner, said Archegos has given regulators clear evidence that they should revisit the family office definition.

“The no-investor, no-harm rationale for exemptions doesn’t work anymore,” he said in an interview. “It’s just too big for that.”