Recent private sales value Coinbase at approximately $100 billion, but investors should proceed with caution.
Over the past 11-plus years, cryptocurrency has grown from a single coin to a global asset class worth more than $1.5 trillion. That growth has been spurred, in part, by the inflow of institutional capital from the likes of MicroStrategy, Square and Tesla. The market is as bullish as it’s ever been and Coinbase, the largest crypto exchange in the United States, has opted to strike while the iron is hot.
The Coinbase direct listing is being hailed as a watershed moment where the innovative spirit of crypto will finally collide with the decades-old tradition of Wall Street. While the moment itself should certainly be celebrated, investors should take a step back and analyze whether Coinbase is really worth $100 billion. Although many articles have been written praising the valuation, in the immortal words of Lee Corso, “Not so fast, my friends.”
Investors should proceed with caution
While Coinbase may very well have a successful listing and an even more successful year, investors should be aware of the risks. A few of those potential pitfalls include an overreliance on trading fees, significant competition from other exchanges and investment platforms, and the threat of decentralized finance (DeFi).
In late February, the U.S. Securities and Exchange Commission published the company’s S-1 form. Coinbase disclosed a few facts that are somewhat alarming, including:
- “We generate substantially all of our total revenue from transaction fees on our platform.” (p. 17, Risk Factors)
- “For the year ended December 31, 2020, transaction revenue represented over 96% of our net revenue.” (p. 92, Our Business Model)
Even though bitcoin set an all-time high last month, remember that cryptocurrency is still a highly volatile market and cyclical in nature. Although not everyone subscribes to this theory, one common school of thought is that crypto tends to operate in a four-year cycle of exponential highs, a bear market, an accumulation phase and then a recovery and continuation period. Although some may disagree on the specifics, one cannot argue that the crypto market is cyclical in nature and will likely remain so until the entire asset class reaches maturity.
In 2019, Coinbase reported a net loss of $30.4 million on revenue of $533.7 million. Last year, as would be expected, those numbers improved significantly with the company reporting a net profit of $322.3 million on revenue just under $1.3 billion. If we take the most recent valuation of $100 billion and divide it by 2020 revenue, that results in a 76x valuation multiple (remember this for later).
Given Coinbase’s disclosure that 96% of its revenue comes from trading fees, it should be obvious that when asset prices are rising and volume is exploding, Coinbase is likely to perform extremely well. Because of crypto’s strong start this year, Coinbase has opted to list at precisely the right time.
But what happens after bitcoin peaks, which, according to some models, may happen as early as this summer? Well, if the last bear market was any indication, investors should expect to feel pain, significant pain.
Currently, Coinbase is the undisputed king of regulated crypto trading in the United States. While that’s an ideal position to be in, it also means competitors will devote endless resources towards innovation with the end goal of dethroning the champ. One such innovation in the crypto space is deposit interest.
While traditional bank accounts typically offer close to 0% interest on deposits, cryptocurrency accounts can often pay more than 5% on assets such as BTC and ETH and more than 8% on stablecoins. The primary players in this space are BlockFi, Celsius and Voyager. Although they may lack all the bells and whistles that a trading platform like Coinbase offers, for those who are interested in a basic long-term buy and hold strategy, they are more than sufficient. Imagine holding bitcoin for the next five years and being able to simultaneously capture price appreciation along with a 5% annual interest payment. That’s extremely compelling.
In fact, the case for paying interest on deposits is so compelling that Gemini launched Gemini Earn, a new interest-generating program that offers customers up to 7.4% APY on cryptocurrency deposits, in early February. Tyler and Cameron Winklevoss have been at the forefront of crypto innovation for years. So, if they are making the leap it’s safe to assume they have identified an opportunity to generate substantial profit. The question is whether Coinbase will launch a similar program and take advantage of a prime opportunity to help diversify its revenue stream.
The looming threat of DeFi
Pressure from other regulated centralized exchanges isn’t the only risk facing Coinbase. DeFi has soared in popularity with total value locked (TVL) hovering at approximately $40 billion. In fact, the growth trajectory of DeFi TVL over the past 12 months is nothing short of spectacular.
Uniswap, the most active decentralized exchange (DEX), recently reached $100 billion in cumulative all-time volume. While that pales in comparison to Coinbase’s all-time volume of more than $450 billion, Coinbase was founded in 2012, whereas Uniswap didn’t get its start until late 2018. Below is a tweet from Hayden Adams, the founder of Uniswap, that shows just how explosive the trading volume at Uniswap has been since the summer of last year.
Uniswap’s native governance token, UNI, currently gives the exchange a token capitalization of approximately $17.2 billion. It is estimated that Uniswap generates approximately $1.2 billion in annualized revenue. Based on that estimate, Uniswap currently has a 14x valuation multiple. Since equity ownership entitles holders to a portion of the company’s profits and a right to vote on the company’s future, it’s not entirely fair to compare token and equity valuations, but this does help to put everything into proper context.
Until more data is available, whether Uniswap, and to a lesser extent Sushiswap, can overtake centralized exchanges like Coinbase is a matter of opinion. It’s entirely possible they can all co-exist, but Uniswap may end up taking a huge bite out of Coinbase’s pie.
Valuation can be more of an art than a science. A lot of factors must be taken into consideration before deciding the exact price tag to put on a business. Coinbase is currently the biggest name in U.S. crypto trading and has certainly earned a premium for that as the market has climbed. However, crypto is an all-out arms race with innovation occurring at breakneck pace. Can Coinbase keep up to justify a $100 billion valuation? Color me skeptical.
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