The Securities and Exchange Commission has sued crypto exchange Coinbase over allegedly running as an unregulated securities exchange. Mark Palmer, Berenberg Capital Markets Senior Equity Research Analyst – Fintech and Digital Assets, breaks down the implications of this landmark case upon the entire crypto industry.
BRAD SMITH: Also, we got to talk about the SEC. The SEC suing Coinbase. Alleging the crypto exchange operator evaded regulations by trading unregistered securities. Shares are plummeting. It's been under investigation by the regulators since last summer.
Yesterday, the SEC took legal action against rival Binance and its CEO CZ for what it called multiple securities violations. Berenberg analyst Mark Palmer thought some action against Coin was likely in the aftermath. And guess what? Mark joins us now.
So Mark, great to have you here on set with us.
MARK PALMER: Good to be here.
BRAD SMITH: You saw this coming essentially, as the rest of us were probably sensing was in the cards here for the SEC.
MARK PALMER: The SEC telegraphed this action. We had seen prior actions brought against crypto exchanges, Bittrex, BXC, Kraken, and now, Binance. Each of which included elements that were consistent with the Wells notice that the SEC presented to Coinbase back on March 22.
So in our view, nobody should have been surprised that this occurred. And even the elements of the case lined up with what we expected. The one thing that was a bit of a twist is the fact that the SEC focused on 13 tokens in particular that it identified as securities that Coinbase trades. Big names in there-- Solana, Cardano, Polygon, as well as 10 others that are a bit less well known. But the upshot here is that the dragnet that the SEC has put out against crypto continues.
And we don't think it's going to stop anytime soon.
JULIE HYMAN: So Coinbase, obviously, had been in discussions with the SEC about all of this. Has complained about the lack of clarity. But I have to wonder presumably the company also knew that this was coming, why didn't it stop doing what the SEC didn't want it to do?
MARK PALMER: Well, frankly, I don't think it would be able to given the portion of its revenue that is represented by these actions. If you look at the unregistered or the trading of unregistered securities, which is what the SEC characterizes the crypto tokens that Coinbase trades, bitcoin is the one big exception there that the SEC sees as commodity.
JULIE HYMAN: And how much of trading on Coinbase is Bitcoin?
MARK PALMER: Bitcoin is a significant portion. It's about a third of its trading in terms of volume. But it makes very little money on that Bitcoin trading. If you look at alternatives, they offer Bitcoin trading fee free. And so Bitcoin is effectively a way to bring consumers onto the platform. It's not a way that the company makes money.
If you look at staking, that represents about 10% of the company's revenue. That's targeted in the lawsuit. So you put all of that together, what we estimated was that if you looked at all the unregistered securities, i.e. the tokens that Coinbase trades, other than Bitcoin, add to that staking, it was about 37% of the company's first quarter net revenue.
BRAD SMITH: And so in simple terms too, as we were reading through the SEC allegations here in the suit, I was trying to the best of my ability to figure out what they did wrong within their staking practice as well. Is it clear? Is it evident what they were doing in terms of the number of clients that they had marketed staking to seen revenue come in from? And then what essentially were they doing with those coins that they were staking?
MARK PALMER: Well, really, it was just the fact that Coinbase was involved in staking, in general, without registering a staking platform with the SEC.
BRAD SMITH: Got it.
MARK PALMER: In the eyes of the SEC, staking, the action through which proof of stake tokens are created is in itself a means through which securities are created and exchanged. There's really no way around that. Kraken already settled with the SEC. Basically, put its US staking operation to rest. Continues to operate overseas. And that really is one of the big questions now with regard to Coinbase is, will it be able to pivot overseas the way that it has begun to do beginning with the launch of a derivatives exchange in Bermuda. And it's also looking at Dubai, Singapore, other geographies, where it could set up shop.
But in the first quarter, the US represented about 86% of Coinbase's net revenue. That is not an easy pivot to execute.
JULIE HYMAN: You have, I think, a hold recommendation on the stock.
MARK PALMER: That's correct.
JULIE HYMAN: From that, I'm implying that you think the jury's out on whether to be able to pivot. What is the probability that they're going to make it through this even as a viable business?
MARK PALMER: First of all, it is going to be a pushback from Coinbase in the courts. And that is on multiple fronts. In fact, we believed it was possible that the SEC would hold off on bringing this action against Coinbase until there was a resolution of Coinbase's request for a writ of mandamus that would compel the SEC to bring rulemaking on cryptocurrencies.
That case is still pending in the Third Circuit. But I think the confidence the SEC has that it will win was demonstrated in the fact that they just pushed forward. And then filed an enforcement action against Coinbase.
Beyond that, there's the possibility that portions of the business beyond what we have identified could continue to operate. But there are other portions that could be at risk. For example, the company generated about 27% of its net revenue in the first quarter from interest earned on USDC, the stablecoins.
Now, if you go back and look at the Federal Reserve's rejection of custodian banks request to become part of the Federal Reserve network back in January, there was a lot of language in there that was very specific about their concerns about stablecoins and the potential for their use to facilitate illegal activity.
Frankly, I think that same argument could be applied to USDC. And we would not be surprised if USDC came within the SEC's focus. Again, that was 27% of the company's revenue on top of the 37% of the company's revenue in the first quarter that we viewed as at risk.
That's effectively 2/3 of the company's revenue that we're talking about. At some point, you have to ask, where are they going to be able to make this up?
BRAD SMITH: You mentioned Kraken and the settlements that they went forward with the SEC. That won about $30 million just for staking alone. So now, if we were to add any type of proportion to this for Coinbase or even for Binance, what does that look like as investors are trying to wrap their heads around how much the company might actually have to pony up just to settle with the SEC or in fines with the SEC in the future?
MARK PALMER: Well, again, if you look at the Kraken situation, I think that number is one that is the result of a settlement where they talk about what's big enough to make the SEC look like they took their pound of flesh. But at the same time, not something that's going to put the company out of business.
I think, in this case, this is more existential. Coinbase has basically said straightforward, they cannot operate their business in the US, if they have to register it with the SEC.
Hence, there's not a lot of middle ground there.
JULIE HYMAN: And isn't there then also the idea that if I'm a US-based investor with my assets at Coinbase, I already saw one retail investor tweet this morning, like, take your money out. So how big a risk is that you see now flight of customers from the platform when they see these headlines?
MARK PALMER: I think, based on what we saw happen in 2022, when so many different crypto platforms effectively trapped the assets of their customers on their platforms, it's almost inevitable that you're going to see at least some reaction among consumers. And that's prudent on their part.
The reality is that right now, the only crypto token that is beyond the purview of the SEC or that the SEC has effectively blessed is Bitcoin. So if you look at Bitcoin-focused operations, Lightning Network, which is the layer 2 built upon the Bitcoin blockchain, those operations, I think, are going to be able to operate and may flourish in the US simply because all of the other crypto operations are going to find it difficult to do so.
JULIE HYMAN: So the industry has painted this as the SEC is at war with crypto . Is that accurate? And what are the implications for not just Coinbase, not just Kraken, and the others you mentioned, but really the whole US crypto industry?
MARK PALMER: I think the way that you can characterize this is that the SEC is trying to bring crypto under the umbrella of its compliance and wants to see all tokens that it views as securities. And that's a big question. Which tokens are securities? Which are commodities? Wants to see all of those tokens ultimately trade as registered securities on platforms.
Bitcoin, again, because of its decentralized nature, is an exception to that. So yes, Bitcoin will continue to exist in the US, to be traded in the US. We actually expect that one of the things that could occur as a result of what we're seeing is that the Bitcoin blockchain, as an application layer, could begin to thrive. We're already seeing this recently with what are known as Bitcoin ordinal NFTs.
The Bitcoin blockchain suddenly in the last few months jumped up to be the number two blockchain in terms of sales of NFTs.
BRAD SMITH: What's the number one right now?
MARK PALMER: It's still Ethereum. And Ethereum is the monster. Frankly, one of the things that we were looking for in this case to get a sense of what the SEC is thinking is what Ethereum be or Ether, the token of the Ethereum blockchain, be seen as a security as well. It was not mentioned as one of the 13 in the case.
JULIE HYMAN: And just very quickly before we let you go, you talking about what sounds like almost Bitcoin maximalism reminded me to ask about MicroStrategy. Speaking of the Bitcoin maximalist of all maximalists, Michael Saylor, who's the chairman of the company, what does all of this mean for it and its big Bitcoin stake?
MARK PALMER: We are bullish on MicroStrategy for all of these reasons. The fact that we do believe that this could be Bitcoin's moment in the sun, so to speak. And that MicroStrategy holding 142,500 Bitcoin on its balance sheet is well positioned to benefit from that, especially because there is a catalyst here, which in May 2024, we are expecting to see what's known as the Bitcoin halving, which is when the Bitcoin miner rewards are cut in half. It has an effect on the supply of Bitcoin. Hence, it has an effect on the price historically.
There have been three halving so far. And with each one, there was a run up in the price of Bitcoin six months before that event and six months after. Again, the next having is in May 2024. So we view that as an important catalyst for MicroStrategy.
And we think that amidst all of the chaos in crypto, Bitcoin represents a safe haven. MicroStrategy represents a way to play that.
BRAD SMITH: Mark Palmer, Berenberg Capital Markets senior equity research analyst. Mark, great to have you in studio with us today.