Investment management consultant MATTHEW FEARGRIEVE discovers how the world’s biggest Bitcoin exchange courted Wall Street money and betrayed the principles of cryptocurrency.
Cryptocurrency exchange Coinbase has been offered to the public through a direct listing on the US tech index Nasdaq with a valuation of US$76bn (US$99bn including options and stock-based awards).
The valuation, which surprises some commentators, has been taken by many industry players as another confirmation that the more crypto goes mainstream, the greater the confidence investors have in it. Others see in this “going mainstream” only a betrayal of the underlying principles of cryptocurrency.
As Bitcoin prices continued to fly high, Coinbase shares opened at US$381, well above Nasdaq’s US$250 guidance price, before falling to close at US$328. This gives the company a market capitalization of around US$85bn. To give you some size comparison, Facebook is currently worth around US$900 billion. Not a bad start for a cryptocurrency exchange, launching in an end-of-pandemic marketplace. A little worrying is that its market valuation is 79 times its trailing revenue.
The soaring price of Bitcoin, and the way in which the Coinbase listing exceeded analyst expectations, are by no means coincidental. It is no overstatement to say that crypto is booming.
Its leading protagonist, Bitcoin, has been smashing through ceiling after ceiling since mid-2020. When Coinbase was first set up, Bitcoin was priced in single-digits. Its price recently broke through US$64,000.
Exponents of cryptocurrency are hailing Coinbase’s Nasdaq listing as a significant milestone in the global validation and acceptance of crypto as an increasingly “mainstream” asset.
In the space of just a few months during 2020, Bitcoin’s price surge saw a spike in the amount of the cryptocurrency moving into North America and East Asia, and its growing take-up by normally compliance-wary US investors.
Bitcoin was no doubt propelled during 2020 by allocations by hedge funders Paul Tudor Jones and Stanley Druckenmiller, as well as Grayscale and JP Morgan. In October 2020, PayPal announced that it had pivoted to implement the acceptance of cryptocurrencies on its US payment platforms. As we move into the second quarter of 2021, and with the end of the Covid-19 pandemic in sight, institutional allocations to Bitcoin and other cryptocurrencies show no signs of letting up.
And so it was that London’s Financial Times declared in its front page headline on 15 April that Coinbase’s listing “puts [the] seal on cryptocurrencies [as an] asset class”.
Coinbase holds assets for 56 million retail customers and operates the largest digital coin exchange in the US.
The company was offered to the public by means of a direct listing on Nasdaq, as opposed to a more traditional initial public offering (IPO), which allows retail investors to buy shares directly and immediately.
Why Coinbase users will be disinclined to buy
For many Coinbase users, amateur and professional alike, Q4 2020 and Q1 2021 was a painful time. Bitcoin prices it seemed could only go up, and many crypto investors big and small wanted to join the ride.
It was at precisely this critical time that Coinbase users were locked out of their accounts, and so were effectively excluded from the Bitcoin party.
The California-based exchange, the world’s biggest for Bitcoin, is popular with small investors, who are able to buy Bitcoin with smaller sums of money than the thousands of professional traders who use it every day.
So it was deeply frustrating for these customers, during late 2020 and early 2021, to be told that their accounts had been suspended “pending review”, despite having submitted the customary ID and know-your-client (KYC) proofs and documents.
Matters culminated in January in a public statement by Coinbase that fell just short of an actual apology:
“As a regulated financial services company, we’re required to maintain rigorous compliance standards in line with other financial institutions in the UK. To ensure compliance with recent regulations, we’ve had to seek additional documentation or information from some customers. While we appreciate that this is a burden for some, it’s our responsibility to meet the standards set by regulators.”
Herein lies the big problem with Bitcoin and other cryptocurrencies. Not so much the scary price volatility (that hasn’t gone away — it’s still embedded in the asset). Not so much the limitations of the technological infrastructure and support systems (although concern about the integrity of these is a big turn-off for many would-be crypto investors).
No, the big problem with crypto and the investibility of players like Coinbase is the looming financial and legal regulation that is headed their way.
Looming Crypto Regulation
At the same time as Coinbase users were locked out of their accounts in January, the UK’s financial regulator issued this statement:
‘The FCA is aware that some firms are offering investments in cryptoassets, or lending or investments linked to cryptoassets, that promise high returns. Investing in cryptoassets, or investments and lending linked to them, generally involves taking very high risks with investors’ money. If consumers invest in these types of product, they should be prepared to lose all their money.’
This warning by the FCA, the starkest of any financial regulator yet issued about cryptocurrency, came only a day after regulations came into force in the UK requiring cryptocurrency firms to comply with anti-money laundering rules.
It is obvious from its statement that the UK financial watchdog is concerned that some crypto firms do not yet face any formal regulation in the UK beyond basic KYC and AML requirements.
This regulation is most assuredly on its way, and not just in the UK. This, together with the prolonged service failures of 2020 and 2021, will dampen enthusiasm for the company’s listing in many quarters.
Betrayal of the Principles of Cryptocurrency
The company’s pre-listing valuation speaks for itself. In going out of its way to court Wall Street financiers and embrace regulation like know-your-customer and anti-money laundering rules, Coinbase has abandoned both the challenge espoused by crypto of traditional state-controlled fiat money and the privacy of crypto transaction; values that have always been regarded by Bitcoin maximalists as sacrosanct and central to the integrity of cryptocurrency.
Coinbase has in fact dominated its competition in the US by maintaining a close relationship with financial and other regulators. Its investibility and pricing have been driven, to a large extent, by its wholesale adoption of mainstream market etiquette, to the distaste of crypto maximalists.
Many purists will see a further betrayal of the basic tenets of cryptocurrency in the way that Coinbase founders and senior management have monetized the accounts held by retail investors. Wall Street insiders have been aware for some time, well before the listing, that the company’s true value for institutional investment is not to be found in its (putative) status as an “exchange”, but in its cash- and data- rich customer accounts, the majority of which are held by retail, small investors.
To add insult to the injury suffered by Coinbase’s retail users, analysts predict that its newly cash-rich management will chase after institutional customers post-listing.
Coinbase has essentially always been a fee earning, Wall Street intermediary. Most transactions on its platform are not even settled through any public blockchain.
Betrayal of crypto tenets = regulatory intervention
The very fact of Coinbase being offered more widely to the public will usher in more regulatory scrutiny, the cost of which will in time act as a significant drag on the company’s balance sheet.
The nature of how the exchange is currently regulated in the US is also of concern. Coinbase is regulated and licensed under the US Money Services Business legislative framework. It is not regulated as a traditional exchange or prime brokerage provider for credit for trading. True, this gives Coinbase a competitive advantage over its more heavily regulated counterparts like ICE or the CME.
If US financial regulators started to take more of an interest in Coinbase — which we think is not unlikely — the nature of how it is overseen could change significantly, with costly consequences. Were it indeed regulated as an exchange, its capacity to generate earnings from prime brokerage, over-the-counter brokerage and principal trading would be firmly clipped back. If overseen as a prime broker or a bank, its capital burden would be increased significantly.
More generally, cryptocurrency and players like Coinbase will pay the price for the meteoric rise of Bitcoin and the influx of investors. The more cryptoassets look as if they are being embedded in the global financial system, and the more they achieve a wider investment base through public offerings and exchange-traded funds (ETFs), the more investors must expect governmental and regulatory scrutiny.
The unhappy experience of Coinbase users compounds two of the three biggest drawbacks of Bitcoin and cryptocurrencies: one operational, the other regulatory. The third drawback being, of course, its infamous volatility.
These three primary sources of risk for any investment in cryptocurrency will increasingly become the focus of the FCA and other financial regulators worldwide over the course of 2021, an inevitable process that will only be accelerated by a sustained rise in crypto prices and investor influx.
Read more: How Bond Yields are driving Bitcoin Prices.