Coinbase Wants Wall Street to Resolve Its Bitcoin Trust Issues

(Bloomberg) -- A cheer went up in the San Francisco offices of cryptocurrency exchange Coinbase Inc. when bitcoin breached $10,000 in November. But the 225-employee startup has a goal beyond price. The company wants to use digital money to reinvent finance.

In Coinbase’s version of the future, loans, venture capital, money transfers, accounts receivable and stock trading can all be done with electronic currency, using Coinbase instead of banks.

Coinbase Wants Wall Street to Resolve Its Bitcoin Trust Issues

But first, Coinbase, already popular with individual traders, needs to legitimize itself -- and bring in revenue -- by convincing big money managers to trust it enough to trade on its exchange. That means giving institutions what they want, including a safe place to stash their cryptocurrency. It also has to reassure regulators that bitcoin isn’t a silk road for hackers, money launderers and tax evaders.

“How do we get institutional money to flow into this space?” said co-founder and Chief Executive Officer Brian Armstrong, 34. “It would help grow the whole industry. It would create more trust, surety, maybe reduce the volatility of it over time.”

Founded in 2012, Coinbase’s offices still buzz with startup charm: a beer fridge, a game room, plenty of company swag. A cowbell calls employees to weekly “code school” on Fridays, and the guest wifi password is “openfinancialsystem!”

Glimmers of Maturity

Despite the table tennis, Coinbase shows glimmers of maturity. More than 10 million customers have used the company since it began, though it recently quit updating the tally on its website. About $57 billion of digital currency has traded on the exchange so far this year. It doubled its staff in that time and expects to do so again in 2018. Ultimately, Coinbase plans to go public.

Coinbase Wants Wall Street to Resolve Its Bitcoin Trust Issues

Just three years ago, the company was working out of a one-bedroom apartment. It’s raised $217 million from investors such as Andreessen Horowitz and the New York Stock Exchange. It operates a platform for more sophisticated traders called Global Digital Asset Exchange, or GDAX, and is opening a New York office to lure Wall Street business. It’s also looking to hire the battle-hardened engineers who’ve prevented technical problems at major stock exchanges.

“This is not a couple dozen kids in a garage kind of hacking away,” said Adam White, who runs GDAX. “We recognize we’re protecting people’s money.”

Mt. Gox

The firm said it’s prevailed against security threats, helping it avoid the fate of Mt. Gox, the world’s biggest bitcoin exchange before shutting its doors in 2014 after $480 million of customer funds went bye-bye. Coinbase stores 98 percent of users’ digital currencies in offline safe-deposit boxes. The remaining 2 percent, which is vulnerable because it’s online, is covered by insurance. The company holds more than $10 billion in digital assets.

While individual investors make up most of Coinbase’s customers, a handful of institutions drive a majority of trading volume, White said. Most of those firms are small hedge funds, and the company is pushing to land customers such as Goldman Sachs Group Inc., Armstrong said.

Before diving in, big institutions need clear regulatory rules, safe places to store their assets and exchanges that don’t crash or get hacked, said Paul Veradittakit, a partner at cryptocurrency hedge fund Pantera Capital.

Coinbase Custody

In traditional finance, custody banks like State Street Corp. hold securities, keep records and provide other services for investment advisers. A lack of similar offerings in the cryptocurrency world has kept many institutions on the sidelines.

Coinbase Wants Wall Street to Resolve Its Bitcoin Trust Issues

Coinbase has offered a solution: crypto custodial services, slated to roll out next year. Called Coinbase Custody, it’ll be available to investors with at least $10 million in deposits.

State Street has considered expanding into digital-currency custody, according to Hu Liang, the bank’s former head of emerging technologies. That could give Coinbase a formidable competitor.

The new product line has doubters. One of them is Morgan Hill, principal at cryptocurrency hedge fund AxionV.

Circle of Trust

“If you’re a huge hedge fund and you have almost a billion or a half billion in assets, are you really going to want to trust your money with Coinbase?” Hill said. “I like their concept. I just don’t know how attractive it’s going to be to everyone.”

Ari Paul, chief investment officer of BlockTower Capital Advisors, disagreed, arguing that Coinbase’s special expertise in cryptocurrency makes it an ideal custodian.

Coinbase Wants Wall Street to Resolve Its Bitcoin Trust Issues

“They’ve been the largest hacking target in the world for a long time and they’ve proven they can handle it,” Paul said. “And they’ve built strong relationships with regulators.”

When it comes to regulation, the industry is rife with gray areas, making it tough to navigate.

IRS Probe

“There’s no such thing as a compliant crypto company,” said Marco Santori, a partner at Cooley LLP who leads the law firm’s fintech practice. “We’re doing the best we can with limited resources and limited direction from the courts and limited direction from regulators.”

Last month, Coinbase lost a bid to block an Internal Revenue Service investigation into whether some of its customers failed to report their gains. The company has 30 days to decide whether to appeal the Nov. 29 ruling.

Coinbase also drew scrutiny from the Commodity Futures Trading Commission after a June flash crash on its GDAX exchange erased most of the value of ether, the second-biggest cryptocurrency, before it recovered. Mike Lempres, the chief legal and risk officer, said Coinbase continues to talk with the regulator, which is focused on what role margin-trading might have played in the plunge. The company at the time allowed customers to use borrowed money to make bigger bets.

Margin Risk

The CFTC is also looking into whether customers were experienced enough to take on the risk of margin-trading, Lempres said. To qualify, they were supposed to have met at least one of several requirements under federal law. For instance, individuals were supposed to invest more than $5 million in financial markets and use the margin accounts to hedge risks.

Three traders who lost money margin-trading on GDAX told Bloomberg they didn’t meet the requirement. One said he’d used half the gift money from his wedding to buy ether before the crash.

Coinbase Wants Wall Street to Resolve Its Bitcoin Trust Issues

Coinbase reimbursed users for their losses and discontinued margin-trading after the incident. The company wasn’t legally obligated to double-check on whether customers met the requirements. Coinbase said it’s working to bring back an improved margin-trading program.

Developing ties with banks is one of the biggest challenges. Coinbase doesn’t publicly disclose its banking relationships, but a person familiar with the matter said the company is partnering with Cross River Bank, Metropolitan Bank and Silvergate Bank in the U.S.

“We’re going to be successful not because the price goes from $10,000 to $100,000,” said Dan Romero, who runs Coinbase’s trading platform for individuals. “It’s because we have millions of customers who trust us.”

©2017 Bloomberg L.P.