The current scare surrounding Coinbase is entirely valid in terms of proper risk disclosure, but I agree with the CEO that even in a total meltdown, the company is very unlikely to go bust.
Due to a new regulation from the SEC, Coinbase was required to add a risk warning to its filings that make it extremely clear exactly what Coinbase is and the risks that its users are taking by using its platform. This warning basically states that if Coinbase was to go bankrupt, then client assets would be treated as unsecured creditors, meaning that both the deposits and the tokens in the wallets could be lost as the secured creditors would be paid back first.
This caused consternation among shareholders and triggered a further collapse in the shares which had already been clobbered by a bad set of results and horrendous market conditions.
The simplest way to understand the risks attached to Coinbase is to view it as a bank and not an asset manager or asset trading platform. This is a key distinction because of the way that client assets are held by banks as opposed to asset managers.
Asset managers and trading platforms are required to segregate client assets, meaning that if the company goes bankrupt, then the client assets are unaffected. Banks are different in that they borrow money from depositors, lend it out at a higher rate and keep the difference in interest rate between what they pay and what they earn. There can be no segregation of assets, which is why if there is a run on the bank and everyone wants to get their money out at the same time, the bank will quickly become insolvent.
Coinbase is set up as a bank, except that it does not lend the money out but makes money on fees and services when its depositors trade in crypto assets. The company itself has a relatively small direct exposure to cryptocurrencies, as client deposits that are not invested in cryptocurrencies are stored in deeply liquid and very secure money market instruments. These deposits are kept in financial institutions and are covered by the usual depositor insurance.
This means that Coinbase has not lent its clients’ money out as term loans, meaning that if everyone suddenly wanted their money back, Coinbase would be able to oblige them although it might take a week or two.
Furthermore, the chance of the company going bankrupt is very, very low, even if there is a total crypto meltdown and the sector goes into a nuclear winter. This is due to the strength of the company’s balance sheet, which I suspect that almost no one has looked at.
As of March 31st 2022, the company had $6.1 billion of cash and $3.4 billion of debt giving the company a $2.7 billion net cash position. It also is holding $9.7 billion in custodial funds from customers (deposits) which had a market value of $10 billion (highly liquid, money market instruments). Coinbase holds $1.3 billion in crypto assets for its own account and $246 billion of crypto assets that belong to its clients, but the client assets are currently off-balance sheet.
Surviving crypto’s nuclear winter
Part of the new regulation will require Coinbase to recognise a liability with regard to its obligation to safeguard client assets as well as an associated asset. This safeguard does not mean protecting clients from bad investments that they make, but ensures that it has adequate safeguards to protect those assets from hacks and other preventable risks.
Hence if the $246 billion goes to zero, this is not on Coinbase, and its trading losses would be limited to the $1.3 billion that it holds for its own account.
I think the company is strong enough to survive this eventuality given its net cash position. In Q1 2022, the company had gross margins of 79% but still lost $554 million at the operating level due to its very high investments in technology and general and administrative expenses which have grown substantially over the last 12 months.
If there is a nuclear winter for crypto, then Coinbase can drastically cut its opex to match the demand that it has for its services and probably even turn a profit and generate cash, although this would be miles below where current forecasts are. Forecasts are on the way down given how badly the company missed its Q1 2022 revenue and the weakness of the guidance that it gave for Q2 2022.
Coinbase shares are down 89.3% from the close of the first day that the company was publicly listed and so the question on everyone’s mind is where is the bottom?
Coinbase’s business and risk profile look to me to be like a bank rather than an asset manager – and as such, one should look at it as a bank.
The best simple measure for bank valuation is price to book value – the biggest and best US banks currently trade between 1.0x and 1.5x.
Coinbase is a low-risk bank but is active in a market that can only be described as high risk and speculative. Even after falling nearly 90%, it still trades at 2.3x PBV which leads me to think that there is plenty of room for it to fall further.
I think it quite likely that Coinbase may sell off way too far before it bottoms, but on the measures that I would use to look at this, that bottom is still far off.
This is another one of those to watch as a deepening of the current crypto crash is likely to push what is a pretty well-capitalised bank into deeply discounted, highly attractive territory.