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Coinbase Has Been on a Wild Ride This Week. GameStop Dynamics Are at Work. -- Barrons.com

Barron's · 01/06/2023 11:36
By Jack Denton

Coinbase Global and other beaten-down cryptocurrency stocks ripped higher on Wednesday, only to fall sharply on Thursday. Analysis of the wild ride suggests that "short squeeze" dynamics in a volatile market are at play, and could continue.

Crypto broker Coinbase (ticker: COIN) jumped 12% on Wednesday, only to fall right back down on Thursday, plunging 11%. The stock was flat in early Friday trading as investors got a bit of a breather from the rollercoaster.

It was much the same for other stocks exposed to digital assets. Shares in Silvergate Capital (SI) -- a banker to crypto investors -- surged 27% on Wednesday as MicroStrategy (MSTR), a software company that holds significant Bitcoin in its corporate treasury, rose almost 14%. Both stocks later gave up the eye-popping gains.

There was little material news to prompt the violent moves. An exception came from Coinbase, which settled a case with New York financial regulators, agreeing to pay a $50 million penalty and invest $50 million over two years into its compliance program. While that news is meaningful -- removing some regulatory uncertainty for investors, who were aware of the investigation -- it's not a factor warranting a double-digit rally.

Unexplained, drastic gains on a day when the S&P 500 rose less than 1% should raise eyebrows. Understanding what the stocks have in common makes the situation clearer.

They all, in one way or another, are exposed to crypto prices and the industry at large. In fact, this is a group of stocks that largely trades in lockstep with the price of Bitcoin -- which has been remarkably stagnant of late, hovering between $16,500 and $17,000 for weeks now.

It's likely that the same dynamics that propelled GameStop's (GME) iconic rocket higher amid the 2021 meme stock frenzy are at work. This is a so-called short squeeze, where technical market factors cause often-explosive market moves. It has happened before at Coinbase.

In order to bet against -- "short" -- a stock, investors have to borrow the underlying shares and then sell them, wagering that they can be repurchased at a lower price. The trade involves pocketing the difference between the price at which the shares were borrowed and the price at which they were returned.

If the bet goes wrong and the price rises, investors can come under pressure and some may opt to repurchase and return the shares at a higher price, taking a loss. If shorting a stock is a crowded trade, then short sellers might end up clamoring to buy up the same shares, "squeezing" the price higher.

And shorting crypto stocks is a very, very crowded trade. More than 28% of the free float of Coinbase is sold short, according to financial data group S3 Partners. It's even higher at Silvergate, which has 51% short interest, and MicroStrategy, with 35%. The average short interest among U.S. stocks is just over 5%.

"There are not very many shares left to borrow -- short sellers are starting to run out of bullets," says Ihor Dusaniwsky, a managing director at S3 partners.

It has been a profitable trade so far. Investors short-selling these three stocks in addition to two others -- Bitcoin miners Riot Platforms (RIOT) and Marathon Digital (MARA) -- recorded an average return of up to almost 32% over the past month, according to S3. Recently the trend has shifted, with squeezes marking a reversal in fortune and ushering in an average loss of 20% over the past week.

"The stocks are getting much more squeezable due to these recent large mark-to-market losses," said Dusaniwsky, "but there is still a cushion of recent profits that should help short sellers hang on to their positions for a while longer even though they are getting smacked around pretty hard over the last week." While the move lower on Thursday alleviated some of pressure, these stocks are still vulnerable to a squeeze.

For Coinbase at least, investors would be wise not to read too much into the regulatory news that inspired this week's ride higher.

"Anytime a stock has high short interest, like Coinbase does, it's subject to volatility. For the last couple of months it's been on a deep and steady downward trajectory. It caught a squeeze on that news," says Ryan Coyne, an analyst at Mizuho Securities. "The way we thought about it [on Wednesday] was that...the problems at Coinbase still exist -- it doesn't cure any of their financial problems."

While a settlement with the New York Department of Financial Services is a boon to Coinbase, the company has disclosed an investigation from the Securities and Exchange Commission. The implosion of FTX has also left Congress and state regulators with a dim view on the industry, which some say is overdue for a crackdown.

"Given the events in the last couple of months, the industry is viewed as a little bit toxic. There's distaste among consumers and there's obvious distaste at the regulatory level at this stage," says Coyne. "There's a lot more crackdown that we expect to come in the future."

Write to Jack Denton at jack.denton@barrons.com

(END) Dow Jones Newswires

January 06, 2023 11:36 ET (16:36 GMT)

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