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Coinbase
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==Regulatory concerns and key risks to our price target and investment view== The nascency of the cryptocurrency industry as well as its overlap with one of the core functions of governments in providing a means of exchange in the economy lead to significant risks to the crypto industry over time. Below we walk through a handful of these risks. Risks of governments moving against cryptocurrencies: One of the biggest risks to our view is geopolitical, as governments usually have sole responsibility for administering local currencies, and a product such as crypto that presents itself as a substitute for government fiat currency could face additional regulation or outright bans in the future. For example, in March 2021, the Indian government was in the process of proposing an outright ban on cryptocurrencies that would prevent the ownership, mining of, and transactions in cryptocurrencies. In addition, the Turkish Central Bank recently decided to ban cryptocurrencies as a form of payment, citing concerns over volatility and the lack of regulation. While we believe the nature of a decentralized system running on the internet would make it very challenging to completely get rid of cryptocurrencies, we believe the biggest lever that governments have at their disposal is the control over the convertibility of fiat currencies into cryptocurrencies. If governments restrict banks from facilitating the convertibility of cryptocurrencies with fiat currency by not allowing banks to do business with crypto firms or to offer depository services to crypto firms, we believe the value of crypto currencies would be negatively affected as their perception by the public as a store of value or a medium of exchange would diminish. This could potentially result in falling crypto prices, which in turn could lead to accelerating pressure on crypto prices, as declining value could lead to further loss of faith in crypto prices, not dissimilar to a bank run in a traditional banking sector where fears over the convertibility of bank deposits into cash leads to withdrawals, leading to a liquidity crunch and a self-fulfilling prophecy of total loss of faith of the bank’s ability to remain solvent. The current state of government regulation is mixed. The United States has recently taken steps to normalize the crypto industry by allowing banks to offer custody for crypto assets and by providing OCC charters to certain custody agents in the industry. In China, the government has been experimenting with central bank digital currencies, a move that has the potential to drive more crypto-native means of exchange activities through state-backed crypto assets, which could be a catalyst for crypto adoption. That being said, it remains unclear whether state-sponsored crypto assets will catalyze or crowd out non-state-sponsored crypto assets over the long term. Risks from US securities regulations: The regulatory status of various cryptocurrencies has been in flux over time and could lead to uncertainty in the future if the regulatory framework shifts. Today, Bitcoin and Ethereum, the two largest cryptocurrencies are officially regulated as commodities in the United States and therefore fall under the CFTC for regulation. That said, the regulatory status of other crypto assets is less clear. For example, in December 2020, the SEC filed a lawsuit against Ripple Labs, the company behind the Cryptocurrency XRP, claiming that the company conducted $1.3bn of unregistered securities sales, implicitly deeming XRP to be a security. This led to a selloff in XRP (Exhibit 62 - although it has more than recovered since then) and resulted in some cryptoexchanges, including Coinbase, to delist XRP. Coinbase noted in their S-1 that they have a policy of not listing assets that are likely to be deemed a security given that the company does not have the regulatory licensing to list such assets. However, because of the lack of clarity around this issue, it is possible that COIN could incorrectly categorize certain cryptocurrencies, as was alleged to be the case with XRP. While this is the most recent example of such issues, we believe that in general, the changing landscape for cryptocurrency regulation will be a focal point among investors. KYC / AML: In the traditional finance space, banks and payment companies play a large role in detecting and preventing money laundering, from reporting large cash transactions to flagging suspicious activity, as well as conducting rigorous “Know Your Customer” (KYC) checks when onboarding new clients. This, combined with the highly ringfenced nature of the USD payments system (with a few exceptions, only banks can hold and transfer Federal Reserve balances) means the US Dollar system and other similar monetary systems have significant safeguards in place to prevent money laundering and transfers of illicit funds. The decentralized nature of cryptocurrencies, on the other hand, means there are fewer inherent checks on potentially illicit behavior, and thus there is a very high bar to clear for cryptocurrency companies to accept fiat currency payments and allow for deposits and withdrawals of fiat currency, because there is a risk that the money being deposited or the cryptocurrency used to fund the fiat currency withdrawals was sourced through extra-legal activities. Crypto is often compared to “digital cash” due to it sharing some of the same features of physical cash, such as being a bearer instrument and not requiring an intermediary to facilitate transactions. The decentralized nature of physical cash without oversight from intermediaries is why physical cash is often used for illicit activities, and the ability to transfer cryptocurrency in large sums across great distances means that there is an even greater risk of illicit activity in cryptocurrencies relative to cash. Thus, there is a much higher bar for KYC/AML controls to ensure compliance. Coinbase is widely reported to have taken a measured and deliberate approach to compliance, having worked with regulators from its beginnings to invest in the infrastructure to satisfy BSA/AML laws and gain access to the US banking system. We expect that as a ~$2tn asset class, governments around the world will continue to place a high degree of scrutiny on compliance regimes at crypto-native companies, and the larger the space becomes and the more regulatory focus it attracts, the greater competitive moat COIN’s approach to compliance should represent. Cybersecurity / custody risk: Many management teams at traditional financial services companies will cite cybersecurity incidents as the risk to the business that “keeps them up at night.” The cryptocurrency industry faces similar issues with the added risk that a cybersecurity incident in which hackers gain access to the private keys of customer crypto wallets can result in the permanent loss of customer funds. The immutability and cryptographic properties of blockchain technology make it effectively impossible for the funds to be recovered when the private keys are lost. While the same cybersecurity concerns that exist at traditional financial institutions, such as personally identifiable information, account numbers, and confidential information also exist for crypto-native companies, a cybersecurity event has the potential to be the digital equivalent of a bank robber gaining access to the bank vault, with the ability to instantaneously transport away the contents. The most high-profile instance of this happening was in the 2014 collapse of Mt Gox, the then-largest crypto trading platform, which became insolvent after the loss of BTC 850k. This issue highlights the importance of a strong custody solution that safeguards assets. Coinbase highlights their track record of having never had a cybersecurity incident that resulted in the loss of customer funds, and we believe the strength of their custody offering represents a key advantage over time, particularly for institutional clients. However, a hack or loss of customer funds wold likely lead to negative impacts on the broader industry, resulting from a loss of confidence in the safety of crypto assets, and also potentially leading to lower crypto prices overall, which would indirectly have ramifications for COIN earnings. Lastly, we note that at a more operational level, downside risks to our positive investment view on COIN include lower levels of crypto volatility and lower commission rates.
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