Discussing the Archegos Capital Fallout and PayPal's Cryptocurrency Move

In this episode of MarketFoolery, host Chris Hill is joined by Motley Fool Chief Investment Officer Andy Cross, who invokes a name from investing history: Long-Term Capital Management, as more details emerge about Archegos Capital's investments. Also, PayPal (PYPL 0.64%) enables crypto conversions for U.S. consumers and Facebook (META -0.52%) is working on an Instagram app for kids under 13. 

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This video was recorded on March 30, 2021.

Chris Hill: It's Tuesday, March 30. Welcome to MarketFoolery. I'm Chris Hill. With me today, the chief investment officer, Andy Cross. Good to see you.

Andy Cross: Hey, you, too, Chris. Thanks for having me on.

Hill: We've got news from PayPal. We have a project in the works over at Facebook, but I want to start again with Archegos Capital, because now we are starting to get more details in terms of how much leverage this family office was using. Some of these trades were levered up reportedly 20:1. Shares of Credit Suisse (CS) are down again today as its losses are piling up. I want to get to the banks in a minute, but when you look at this whole story and all of the different pieces, what stands out to you?

Cross: Well, Chris, it reminds me, in some ways, what happened with Long-Term Capital Management back in 1998 with the unwinding of that disaster, highly leveraged hedge fund run by exceptionally smart people. Apparently smart people, at least smart-on-paper people. That was far more leveraged than this one, the family office here at Archegos apparently levered somewhere in the 8-1 overall. But like you said, some trades up to 20-1, which means for every $100 in equity they had, they had $800 in investments, so banks were willing to basically lend them $700 to lever up their investments. Massive amounts of leverage and that has ripple effects as we're seeing clearly now. It reminds me a little bit of that, but it's different because this is a family office, which sounds so innocuous.

Hill: It sounds so quaint.

Cross: It just sounds like some small person or maybe a couple of people in an office managing some family money that's been around for a long time. Well, this is Bill Hwang, associated with Tiger Management before that, Julian Robertson's famed firm. He was one of the tiger cubs and had one of the most successful hedge funds investing agent companies, and then ended up having to pay a $44 million fee to regulators for insider trading allegations on Chinese stocks and was essentially just pretty much going out of the game. Then converted Tiger Asia into a family office called Archegos and got back into the game. Then obviously, paid a lot of fees to create the firm and these trades with these banks, including these total return swaps, which are highly leveraged investments. That basically allows the family office to pay large fees to the banks, and the banks essentially lend them money by owning those assets, and then will pay out the gains or losses on the future performance of whatever financial asset, like stocks, for example. They just were heavily leveraged against these bets and these bets started moving against them. All of a sudden, you start seeing the house of cards fall apart in a levered environment. 

Warren Buffett and Charlie Munger raved about this more than 10 years ago in their 2002 annual report. They talked about the risk of specifically total return swap investments. But derivatives in general and how you just don't know who's on the other side of the counterparty trade. The counterparties don't know who else is counterparties. Apparently, the Archegos family office had a lot of counterparties. A lot of these risks, a lot of these swaps associated with different banks. They didn't necessarily know, and then you just start to see this unwinding and these massive block trades in these stocks as the banks tried to raise capital to cover their losses and they couldn't get out of them fast enough. So Nomura and Credit Suisse are starting to see some of those losses pile up as you mentioned. It's just another evidence that we just don't learn anything in this business sometimes. [laughs] We've seen the unwinding of these derivative trades and the leverage in the system, very dangerous at times when things move against you in those firms, and we saw it with the short squeezes in GameStop in some way, and AMC Networks with the Reddit crowd, and now we're seeing it with so-called very experienced investors and very well-known and capitalized banks.

Hill: I will say that I do take a small amount of comfort in being reminded that, for anyone who says, "Wall Street is rigged against individual investors and they're all in it together." You look at this story with Archegos Capital, and you see these quotes from the different banks. One hand didn't know what the other was doing. Just the amount that professionals on Wall Street were completely in the dark about what was happening with this money actually makes me feel slightly better.

Cross: Yes, there's compliance questions that all of these banks from Morgan Stanley, Deutsche, Goldman all have arranged these big block trades. Had to get out of some of these stocks and obviously no more, and Credit Suisse, the ones that are probably on the biggest hook for some of these. Then of course, you have the regulatory compliance question, which is the disclosure for family offices, and that's a big question that the regulators are going to have to look at and start to wonder if they need to change those laws because that's clearly something that you don't really see show up from a disclosure perspective and an individual investor like us, maybe that would have impacted an investment in Discovery or Viacom. But just the dramatic change in share price and those two stocks over the last two weeks have been really dramatic and driven so much by what is happening, if not exclusively what is happening by these so-called experienced institutional banks and investors.

Hill: It's going to be really interesting to see where this story goes from here. Not necessarily with the cleaning up of this mess, but the aftermath. I am curious to see if there becomes a drumbeat for increased disclosures on a regular basis from these family offices. I'm also interested to see what side of this the big banks come down on because the fact of the matter is, there's somewhere between 5,000 and 10,000 family office funds around the world. They managed $6 trillion collectively. This is a market that's growing and there are a lot of fat fees to be had for the banking sector. There's no question that they're going to go after it.

Cross: Yeah, completely. A lot of hedge funds convert into family offices. Tiger Asia did, or they opened family offices because they don't want to deal with other investors. They made lots of money and they create these family offices, but they're still very large institutions designed to manage the money of these families and ostensibly, hopefully, for philanthropic good causes. You can see the danger is if you basically run your family office as a hedge fund, but you don't have disclosure requirements and you don't necessarily have the scrutiny that you might have, that hedge funds might have, or certainly other investment vehicles may have. 

To go to my opening statement though, Chris, [laughs] it seems like we don't learn a lot. Maybe some things will change, I hope they do. Disclosures need to be more transparent. At The Motley Fool, we've been talking about transparency pretty much for the past 25 years and opening up avenues, and insights, and information to more and more individual investors. When you see something like this and those stocks for those investors who may have owned Viacom, maybe you just bought it a month ago for whatever reason, or some of the other stocks that are impacted by this, Baidu, for example, a couple other ones. Then to see this happen and granted, it's short-term. But if there was more information, maybe it may have changed an investing decision. I think disclosure is always generally better to shine the light on that than not. I think something will hopefully change, but sometimes, we just don't learn our lessons.

Hill: PayPal is announcing the U.S. customers can use their cryptocurrency holdings to pay millions of online merchants globally, customers who hold Bitcoin and other cryptos in there. PayPal digital wallets will now be able to convert their holdings into Fiat currencies at checkout to make purchases. Is this a win for PayPal? It seems logical. I'm just wondering, if you're a PayPal shareholder how excited should you be about what this means for either PayPal growing its business or increasing its bottom line?

Cross: Well, I think if you're a PayPal shareholder, it's pretty nice. Certainly, if you're a PayPal account holder and they have, by last count almost 377 million accounts at the end of the year, so massive amounts of accounts. I think this is really, first of all, very interesting and I think it's actually a good thing for commerce in general. PayPal is a leader in the space, obviously. They're one of the early adopters of being able to invest in Bitcoin and other cryptocurrencies through your PayPal account. So I was very excited by that. I'm excited by this. I don't own Bitcoin, I don't own any cryptocurrencies, but just knowing that, again, I have that flexibility to do that, it will be very interesting to see how this impacts because PayPal is going to be handling the conversions back and forth. It's not like if you are one of the 29 merchants, you have to accept Bitcoin payments. PayPal will handle that on their end, so it'll be interesting to see how much transactions and trading goes on in that and converting back and forth and how that conversion works. But from the adoption of cryptocurrencies as an actual workable currency, not just a financial asset. We talked a lot about this during our Bitcoin day recently on Motley Fool Live. But focusing on increasing the likelihood that this will be more and more adopted as a way to transact, this is a very good piece of news for that perspective, and I think it's a good news for PayPal shareholders as well.

Hill: Do you expect others to fall? Part of this story is just PayPal size. In terms of validation, having a company the size of PayPal involved in something like this is certainly one more validator for Bitcoin and cryptocurrency.

Cross: I think it was like $15 billion in transactions went across PayPal's platform last year. So it's massive. I think it is. They were early into trying to serve individual clients overall from the very beginning, even when they are part of eBay. I think you will see others follow. I think this is the way that you see this adoption. You started to see the likes of Tesla, even though I don't really expect it to have a massive impact this year when they said they will start accepting payments in Bitcoin for Tesla's to some extent, and I think you see a leadership for someone like PayPal and their team and just the success they've had in how they offer their solutions. This is yet another example of what they're trying to do to meet their clients on their terms. I imagine you'll start to see other firms that deal in the payment space are going to think about different ways we can use the conversion of fiat currencies and cryptocurrencies and make them much more changeable to actually make them a real exchange of goods and to use in day-to-day transactions which is really what you want to see for a currency now. Whether ultimately cryptocurrencies go that way or they still stay much more in the asset class remains to be seen, but this is a step in that direction.

Hill: Facebook has confirmed it's working on developing an Instagram app for kids under the age of 13. This would, in theory, enable kids to keep up with family and friends in a safe and ad-free environment. Andy, part of me looks at this story and thinks, I don't have to worry about this [laughs] because my kids are beyond the age of 13. What's your blush reaction to this story?

Cross: Well, I'm on the flip side of that Chris, because both my kids, both my girls are younger than 13 and still have a couple of years until they even get to that point. Instagram has rules that you can't join unless you're over 13. They already are serving kids, in some ways, teenagers and so they have that part of the market, but this was something that I think felt was just an attractive demographic if it is done correctly. Of course, that's the big F, Chris. Because we know there's a lot of challenges with opening up this kind of social media to all people in general and certainly Instagram has faced criticism and concerns, as has Facebook, as has Twitter, just about cyberbullying. Some of that is creating an atmosphere of positivity and health. You certainly have to do that when you are talking about Instagram. Same thing with YouTube Kids and YouTube and that platform as well. If they can get this right, and they can do it in a very healthy, positive atmosphere. My kids love to take pictures with their phones or iPhones, doc up the photos, send them to friends. Right now just seems very innocent and active a way for them to be able to connect. If Facebook can do this with Instagram for the young kids in a way that is healthy and positive, I can see it as a good sign. 

Obviously, there's lots of connections, same thing with YouTube Kids when you encourage younger people to adopt your platform and use it and then you're more likely to continue to use it and migrate as you get older and use more. In this case, use Instagram, outside kids, or Alphabet's case use YouTube, the regular platform, not just YouTube Kids, and you're more likely to be involved in that platform. There will be criticisms that you're trying to addict kids earlier to social media into those platforms, and it's just a money grab by Facebook and I can understand those. It really depends on how they execute this, and obviously, it has to be 100% purely full-proof from any kinds of inappropriate behavior for it to work. That's a big question because it hasn't always worked out in lots of other cases even though Facebook has tried.

Hill: Yeah. I think we're all used to and I think we all understand. Let me use an example that has nothing to do with Facebook. Look at the iPhone. The very first iPhone, you couldn't even access the Internet with it. Then each new iteration of the iPhone gets better, more bells and whistles gets better and better. But there are kinks that need to be worked out along the way and it's understandable. I think you're absolutely right that this is something to the extent that something needs to be perfect right out-of-the-box. This is one of those things that if Facebook gets this right, there will be rewards further down the line by making what should be a first experience with social media a positive one. That pays dividends for Facebook if they get it right out-of-the-box. If this is 95% perfect, I don't know that cuts it. I see both versions of it. There's the version where everything works out and there's the version where it's like, it's almost perfect, but there's still enough problems that it leads to tabloid stories or the business version of tabloid stories.

Cross: Yeah. There's a single point of failure in there that they can't afford. We know Facebook's track record on this. Again, it's so massive and there's three billion global users. Instagram, itself, probably has more than a billion. Their record even from the very early philosophical days of moving fast and breaking things. Well, this can't be broken out of the gate. This has to be as locked in and clear and hack-proof and all of those precautions because I can guarantee you, just like it is with a company like Roblox, I will not let my kids on that platform unless I'm 100% sure that they are protected and it is safe and it is friendly and it is positive. Because one sniff of negativity comes across, I know it's very hard to protect your kids all the time, but that's going to kill that platform and will kill the user base of it and the adoption of it, which is really what they want to go after a night, not even talk about how they might monetize it, but advertising, which is a whole other question, Chris, probably don't even have time today to talk about. 

Hill: Andy Cross, it's going to be interesting to see how it all plays out. Thanks for being here.

Cross: Yeah, thank you, Chris.

Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.