Brother, can you spare a COIN?
We believe Coinbase is a cash-burning regulatory nightmare with limited upside. Here's why.
Disclaimer: We are short COIN… and should have finished this article yesterday! Nothing in this article should be taken as individual financial advice or an inducement to make any investment decision. Full disclosure at bottom of this post.
Coinbase is a cash-burning machine projected to lose money for at least the next two years
Coinbase’s business model is simple: Selling people various unregistered investment schemes and taking a commission off the top. In 2021, this business model was quite successful, with the firm growing revenue over 600%. The company earned $3.6 billion in net income. Things did not go nearly as well for Coinbase in 2022. With the crypto market peaking and then deflating, the company saw massive declines in revenue. They ended the year with a net loss of $2.6 billion.
With 2023 shaping up to be a hellish year for even the legitimate economy, we struggle to see how Coinbase’s financial condition will improve. Indeed, analysts agree with our assessment and project significant losses for Coinbase in both 2023 and 2024.
Coinbase’s net income doesn’t capture another major expense: stock-based compensation. Over the past two years, Coinbase paid over $2.3 billion worth of employee compensation via stock. Of course, one solution to the problem of compensation is by cutting staff, with Coinbase announcing they planned to cut approximately 20% of their workforce (950 employees) in January 2023.
So Coinbase is a shrinking business expected to lose money for at least the next two years WITHOUT any significant changes to its business model. And guess what? These obvious financial issues are only the icing on top of more foundational concerns. It turns out that Coinbase’s entire business model is at risk of annihilation at the hands of regulators…
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Coinbase faces direct regulatory risks that may be existential threats to its business
Coinbase partially compensated for the 2022 collapse in transaction fees by growing their crypto staking business. “Staking” crypto enables investors to generate returns by locking their tokens into various platforms. Unfortunately, the SEC does not take kindly to this type of activity. The U.S. crypto exchange Kraken recently paid a $30 million fine and ceased offering all staking products after settling with the SEC for offering similar services to Coinbase. However, Coinbase has chosen to keep offering these services, essentially daring the SEC to come after them for the offering:
However, this is how Coinbase describes staking on its website:
Staking serves a similar function to mining, in that it’s the process by which a network participant gets selected to add the latest batch of transactions to the blockchain and earn some crypto in exchange. Stakers also help establish which blocks are valid….
Many long-term crypto holders look at staking as a way of making their assets work for them by generating rewards, rather than collecting dust in their crypto wallets.
To us, this sure seems like an investment contract, right? Coinbase acts as the intermediary for its staking customers, taking a fee off the top for offering these services. For reference, this is how the SEC defined an investment contract in its recent lawsuit against Tron founder Justin Sun (more on that shortly):
An investment contract, for purposes of the Securities Act, includes any “contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits” from the efforts of others. This broad definition is “flexible” and “capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
Coinbase, however, argues that their service does not meet these criteria and has threatened to sue the SEC to prove this point.
Coinbase faces other direct regulatory headwinds at both the state and federal levels. Coinbase recently settled with the State of New York for flagrant compliance violations, paying a $50 million fine and agreeing to invest another $50 million in improved compliance. With scrutiny on the crypto-conomy reaching a fever pitch, Coinbase may face similar actions in the coming months.
The company has long exhibited an antagonistic attitude towards regulators. At one point, their CEO Brian Armstrong called the SEC “sketchy” in a long thread complaining about a supposed lack of regulatory clarity:
Armstrong’s attitude displays the broader cognitive dissonance displayed by crypto-conomy advocates. They argue that there is “no regulatory clarity,” therefore it is fine for them to offer whatever investment products or services they please. They argue that the “innovative” components of their investment products (i.e., listing things on a decentralized ledger) means that these products don’t fall into traditional regulatory categories and require special treatment.
However, the SEC has an understandably different view: that crypto tokens, despite being issued using a blockchain, neatly fit the well-established definition of a security. The SEC has made this stance publicly clear for some time, with SEC Chairman Gary Gensler stating that most crypto tokens are securities:
"Whatever they're promoting and putting into a protocol, and locking up their tokens in a protocol, a protocol that's often a small group of entrepreneurs and developers are developing, I would just suggest that each of these token operators ... seek to come into compliance, and the same with the intermediaries,” Gensler said.
The SEC just announced legal action against the Tron (TRX) cryptocurrency token issued by the infamous Justin Sun. In this action, the SEC alleges market manipulation by Sun and asserts that Tron is a unregistered security due to its “proof of stake” mechanism. This assertion applies to many other crypto tokens currently offered in the crypto-conomy, meaning many more enforcement actions could be on the way.
The SEC isn’t the only regulatory agency asserting that cryptocurrencies are securities. In a recent lawsuit against the KuCoin crypto exchange, New York Attorney General Letitia Jones asserted that the second-largest cryptocurrency, Ether, is also a security due to its “proof-of-stake” validation mechanism, its promotion as an investment by the Ethereum Foundation, and its initial issuance via an “initial coin offering.”
How big of a problem might this be for Coinbase? According to Coinbase’s 10K:
For the years ended December 31, 2022 and 2021, we derived a meaningful amount of our net revenue from transaction fees generated in connection with the purchase, sale, and trading of Bitcoin and Ethereum; these trading pairs drove approximately 55% and 45% of total Trading Volume on our platform during these periods, respectively.
In other words, >45% of Coinbase’s trading volume in 2022 was in crypto tokens other than Bitcoin. This suggests that a regulatory crackdown on Ethereum or other smaller crypto tokens could have a devastating effect on Coinbase’s revenue and overall business model.
Coinbase received a Wells Notice regarding incoming enforcement actions related to several aspects of its business
It looks like Coinbase will be getting their day in court: as we were putting the finishing touches on this piece, Coinbase disclosed that they had received a Wells notice from the SEC threatening enforcement actions against multiple aspects of their business including their spot markets and staking offerings.
This is Very Not Good for Coinbase. Coinbase has insisted they will continue to operate in the same manner after they receive the formal enforcement actions related to this notice. However, they will be forced to choose between two unfavorable responses. Either they can settle with the SEC and radically alter their entire business, or they will be embroiled in lengthy legal battles that appear (to us) to likely end in the regulators’ favor.
Coinbase faces other indirect regulatory risks that may be existential
Coinbase’s business model faces major downsides in the event of legal action against industry-dominating firms like Binance and Tether. Coinbase itself has at several points called the legitimacy of both firms into question. For example, Coinbase told its clients to swap out their Tether stablecoins for Circle’s USDC stablecoin, suggesting that Tether is not a trustworthy entity.
Ironically, USDC itself recently had a brush with insolvency last week when Silicon Valley Bank went down…
We note that there is substantial public evidence that both the largest stablecoin (Tether) and the largest crypto exchange (Binance) are active targets for regulators and criminal investigators. Should either of these entities face criminal prosecution or significant regulatory action that prevents them from doing business, broader crypto markets will face potential devastation.
Coinbase does a very good job of explaining how fraud in the crypto ecosystem could destroy their business:
Further, in 2022, a number of blockchain protocols and crypto financial firms, and in particular protocols and firms involving high levels of financial leverage such as high-yield lending products or derivatives trading, suffered from insolvency and liquidity crises leading to the 2022 Events. Some of the 2022 Events are alleged to be the result of fraudulent activity by insiders, including misappropriation of customer funds and other illicit activity and internal controls failures….
Forced selling by distressed companies may also depress the prices of assets used as collateral by other firms. If this market condition becomes widespread in the cryptoeconomy, including as a result of the 2022 Events, we may suffer from increased counterparty risk, including defaults or bankruptcies of major customers or counterparties, which could lead to significantly reduced activity on our platform and fewer available crypto market opportunities in general. Further, forced selling of crypto assets by distressed companies could lead to lower crypto asset prices and a consequent reduction in our revenue.
In other words: Coinbase’s future may rest entirely outside of the company’s control!
Conclusion: No risk of bankruptcy, guys. Promise!
It is certain that Coinbase faces substantial threats to its business in the coming months. We do note that the company has certain advantages. For example, the company has a good reputation in the crypto industry. We also have not discovered any evidence suggesting the company is actively engaged in fraud or malfeasance with customer assets. Coinbase also has a significant amount of cash that will allow them to weather the possible collapse of their industry.
And most importantly, Mr. Armstrong himself has assured everyone that there is no risk of bankruptcy for Coinbase:
We will breathe a sigh of relief and trust that you are right, Brian!
Celsius Network. FTX. Signature Bank. Who’s next?
*The use of this research is at your own risk. We are not liable for any losses, direct or indirect, caused by any information in this report. You agree to perform your own due diligence and consult your own expert advisors before making any investment decisions related to the securities mentioned in this article. The author has a short position in Coinbase via put options. We may continue to transact in this security after publishing this report. This post is not offering to sell or soliciting an offer to buy any securities. We are not investment advisors and nothing in this post should be considered investment advice. The information contained herein was obtained from public sources including regulatory filings, social media posts, and third party news outlets. To the best of our knowledge, ability and belief, we believe this information is accurate. However, we cannot guarantee the accuracy of this information and as such it is presented “as is,” without any express or implied warranty.
I have a feeling they’ll fight it in court, not because they believe they’d win but because they’d prefer to delay the outcome while preparing for the downside
The anti-crypto bias is getting stronger and stronger in these articles, making them less and less interesting. Try not to pick a side! The people who hate crypto are just as full of shit as the people who are overly zealous about it. Time will tell.