Famous growth stock investor Catherine Wood (Trades, Portfolio) was just buying shares of Coinbase Global Inc. (COIN, Financial) for Ark Invest in the second quarter. Even as the stock tanked amid the crypto winter, Wood remained firm about the long-term outlook for crypto in general and Coinbase in particular.
However, even the most bullish investor might get cold feet when insider trading allegations come into play. On July 21, U.S. authorities charged three people with a scheme to commit insider trading using crypto. Among them was a former product manager at Coinbase.
Just a few days later, on July 26, daily trade information from Ark showed the firm sold Coinbase shares from three of its exchange-traded funds to the tune of more than 1.4 million.
Is Wood finally giving up on Coinbase, and should investors follow her example? Has the stock simply become too risky amid declining interest in crypto and the introduction of regulatory scrutiny?
Insider trading allegations
On July 21, the U.S. Attorney’s Office for the Southern District of New York, in conjunction with the New York Field Office of the Federal Bureau of Investigation, said it had filed an indictment against a former Coinbase product manager along with his brother and another associate.
Allegedly, the three used confidential information obtained from Coinbase to make roughly $1.5 million trading various cryptocurrencies. According to the authorities, the former product manager was in a position to know insider information on when Coinbase would list cryptocurrencies on its exchanges, and he passed that information on to his brother or associate so they could invest in the coins before an anticipated price jump.
“Although the allegations in this case relate to transactions made in a crypto exchange — rather than a more traditional financial market — they still constitute insider trading," FBI Assistant Director Michael Driscoll said.
The SEC also filed parallel charges against the three, claiming it would seek “permanent injunctive relief, disgorgement with prejudgment interest, and civil penalties.”
This is big news, and not just because it is an insider trading scandal; it marks the first ever charge brought against those accused of a crypto-related insider trading scheme.
Regulatory scrutiny is just getting started
Shares of Coinbase closed at $52.90 on Tuesday, down 21% as Ark’s ETFs sold shares, though they have recovered to $62.40 as of Thursday. Year to date, the stock is down 75% due to a combination of slowing revenue on lower crypto trading volumes and the fears of regulatory attention turning to the crypto space.
This is doubtless just the beginning of increased regulatory scrutiny on crypto, which critics have long decried as being a safe haven for criminals and a breeding ground for money laundering schemes.
It is not just insider trading and payments to cyber criminals that have regulators finally moving toward a decision-making mindset. According to a recent white paper from the New World Economic Forum, regulators continuing to stand on the sidelines is the least effective approach for monetary and financial stability. In order for further innovation and integration to truly move forward with digital currencies, they must be allowed to play a regulated role in the economy rather than an unregulated role.
So how would the introduction of regulation to the crypto industry work out for Coinbase? We do not know the answer to that question yet, which is part of the reason why investors are wary. However, one potential outcome came to light on Tuesday, which was the same day that Ark sold some of its shares: the SEC brought into question whether or not some crypto tokens are in fact securities.
Now, Coinbase faces an investigation on whether it improperly allowed Americans to trade digital assets that should have been registered as securities, anonymous sources told Bloomberg.
Coinbase understandably took issue with this classification. “We 100% disagree with the SEC’s assertion that any of the crypto assets we list are securities,” Paul Grewal, Coinbase’s chief legal officer, said.
Last Thursday, the company also filed a petition requesting that the SEC “begin rule making on digital asset securities.” The longer regulators take to introduce proper definitions and rules to the crypto market, the higher the risk for companies like Coinbase that are in some sense flying blind in regards to whether their currently legal business operations may suddenly be deemed to have been illegal all along.
The crypto winter will not last forever
With regulatory questions at last coming into the spotlight and with crypto trading volumes, Coinbase’s main source of revenue, in decline, it may seem like all the cards are stacked against the crypto exchange company.
However, the crypto winter will not last forever. There are still many that believe crypto will play a key role in the transformation of the financial industry and the global economy. In a sense, decentralized digital currencies are the ultimate form of capitalism, with the potential to increase economic freedom and accelerate global innovation. Cities, nations, companies and individuals around the world are still investing in building out crypto infrastructure.
The crypto space is now beginning to undergo the painful but necessary process of the law deciding exactly where it stands on the matter. What the law decides will not necessarily spell doom for all crypto companies. It is possible that some of these decisions could render some crypto companies obsolete or cause them to need to overhaul their operations in order to become compliant.
However, that in and of itself does not mean crypto will just go away. Some tokens might become obsolete, and some companies might go bankrupt or end up being dissolved because of non-compliance with future laws, but both the concepts and the major cryptocurrencies will likely make it through.
Coinbase is confident in its risk-management
While Coinbase’s regulatory future is uncertain, its business is not likely to become illegal unless crypto itself becomes illegal. Thus, while it may continue taking short-term hits, the question of its long-term survival falls to how it will avoid bankruptcy amid tanking revenues and the potential for regulatory fines.
With a cash-debt ratio of 1.73 and an interest coverage ratio of 69.31, Coinbase appears to keep a much healthier balance sheet than many other companies involved in fintech. Analysts are not projecting it will become profitable until at least 2024, though, which is worrying.
Over the past month, Coinbase has combined its USD and USDC markets, closed Coinbase Pro, shut down its affiliate marketing program and laid off 18% of its workforce. All of these signs indicate that a liquidity crisis could be brewing.
Despite paring back operations, Coinbase remains confident in its risk-management steps. Three of the department heads at Coinbase claim the solvency concerns of Three Arrows Capital, Celsius and Voyager were due to “risky lending practices” and “insufficient risk controls” rather than issues with crypto itself. They further stated:
“The issues here were foreseeable and actually credit specific, not crypto specific in nature. Many of these firms were overleveraged with short term liabilities mismatched against longer duration illiquid assets. We believe these market participants were caught up in the frenzy of a crypto bull market and forgot the basics of risk management.”
Takeaway
With all of the risks facing Coinbase, it would not be surprising if even Wood decided to sell more of her firm’s substantial stake in the company, which accounted for 4.03% of Coinbase’s shares outstanding at the end of the June quarter. The combination of a crypto crash and two SEC investigations, one of which could potentially deem cryptocurrencies to be securities, could very well prove to be killer.
It is doubtful that crypto will go away entirely. In fact, given the enthusiasm with which crypto infrastructure is being built out by many cities, states and countries, it will likely continue to grow in influence over the long run. The fate of the industry is not the fate of any individual company, though, and Coinbase’s risks are stacking up.
