Last week, the U.S. Securities and Exchange Commission (SEC) formally sent Coinbase Global (COIN -0.34%) a Wells notice, informing the company that it was considering possible enforcement action. It now appears the SEC will challenge the ability of Coinbase to offer crypto staking services to investors.
After the SEC went after cryptocurrency exchange Kraken earlier this year for staking, it was perhaps inevitable that it would soon turn its attention to other cryptocurrency exchanges such as Coinbase.
As might be expected, investors quickly aligned themselves into two basic camps, as soon as the SEC news came out. The "sky is falling" crowd thought this was the end of the line for Coinbase, and shares of the cryptocurrency exchange promptly fell by 16%. But another camp thought the uncertainty created by the SEC presented a unique buying opportunity. Ark Invest's Cathie Wood, for example, bought the dip, scooping up nearly $18 million worth of Coinbase stock.
The debate over crypto staking
Before you even consider buying Coinbase stock, it's important to understand the fundamental debate that's taking place right now within the world of crypto. Basically, it all comes down to one question: Is crypto a security or a commodity?
This is the question that's at the core of every major crypto debate, including the current one taking place around staking. If crypto were any other industry, this would be a very simple question to answer. But crypto isn't every other industry because there's no unifying regulatory framework.
Image source: Getty Images.
Since that's the case, market participants need to rely on legal precedent, and the one precedent that everyone uses is the Howey Test, which dates back to a 1946 Supreme Court case. The Howey Test, while completely unrelated to anything pertaining to crypto, lays out a four-part test to determine whether a financial instrument should be considered a security. It might sound absurd, but almost everyone agrees that this 77-year-old Howey Test is the best thing we've got right now to evaluate crypto.
When Coinbase recently sent the SEC an 18-page rule-making petition, for example, this is exactly the framework that Coinbase used to make its arguments. The company worked through each point of the Howey Test and concluded that there's no way that staking could ever be considered a security.
For example, Coinbase explained that staking doesn't meet the "common enterprise" or "investment of money" definitions outlined in the Howey Test. And Coinbase offered several legal precedents that might be more appropriate than the Howey Supreme Court case.
If you think Coinbase is right, then you're probably in Cathie Wood's camp and might be tempted to buy the dip. But if you think Coinbase doesn't have a real case, then this stock might be too hot to handle right now.
Why staking matters to Coinbase
This debate over crypto staking has several potential implications for Coinbase. For one, staking is an increasingly important source of revenue.
In 2020, staking accounted for less than 1% of total revenue at Coinbase. By the end of 2022, it accounted for more than 10% of total revenue. If the SEC wins this debate, Coinbase is going to lose a small, but not insignificant, new source of revenue.
But there are deeper implications, as well. If the SEC wins this debate, it might start to challenge whether many of the more than 240 cryptos currently available for trading on Coinbase are actually securities. In 2022, the SEC said that it might even go after Ethereum (ETH 1.22%), the world's second-largest crypto, for being a security, so this matter is not easily dismissed. Theoretically, if "staking" is a form of security, then it would make sense that any proof-of-stake crypto that uses staking (such as Ethereum) would also be a security.
This could be why the market reacted so swiftly to news of the Wells notice. It sensed that the SEC's moves against staking actually have much deeper implications.
Currently, if you look at the most popular cryptos for trading on Coinbase, the only ones that would likely escape the debate over staking would be Bitcoin (BTC 0.97%) and Litecoin (LTC 1.25%), both of which are still proof-of-work cryptos. Right now, Bitcoin accounts for about 40% of all crypto trading on Coinbase, while Litecoin accounts for another 2%.
So imagine a world in which the only reason you use Coinbase is to trade Bitcoin. That would potentially pose an existential crisis for the company. I think that's why Coinbase has planted a flag in the ground here and said that it would challenge the SEC head-to-head on this issue. The stakes (ahem) are just too high.
Should you buy Coinbase?
From my perspective, Coinbase remains an undervalued stock, trading around $62. Even though it's up nearly 80% year to date, it's still well under its initial public offering (IPO) price of $381, nearly two years ago. Like Cathie Wood, I think there's still more upside potential ahead, as long as Coinbase can stay in the good graces of the SEC.
That being said, I have a healthy regard for the SEC and can understand why some investors are nervous right now. That's why you must do your due diligence on this stock. The debate over crypto staking might sound mind-numbingly boring, but it's actually an incredibly important debate with profound implications for the future of crypto.
