When Will Coinbase Shorts Capitulate?

As Coinbase shares continue to defy gravity, I wonder about the pain threshold of the remaining (and likely still sizable) shorts and strive to make fundamental sense of what’s happening.

Coinbase Stock Rally

This year, Coinbase stock soared nearly four times, far outperforming both Bitcoin and virtually all other assets. It has almost doubled from its low a month ago.

Coinbase (USD)

However, in the longer timeframe, Coinbase remains depressed, being over 60% cheaper than its historical maximum price seen in 2021. Coinbase is now at the level last reached in April 2022, identical to Bitcoin's current price, which is also like that of April 2022. However, Coinbase has significantly underperformed compared to Bitcoin, likely due to its overstated IPO price in 2021.

Coinbase (black) and Bitcoin (orange), both normalized at 100 as of end-2021

Surprisingly, this year's huge rally has failed to intimidate traders betting against the stock, as short interest remains very elevated (it was 12.8% of the free float as of November 15). As Coinbase plunged in 2022, the short interest soared, but less than half of these shorts have managed to escape so far this year. Based on the chart below, many short positions were taken at levels 2-3 times below the current price of $141 (the chart is up to November 15, when the latest short interest data was available, and the last stock price was $98, so the actual short interest may be lower due to subsequent stock growth, but the overall thesis about elevated shorts probably still holds). I wonder about the pain threshold of the remaining (and likely still sizable) shorts, but the shorts do seem like fuel for further growth."

Coinbase stock price (USD, left axis) and short interest (millions of shares, right axis)

Reasons to Rise

The most likely catalyst behind the November rally of Coinbase shares appears to be the expectation of spot Bitcoin ETFs, for which Coinbase is slated to provide custody and other related services. As reported by CoinDesk in the article “Coinbase Is Dominating a Key Bitcoin ETF Service,” the race to provide a crucial infrastructure component for Bitcoin (BTC) ETFs – namely, custody services – has been largely dominated by Coinbase (COIN). The crypto exchange has secured this role from nearly every firm aspiring to list an ETF, including prominent names like BlackRock, Franklin Templeton, and WisdomTree. Despite the typically low fees associated with ETFs, Coinbase may earn more from future spot Bitcoin ETFs than the ETF providers themselves.

More broadly, Coinbase seems to be a primary beneficiary of the increasing integration of cryptocurrency into traditional finance. Among major crypto exchanges, Coinbase has the closest ties to the US financial system, which is not only the largest traditional financial system but also deeply connected with the technology sector. The US technology sector is unparalleled in size and advancement globally. Estimates from a major investment bank suggest that Coinbase dominates crypto trading in the US. Unlike other crypto exchanges, Coinbase boasts audited financials and credit ratings, and its stocks are traded on US exchanges. Should US financial institutions venture further into crypto, Coinbase is poised to be their go-to choice. Its involvement in custody for spot Bitcoin ETFs may be just the beginning of the array of new products it offers to traditional finance.

Contrasting the situation at the end of last year, where US regulators seemed almost at war with crypto, this year has seen notable victories for the crypto industry over these regulators. A prime example is Ripple's victory in its longstanding legal battle with the U.S. Securities and Exchange Commission (SEC), establishing that XRP is not a security. Furthermore, asset managers have discovered loopholes to launch new crypto ETFs, including what now seems to be almost guaranteed spot Bitcoin ETFs. These victories are paving the way for broader crypto adoption in the US, which is likely reflected in the rally of Coinbase's stock.

Additionally, the recent regulatory actions against Binance in the US appear to bode well for Coinbase, which is more regulated than other major crypto exchanges. If other major exchanges heighten their Anti-Money Laundering (AML) and other controls, Coinbase could become less disadvantaged and potentially gain market share as the safest crypto exchange.

While exchange tokens offer less business insight than stock prices, it’s unsurprising that Coinbase shares have vastly outperformed the native tokens of Binance and OKX this year. However, in the longer term, the OKX token remains a significant outperformer.

Coinbase stock (black), BNB token (yellow) and OKB token (green), all normalized at 100 as of end-2022

Is Coinbase Worth It?

Coinbase may appear undervalued as it is significantly below its 2021 highs, but it currently trades at around ten times its annual sales. Moreover, it is expected to report negative net income in the next few years, according to the current consensus forecast, which may be somewhat slow to adjust. From a fundamental perspective, Coinbase is not cheap by most metrics, unless one assumes a massive surge in crypto prices or the successful launch of numerous profitable new products by the company. While this is not impossible, as argued in the previous section, it does necessitate an optimistic outlook.

However, it's important to note that nearly all US technology companies might be overvalued at current prices, and in this context, Coinbase may not be the most overvalued. Valuation, it should be cautioned, is not a precise tool for timing market movements, and the current bubble could persist for some time. Large-cap tech stocks, in general, seem to be more overvalued. For example, Apple, which has seen limited growth after reaching a mammoth size, still commands high multiples and could arguably be more expensive than Coinbase. Nonetheless, if or when the tech bubble bursts – which I believe is a probable scenario sooner or later – Coinbase is likely to be impacted as well.

For those who are optimistic about the future explosive growth of Bitcoin, or seek to hedge against it, Coinbase might offer even greater upside potential than Bitcoin itself, particularly considering the substantial short interest previously discussed. Additionally, the at-the-money implied volatility of Coinbase has significantly decreased and remains relatively contained despite the recent rally. Having once been much higher than that of BITO (ProShares Bitcoin Strategy ETF), the implied volatility of Coinbase is now only modestly higher. Though I would be cautious about buying calls after such a rally, for those betting on or hedging against further explosive growth in Bitcoin, Coinbase might still present an opportunity.

At-the-money implied volatility of Coinbase (white) and BITO ETF (orange)

Conclusion

The recent rally in Coinbase shares in November is largely attributed to expectations around spot Bitcoin ETFs, for which Coinbase is expected to provide custody and other related services. This aligns with the broader trend of Coinbase benefiting from the growing adoption of cryptocurrencies by traditional finance sectors.

Despite appearing undervalued compared to its 2021 highs, Coinbase is considered expensive by most fundamental metrics. However, it's important to note that this valuation is in the context of a broader market where nearly all U.S. technology companies are likely overvalued at current prices. Hence, Coinbase may not be the most overvalued among its peers. It's worth mentioning that market valuation is not a precise indicator for timing market movements, and the current overvaluation trend could persist for an extended period.

Contrary to expectations, this year's significant rally has not deterred traders who are betting against Coinbase, as indicated by the still elevated short interest in the stock. For investors who are optimistic about Bitcoin's future explosive growth, or those looking to hedge against it, Coinbase might present an appealing opportunity. This potential is underscored by the sizable short interest and the relatively contained implied volatility of Coinbase shares, which is only modestly higher than that of BITO (ProShares Bitcoin Strategy ETF).

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