Coinbase Investors Beware: There Is Serious Cause for Concern Ahead

Down more than 81% from its all-time high and yet up by more than 88% since the beginning of 2023, Coinbase Global (COIN 10.62%) is in a peculiar position. Benefitting from the recent rally in the crypto market, Coinbase's price jumped significantly in the last few months as a renewed sense of optimism has investors hoping that the worst might just be over. 

However, there is reason to believe that bumpy and dangerous roads are ahead. 

After a tumultuous and controversial 2022, which was riddled with multiple cryptocurrency companies going bankrupt, U.S. regulators have ratcheted up pressure on the crypto industry as a whole. This could be bad news for Coinbase.

Regulators turn up the heat

At the beginning of February, the Securities and Exchange Commission (SEC) reached a settlement with the cryptocurrency exchange platform Kraken after alleging that their staking service met the criteria of an unregistered security. As a result, Kraken was forced to discontinue its staking product and pay a fine of $30 million.

More recently, New York Attorney General (NYAG) introduced a lawsuit with KuCoin, another cryptocurrency exchange. Similar to the SEC-Kraken case, the state of New York alleges that KuCoin's staking products are technically unregistered securities and, as such, are currently out of compliance.

Furthermore, the NYAG took the allegations a step further and claimed that not only were the staking products technically securities, but that the world's second-most valuable cryptocurrency, Ethereum (ETH 5.90%), also met the criteria of a security. 

This is where things could get particularly troublesome for Coinbase.

The staking problem

To diversify revenue outside of just transaction fees, Coinbase has prioritized building out its staking services and intends to become "the best platform to generate rewards on crypto."

Potentially even worse for Coinbase is the NYAG's allegations that Ethereum is technically a security. If this is judged to be true, it could deal a serious blow to Coinbase's future profits. 

The reason why is due to a planned Ethereum upgrade scheduled for 2023 and Coinbase's dependence on the cryptocurrency to generate revenue. 

The new upgrade, known as Shanghai, would allow those who stake Ethereum to withdraw their funds. Currently, users are unable to do so, and as a result, the number of users who stake Ethereum is drastically lower than other proof-of-stake cryptocurrencies which allow withdrawals, like Cardano or Solana. 

In a recent report by J.P. Morgan, analysts found that around 25% of all trading volume on Coinbase is Ethereum-based. The company generates roughly $50 million from clients currently staking the cryptocurrency. J.P. Morgan analysts continued that with the promise of Shanghai looming, Coinbase could significantly bolster profits if it leads to an increase in users looking to utilize the exchange for their staking needs.

J.P. Morgan estimated that on the low end, profits could increase to $225 million and possibly even up to $545 million if 95% of retail investors currently using the platform decide to stake their Ethereum.

But this could all come crashing down. There are arguably too many question marks around Coinbase's Ethereum staking. It's a potentially significant money-making project, but regulators have to pin down their approach to this stuff in order to make it an investable quality. If Ethereum is deemed a security in the NYAG case and the SEC decides to zero in on Coinbase, it could deal a serious blow to Coinbase's future revenue growth.

While much remains unknown in the regulatory environment, it might be best to hold off on adding any Coinbase to portfolios until a clearer picture comes into focus. There are plenty of alternatives available to crypto investors who want a proper stock in the digital asset sector, after all.

JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. RJ Fulton has positions in Cardano, Ethereum, and Solana. The Motley Fool has positions in and recommends Cardano, Coinbase Global, Ethereum, JPMorgan Chase, and Solana. The Motley Fool has a disclosure policy.