Summary Coinbase holds a dominant position in the Bitcoin ETF custody market, managing about 90% of the assets in this sector. The approval of Bitcoin ETFs by the SEC presents a significant opportunity for Coinbase to generate revenue and expand its market share. Despite legal challenges, Coinbase's strong position in the ETF market and its proactive steps to address regulatory concerns make it an attractive investment. Investment Thesis I believe Coinbase's ( COIN ) key spot within the quickly growing Bitcoin ETF market emerges as a strong part of the bullish narrative, with the opportunity to custody Bitcoin ETFs and help facilitate trades within these funds as still being underappreciated over 2 months after their launch. Their pivotal role is backed by their staggering 90% market share in Bitcoin ETF asset custody. As financial advisors increasingly eye cryptocurrency allocations, with some projections indicating a willingness to allocate 1-5% of client portfolios to Bitcoin, I believe this sets up a large upside case for Coinbase, especially if they maintain or even slightly reduce their current market share through their Coinbase Prime offering. While Coinbase and their management face a slew of SEC's legal challenges, the company is taking proactive steps to nullify many of these SEC claims, allowing investors to feel more assured about the resilience of the exchange in the long run. Combined with the SEC's history of setbacks in crypto-related cases, presents a much more clear risk profile and an optimistic outlook for Coinbase legal standing. In my opinion, as Coinbase harnesses its market dominance in ETF custodying and carefully navigates regulatory landscapes, the company stands out as a strong buy. Background Earlier in January, the SEC (Securities and Exchange Commission) approved 11 of the first-ever Bitcoin spot ETFs (or what SEC chairman Gensler calls Exchange Traded Products). These ETFs mark a significant milestone in the cryptocurrency industry, with some analysts claiming this could bring in a new era of asset investments for Bitcoin similar to the transformative impact of gold ETFs two decades ago. For reference, Gold ETFs, since their inception, have attracted over $100 billion in assets under management, significantly simplifying gold investment for most investors and helping to substantially increase price (more dollars could now access this precious metals market). Similarly this is what fuels current optimism that Bitcoin ETFs could similarly catalyze a substantial jump in the crypto currency’s value, with some predictions suggesting it could more than double to $150,000. Coinbase, one of the largest crypto exchanges in the US, views these approvals as pivotal for the industry. To capture this, Coinbase entered the business of custodying assets for these ETFs. Where Coinbase Fits In the Opportunity Out of the gate, Coinbase has established a dominant position in the Bitcoin ETF custody market, managing about 90% of the assets in this sector, which amounts to over $37 billion so far. Coinbase is one of just a few institutions in the US who have the capability or regulatory approval to custody these assets allowing the company to have nearly unfettered access to the US market. Coinbase Custody, as a regulated entity and qualified custodian, offers robust security measures and regulatory compliance, making it a preferred choice for institutional investors. It’s with this platform that major traditional finance institutions like BlackRock have been able to bridge the gap between traditional finance and the crypto market, facilitating the growing adoption. For just Blackrock in this case, their ETF fund has swelled to almost $16 billion in AUM since inception. In addition, Coinbase Prime serves as a comprehensive institutional platform providing advanced trading, secure custody, and financing solutions. The platform offers access to a broad range of digital assets, with more than 400 assets available for custody. Coinbase's collaboration with BlackRock and other major players to launch Bitcoin ETFs underscores its significant influence and strategic position in the crypto ecosystem. While I wrote last December about this being a big opportunity for BlackRock ( BLK ), I think there is also a big opportunity for Coinbase. Size Of Opportunity Even with over ~$35 billion flowing into Coinbase custodied Bitcoin ETFs since they were launched in January, I still think there is significant market potential. Within just 20 days of their launch, spot Bitcoin ETFs amassed $10 billion in assets under management ((AUM)), with major contributions from products like BlackRock's iShares Bitcoin Trust IBIT and Fidelity's Wise Origin Bitcoin Fund FBTC. BlackRock's IBIT, in particular, reached $1 billion in AUM within its first week of trading, demonstrating strong investor demand. In another way to look at this, BlackRock's IBIT experienced significant inflows, placing it in the top 7% of all ETFs by market capitalization in just 23 trading days, with total inflows exceeding $5 billion (like I mentioned before they are now up to ~$16 billion). Like I did with my Blackrock research, we have to look at the U.S. wealth management industry, with assets managed by broker-dealers, banks, and RIAs totaling $48.3 trillion , to understand the market for Bitcoin ETFs. Galaxy Research estimates that the addressable market size for a U.S. Bitcoin ETF could reach approximately $14 trillion in the first year post-launch, expanding to $26 trillion and $39 trillion in the second and third years, respectively. While I think Bitcoin ETFs could capture a significant part of assets managed by financial advisors in the US, I know year 1 estimates need to be more reasonable. I think Bitcoin ETFs (given they are at close to $40 billion already) could capture $140 billion in AUM by the end of the year. Financial advisors have said they plan to allocate 1-5% of client assets to Bitcoin ETFs. A 1% allocation of the $14 trillion TAM would be $140 billion. 90% market share implies $126 billion in AUM to custody for Coinbase. At the standard 0.2% custody fee Coinbase is charging, this creates $252 million in annual revenue opportunities. On top of this, Coinbase makes 0.1-0.2% per Bitcoin transaction . Bitcoin ETF volumes have been approaching $5 billion per trading day. While most of this volume is ETF shares being traded back and forth, if just 20% of this volume is investors buying into the Bitcoin ETF funds or redeeming their shares, this means that over $1 billion ($900 million to Coinbase) worth of transactions need to be processed daily. At a midpoint 0.15% transaction fee rate, this means an additional $1.35 million per day in transaction fees. Over the course of one year (252 trading days) this means $340.2 million in additional revenue opportunities. All together, it looks like there is $592.2 million in revenue upside just under current market conditions per year for Coinbase. Keep in mind that the market for these ETFs will likely grow going forward. Valuation Coinbase currently trades at a forward Price to Sales of 12.22 . While this is significantly higher than the sector median, I think this reflects the market partly pricing in the revenue opportunity available from Bitcoin ETFs. If we apply this 12.22 forward price to sales to the forward revenue estimate of $592.2 million, we get a market cap appreciation potential of $7.236 billion, implying about 12.5% upside in stock price from where the company’s market cap is as of the time I am writing this. Why I Don’t Think This Is Priced In While I think institutional revenue for Coinbase will grow going forward, the financials of Coinbase as revealed in the 10-K report suggest a significant downturn in last year's revenue across institutional segments compared to 2022, with total transaction revenue decreasing by 36% year-over-year. Institutional net revenue experienced a 24% decrease compared to the previous year ( 10K ). Transaction Revenue Breakdown (Coinbase 10K) In addition, while EPS estimates for this year have come up from a low of -$2.54 to now $1.57, this is only slightly higher than the EPS the exchange earned in Q4 2023 ($1.04/share). In my opinion, the market is not pricing in the full earning potential of Coinbase. Part of this appears to be missing the opportunities in institutional revenue, specifically the fees from Bitcoin ETF custodying. Risks: SEC Lawsuit The biggest elephant in the room is that Coinbase is currently engaged in a significant lawsuit with the SEC, which sued the exchange for operating as an unregistered securities exchange, broker, and clearing agency. Their lawsuit also includes claims regarding Coinbase's staking-as-a-service program, which the SEC argues should have been registered with the agency. The government’s lawsuit seeks civil penalties and the disgorgement of profits obtained from these activities. Obviously this could be a large downside risk to the exchange. During court proceedings , the SEC contended that the crypto tokens in they are litigating over are tied to larger enterprises, thus resembling investment contracts. According to the SEC's viewpoint, the value of these tokens is linked to the success of the associated network or ecosystem, akin to traditional securities like stocks or bonds. Coinbase's defense has disputed this classification, arguing that buyers of such tokens do not enter into contracts entitling them to proceeds of a common enterprise, which is a typical characteristic of securities meaning these should not be classified as securities. As a counter, Coinbase has taken a strong stance against the SEC's claims, asserting that the Commission does not have jurisdiction over the cryptos listed on their platform. They argue that the SEC's rules are ambiguous and that the SEC is overreaching in its attempt to regulate them. Obviously, the outcome of these proceedings could have far-reaching implications for Coinbase and the wider cryptocurrency market, especially regarding how digital assets are classified and regulated in the United States. As a silver lining Judge Katherine Polk Failla, who is presiding over the case, has previously dismissed a class action lawsuit against Uniswap and acknowledged that ether is a "commodity," indicating a possible favorable stance towards Coinbase's argument that cryptocurrencies should not be classified as securities. While this is definitely a contentious situation (and I am not an attorney) I think the actual risk here may be lower than the perceived risk. For example, while the SEC is suing Coinbase, they have also approved 11 ETFs many of whom custody with Coinbase. I do not think the SEC would approve ETFs to trade on major US exchanges and major financial institutions (like Blackrock) would let Coinbase custody these assets if they believed that the custodian would be wiped out in a lawsuit. Bottom Line While Coinbase, amidst its legal wrangles, stands in front of the burgeoning Bitcoin ETF market, presenting what I think is a very promising picture. The crypto exchange’s commanding 90% custody share positions them well to capitalize on this growing market, potentially promising asymmetric revenue streams from custody fees and trading volumes amid forecasts of a substantial market expansion. Given the opportunity, I think Coinbase presents a strong buy. I’m excited to see where the Bitcoin ETF market evolves from here and what Coinbase’s growing involvement looks like.
