(Veteran tech analyst Jon D. Markman publishes Strategic Advantage, a guide to investing in the digital transformation of business and society. Click here for a free trial.)
It was inevitable. With cryptocurrency heating up, regulators want to make sure that bad actors can be monitored. Unfortunately that is a problem for early crypto advocates like Square Inc. ( (SQ) - Get Report).
Managers at the San Francisco, Calif.-based company wrote Monday to government regulators. They want plans for closer scrutiny of crypto transactions to be shelved. That is wishful thinking.
It’s also the Achilles heel of Square’s digital currency strategy.
Bitcoin, the biggest cryptocurrency, has been on fire. The digital coins have risen 40% in value since December 20. Financial institutions are starting to take larger positions. The rise is merely a function of supply and demand. There is too little bitcoin to meet the demand of intuitional-scale buyers.
Square was very early to the crypto party. Jack Dorsey, chief executive officer, above, is on record in 2018 as a strong advocate for bitcoin. He engineered the purchase of $1.5 billion worth of bitcoin in 2020 to facilitate its use inside the Square ecosystem. Dorsey got it right and Square shareholders have been the beneficiary spectacularly.
Square shares were up 245% in 2020 even as small businesses, its core constituents, were decimated by COVID-19 and the shuttering of the economy. Investors see Square as a crypto play.
Authorities at the U.S. Financial Crimes Enforcement Network don’t care about Square shareholders. FinCEN wants the company to begin keeping detailed records of its bitcoin transactions.
The new rules are essentially an enhanced “know your client” implementation. KYC rules require financial institutions to keep records of their customer’s identity, the suitability of investments, and large transactions. FinCEN wants Square and others to record digital wallet withdrawals of greater than $3,000. Transactions greater than $10,000 would have to be reported directly to FinCEN.
The Square rebuttal letter claims the new regulations will lead to unreliable data about customers that have not even signed up as Square customers. Further, managers are concerned their digital wallet customers will move elsewhere. That’s a fair assessment. Undoubtedly many cryptocurrency holders are drawn in by the idea of anonymity.
Again, FinCEN does not care what crypto swappers want. Its purview is putting up roadblocks to money launderers and other illegal activities.
And that is the crypto problem in a nutshell. As digital currencies become more mainstream they bring more scrutiny. It’s not a matter of if this will come. It is when.
A big part of the allure of Square stock is the early adoption of bitcoin. Today Square digital wallet customers can buy and sell bitcoin for their own account. Small businesses can also accept fractional amounts of bitcoin as currency for goods and services. Square, along with PayPal ( (PYPL) - Get Report), its digital wallet competitor, has an elegant cryptocurrency solution.
As new FinCEN regulations are implemented everything will get messier.
Outside of crypto, the outlook for Square is bright. The company has built significant businesses in payment processing, point of sale and business services, software, and financial services. Square even provides financing to small businesses.
During an investor presentation in September 2020 Dorsey claimed that the total addressable market in the United States alone represents $85 billion. This optimism is reflected in the current valuation.
Square shares trade at 197x forward earnings and 12x sales. The market capitalization has risen to $101 billion. For context, American Express ( (AXP) - Get Report) shares trade at 17x forward earnings, 2.3x sales and its market capitalization is only $93 billion.
Shareholders of Square should worry about a near term price correction as the FinCEN headlines take center stage. The stock would be attractive in the $180 range.