Will Coinbase be a Good Investment?

Coinbase has dethroned Uber as the king of the unicorns (companies awaiting initial public offerings). The internet is abuzz with chatter about a Coinbase IPO, and our friends at Seeking Alpha are even listing a Coinbase ticker symbol even though the company is still privately-held.

All that speculation brings us to two important questions: is Coinbase making money, and would Coinbase stock be a good investment? Unfortunately, there is no easy answer to those questions only more speculation.

There are some strong indications that Coinbase is making a lot of money. The cryptocurrency exchange and digital wallet company has so much cash to burn it set up a hedge fund to invest in cryptocurrency and blockchain startups called Coinbase Ventures.

Coinbase Tries to Expand Market for Cryptocurrency

“We’re going to invest off our balance sheet into crypto companies,” Coinbase President and Chief Operating Officer Asiff Hirji told the talking heads on CNBC’s Fast Money. “We will invest in companies that are in the space and are aligned with our values.”

Coinbase Ventures will make early investments in new cryptocurrency companies and technologies. Hirji did not name any investments but said the Coinbase Ventures fund will start with $15 million for seed money.

One hope of Coinbase Ventures will be to give companies developing ERC20 protocol tokens and Ethereum blockchain platforms money to expand their businesses. That would presumably help Coinbase make more money by increasing the demand for Ethereum (ETH); one of the cryptocurrencies Coinbase accepts in its wallet. ERC20 protocol tokens can be converted into Ether (ETH).

“We are not investing in currencies because we do not want even the appearance of a conflict of interest,” Hirji said. Coinbase Ventures will invest in companies and not cryptocurrencies or initial cryptocurrency offerings (ICOs), Hiriji made clear. The fund’s existence lends credence to reports that Coinbase has more money than it knows what to do with.

Coinbase wants to become a Brokerage

Coinbase is trying to get a license as a brokerage firm, Digital Trends reported. The company has reportedly asked the Securities and Exchange Commission (SEC) if it would approve a brokerage license for it, The Wall Street Journal claimed.

That sounds as if Coinbase is trying to get legal cover for its activities and avoid being banned like cryptocurrency exchanges in South Korea and the People’s Republic of China were. Another catastrophe Coinbase wants to avoid with the SEC’s stamp of approval is a ban on bank processing of cryptocurrency payments. The Federal Reserve Bank of India just enacted such a ban. The ban effectively shut cryptocurrency exchanges in India off from the banking system.

Other goals are to give Coinbase more protection from lawsuits and to make it easier to hold an IPO. Few people would buy stock in a company whose business can be banned or shut off from the banking system. A brokerage license might make it easier for Coinbase to add cryptocurrencies including ERC20 tokens, Ripple (XRP), and bank-issued cryptocurrencies like Utility Settlement Coin (USC) to its offerings.

A long-term goal would be to issue stock-based cryptocurrencies, annuities, and offer cryptocurrency-based products to exchange-traded funds (ETFs), retirement funds, and mutual funds. It would also make it possible for brokers and investment advisors to sell Coinbase products or securities to the public.

Can Coinbase’s Business be expanded?

It might be possible to expand Coinbase’s current business to the size necessary to serve a mass market. The company is already having problems serving its existing customers, yet it wants to embark upon a vast expansion.

Coinbase served around 4.3 million users in December 2017, and it was as slow as the devil. It takes around a week for Coinbase process a simple Ethereum (ETH) transaction buying a small amount with my account.

The reason for that is the blockchain scalability problem. Current-generation blockchains are built from pieces or blocks of encrypted software that have very severe size limits. That means the number of transactions they can process is very limited.

The best estimates are that Ethereum blockchains can process between 12 and 20 transactions a section depending on which expert you ask. That means it would simply be impossible for Coinbase to handle several hundred Ethereum transactions a minute let alone a second.

There is no way Coinbase can open a brokerage for Ethereum or take Bitcoin (BTC) payments for several hundred websites at once. You can also forget about a functional Coinbase Visa debit card or bank account.

Current blockchain technology is so slow Coinbase might run afoul of the banking laws simply because it could not process funds fast enough to comply with them. The Federal Deposit Insurance Corporation (FDIC) requires banks to have a certain amount of liquidity, present blockchains are too slow to provide that liquidity.

Has Coinbase Solved the Scalability Problem?

This situation will lead many people to wonder if Coinbase has solved the scalability problem or knows of an impending solution.

A lot of smart people including Ethereum creator Vitalik Buterin are working on such a solution. The Lightning Network is testing sidechain technology designed to greatly speed up Bitcoin processing. A sidechain is a solution to the scalability problem in which engineers build a less secure path around the blockchain called a sidechain through which certain transactions are supposed to move.

The road to working sidechain technology is hard a Lightning Network wallet called Éclair was removed from Google Play just days after it went live life, The Merkle reported. The wallet was removed because the team that built it lost part of the necessary software, a signing key.

Such bungling puts Coinbase Ventures in a new light. The fund might be a desperate effort to find a solution to the scalability problem by bankrolling the efforts of lots of software developers. That sounds like a pretty poor business plan.

Investors would be well advised to stay away from Coinbase until the scalability problem gets solved. Until then there are better Fintech Stocks with technology that actually works out there. Two good ones are PayPal (NASDAQ: PYPL) and Square (NYSE: SQ).

Once the scalability problem has been solved, Coinbase might become a value investment. Until then it is simply an interesting experiment in blockchain technology and should be avoided by all but the richest investors.