15 April 2021

Is Coinbase the future – or a digital South Sea Bubble?

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Wednesday April 14 is a date when the world of finance changed.

In 1720, it was the day when the South Sea company first sold stock to the public. £2 million worth of stock was offered at £300 per share, and the issue sold out within an hour. Sales were especially brisk thanks to investors only needing to pay a 20% deposit, with the remainder due in installments over 16 months. The only problem was that the bubble burst before the stock was fully paid up, great fortunes were lost and the British economy suffered a colossal tumble.

Wednesday April 14, 2021 may also have marked a turning point in the financial world – the only question is precisely what that turning point was?

Given South Sea Bubble anniversary, some suggested the omens were not propitious – a feeling that was bolstered by news that the ghastly Bernie Madoff had died in US custody while serving a 150-year sentence for fraud.

For the financial media, though the real focus yesterday was the Nasdaq listing of a remarkable company. On its arrival in public trading Coinbase immediately became the largest exchange group in the world. Despite lacking the same regulatory status as the legacy bourses its $100bn valuation it was more than $25bn higher than the previous leader, Hong Kong Exchanges.

For an exchange to be listed and simultaneously launch into the top tier of the publicly traded exchanges is rare. For a de facto exchange – and one which is really more a collection of disparate licenses than a fundamentally regulated entity – to be so richly valued is unprecedented.

The fuel which helped propel Coinbase’s enormous valuation is Bitcoin. The vagaries of the crypto-currency are legion, but at least it has achieved one thing – becoming the Ford Model T of digital money. Electronic currencies have come and gone for years (think Beenz in the 1990s) but Bitcoin was the first to actually encourage lasting infrastructure to be built around it, much as Ford’s car energised an economy built around paved roads, filling stations, motels and so on.

The Coinbase story

As for Coinbase, it was created in 2011 in San Francisco with a modish mission to deliver “more economic freedom for every person and business”. In less than a decade from start-up to $100bn business, Coinbase has got its fingers in many cryptocurrency pies. At the core is a modern kind of hybrid variation on an ‘exchange’, which would actually be banned if it were regulated like the Nasdaq Stock Exchange, on which Coinbase’s shares are now traded.

Indeed, just last month the firm paid a $6.5 million fine from the US CFTC regulator “for reckless false, misleading, or inaccurate reporting as well as wash trading”. 

Without dwelling on the minutiae of each case, this is somewhat akin to having the casino barman serving you a spiked drink while reading your cards and telling the dealer your hand. Suffice to say that the London or New York Stock Exchanges are strictly forbidden from trading against the bourse’s clients. However the weirdest element of this case is that Coinbase isn’t even directly under the US CFTC’s remit. In fact it’s not clear just where cryptocurrency lies in US regulation, leading to the curious conundrum that while Coinbase’s CEO and co-founder Brian Armstrong now enjoys a $15bn fortune (on paper at least), other pioneering crypto exchange founders, like Arthur Hayes, of Bitmex watched Coinbase stock trading in New York while on a $10 million dollar bail bond.

Optimism or hubris?

Away from those puzzling regulatory factors, the question immediately arises as to how Coinbase suddenly found itself propelled to a giddying $100 billion valuation in the midst of the current Bitcoin craze.

There is no doubt Coinbase has grown rapidly – its prospectus states some 43 million users, attained in under a decade. Still, at its opening trade price, a $100 billion dollar valuation made each client worth over $2300. Moreover, the prospectus noted 2.8 million users were active over a month, valuing them at a giddy $35,000 each as trading got under way. Saying each user is worth roughly half a Bitcoin in these bullish times may be a mark of optimism in the crypto-economy, or it could turn out to be the height of hubris. Either way, history is in the making.

Before you rush in to sell, though, perhaps we ought to remember JM Keynes’ maxim that “the markets can remain irrational longer than you can remain solvent”.

Peeling back some more layers of the value justification behind Coinbase, the core argument is that this is a ‘new new thing’: Bitcoin represents a future to which we all hope to subscribe, where Jetson life comes to reality. Or something.

Reasons to  be fearful

Given that I wrote the first bestselling book on the concepts of fintech,  Capital Market Revolution, which in 1999 outlined a likely digital currency future, it is fair to say I am not anti-digital currency.

Nonetheless, I am left scratching my head at Coinbase. Granted, the company did offer some exciting guidance on their profit and user outlook, but even when we factor these into the model, it’s really tough to deploy a coherent risk/reward model and assert that the family fortune ought to be heading into Coinbase stock right now.

Client accounts on these projections are said to be 56 million while the Monthly Transacting Users will leap from 2.8 million to 6.1 million. Then again, even at the relatively subdued first day closing valuation of $86bn, that still makes each active user worth about a quarter of a Bitcoin – over $14,000 in old money.

Fair enough, if this business has staggering margins then perhaps it can justify valuing every client at such an extravagant level, but that route reveals some worrying home truths about the crypto-currency business and particularly the Bitcoin itself.

The driving zeitgeist of digital money, electronic markets and so forth was always about efficiency and scale. Computerisation made markets cheaper to operate, reduced headcount (think of all those people populating vast exchange floors alone). This could drive down costs for the consumer. By way of comparison, when I worked at the lowest echelons on the floor of LIFFE in Thomas Gresham’s storied Royal Exchange in 1987 we could charge massive multinational banks over $30 per round turn trade (buy/sell). With electronification you can now buy the same contracts online through a retail broker for under $5. Institutions can pay a lot less.

Transaction costs

To advance the Coinbase analysis: your word for today in the Sesame Street of financial markets jargon is ‘basis point.’ That’s 0.01 (1/100th) of a percentage point. So as we can see above in the case of a million dollar futures contract you can transact a million dollars of Eurodollar interest rates for less than $5 (buy and sell) as a retail investor – significantly less than 1 basis point ($100). In pure exchange fee terms (i.e stripping out what a broker may charge on top for their services to give you bourse access) the transaction cost is generally at most one basis point, or as in the example above, far less.

Now, if we examine Coinbase’s financial history and its projections, what we rapidly see is a business which appears to be charging its retail customers somewhere between 46 and 57 basis points. In other words, easily 46-57 times what exchanges charge for dealing on regulated (and, one might presume, more secure venues) such as the blue riband exchanges of London or New York. Of course they don’t trade crypto-currency so clearly one can argue there may be a premium for allowing people to deal in this new paradigm of ‘assets’, but then again…

Remember, the whole original point of a ‘Capital Market Revolution’ and more ‘tech’ in finance was greater efficiency, lower costs and all that.

The problem with cryptocurrency is that while it has a fascinating backbone in the blockchain: distributed ledger technologies (DLT) can have issues when it comes to being scalable and cost-effective to use. That doesn’t apply to all of them, but the problem is the likes of Bitcoin are using the earliest variants of DLT to be found in the wild. Again this makes it akin to the Ford Model T – a nifty idea at the time but soon rather outmoded. Think of it like this: the Model T shares a vast DNA base with your modern hatchback, but  few of us would opt for the pre-war wheels. 

With that in mind, some might suggest that Bitcoin isn’t likely to be the long-term solution to anything fiscally significant – a view guaranteed to provoke a baying Twitter mob.

But the serious point is the way Bitcoin delivers its secure transactional protocols is inefficient and thus not very scalable for fast, cheap transactions. So, while you can trade a Satoshi (a Bitcoin basis point if you will) it’s expensive and when you want to transact on the likes of Coinbase you are likely to end up paying something like 50 times what it would cost for more conventional financial assets. In other words, the old-line legacy financial assets are way more efficient to trade and vastly cheaper as a result.

Some have thus argued that this is just a growing pain and market competition will eventually drive down commissions. After all, US stock brokers now offer (nominally) “free” share trading. Presuming even a reversion to the legacy bourse fee rates is feasible, that doesn’t look so encouraging for Coinbase as it’s valuation of $100bn is based on a minimum profit of $730m for the year ahead and overall revenues somewhere around $1.8bn.

However, even a maximum estimated $1.8 billion in revenue relies on charging at least 50 times the prevailing legacy exchange fees. Presuming the Coinbase crypto business was transacted at the level of the much more efficient traditional bourses, that would leave it with something more like $36 million dollars in revenue. That’s not going to pay the salaries of 1,200 staff, or the sky-high wages of CEO Armstrong, who got three times the pay of Goldman Sachs’ CEO last year.

A question of value

This accounts for the staggering range of appraisals of Coinbase. Some pundits value it as low as $5bn, others see it as a ‘Buzz Lightyear stock’ that could go “to infinity, and beyond!”.

The real value is undoubtedly somewhere between the two, but it’s very tough to see how Coinbase can grow fast enough to justify its $100 billion first day valuation without at least a little test of the downside support along the way. Note too that in private market trading pre-listing, Coinbase was very patchily traded, even compared with other similar recent US stock market debutants such as Palantir, Spotify and Roblox, which also enjoyed the vogue for “direct listing” (i.e going to the stock market without selling any shares to new investors).

Nor will investors be overly pleased that they don’t get much say in Coinbase’s corporate governance. Thanks to a skewed share structure, the Coinbase management and board of directors hold 54% of the votes, whatever the stock price.

Bitcoin may go to infinity. I happen to think like the Ford Model T it will bubble, burst and become a sweet relic for hobbyists and enthusiasts. Investors may also note the relatively staggering costs of dealing in crypto-currency, which seem to belie the idea that tech always makes the world cheaper and more efficient.

Regulation of crypto is also a patchwork – or more like a string vest. The crypto-currency business has some licences but no coherent overarching regulation. It is in those grey zones that the great fortunes of Coinbase and others have been accumulated, albeit at the risk of orange jumpsuits being distributed to others who fell off the head of the crypto-pin upon which they danced.

Enter Gensler

Here’s the rub, though. Even if you don’t associate Coinbase with the South Sea bubble of 301 years ago, or that Madoff’s death is somehow totemic, there was one other very significant event in the financial firmament on April 14. Gary Gensler was confirmed as Chairman of the Securities and Exchange Commission: regulator of stock markets and more in the US. Gensler previously ran the derivatives regulator CFTC (which fined Coinbase last month) with an iron fist during the early Obama administration. The new SEC Chairman spent several years at MIT during the Trump Presidency and his Bitcoin lectures have led many to believe he is a crypto enthusiast. 

Perhaps he is, but the Gensler era CFTC was marked by a ruthless desire to clamp down on anything the Chairman perceived as egregious market behaviour and an eagerness to close up the holes where regulation was not being consistently applied. During Gensler’s CFTC tenure a raft of firmly enforced laws transformed the interbank swaps market to a vastly more heavily regulated entity. Who believes he won’t be eager to bring the cryptocurrency market into a properly coherent regulatory framework, away from the current mish-mash where the ‘exchange’ can even trade against its own clients? 

April 14 likely marked its place in financial history once again this year. Time will tell.

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Patrick L Young cultivates the watercooler of markets in the Covid era - “Exchange Invest” the bourse business daily newsletter. His latest book is “ Victory or Death: - Blockchain, Cryptocurrency and the FinTech World”

Columns are the author's own opinion and do not necessarily reflect the views of CapX.