Welcome to Episode 138 of Special Situation Investing.
My quest for high returns has me forever on the hunt for low capex and high margin businesses. Royalties are the ultimate low capex business model, and we write about them here all the time, but financial exchanges are another business type that satisfies the requirement. The only trouble with exchanges, if you can call this a problem, is that everyone else knows they’re great businesses too, and they’re priced accordingly. Most investors know that ICE and CME are fantastic companies and that knowledge is reflected in their P/E ratios and market caps.
Several weeks ago, my search for a small, underfollowed, or little known publicly traded exchange led me to Bakkt. Bakkt was created by Inter Continental Exchange in 2018 to “connect the digital economy of the future,” and from its inception, it had the distinct advantage of access to ICE’s existing infrastructure. Over its history, the company notched up some impressive accomplishments, to include its launch of the first physically settled bitcoin futures contract in 2019. But while Bakkt has succeeded in some areas, it has languished in others.
Bakkt’s main trouble seems to have stemmed from its inability to stay focused on a single line of business. Early on, the company partnered with Starbucks through a consumer-facing app that enabled point-of-sale crypto payments. Bakkt also created a product that allows consumers to spend loyalty points as if they were currency. For a time, retail investors could trade select crypto currencies on the Bakkt app, but today the compan’s focus is back on institutional trading. Change appears to be the only constant at Bakkt, and you can read through stacks of the company’s reports and still come away wondering what they do and what their priorities are.
Bakkt’s ongoing identity crisis is reflected in the treadmill of CEOs that have run it over its relatively short six year history. The string of CEOs begins in 2018 with Kelly Loeffler, the wife of ICE CEO Jeffrey Sprecher, who served in the CEO role until her appointment to the US Senate in 2020 and continued with interim CEO Mike Blandina. From April of 2020 through January of 2021, David Clifton filled the CEO role but he to was replaced in short order by Gavin Michael. Gavin Michael remained in the position from January of 2021 through March of 2024 when Andy Main, the companies current CEO, took over the job.
For all of Bakkt’s shifting priorities and changing leadership, one message has remained consistent over the years. The company wants clear and predictable regulation for the crypto space, particularly in the US. This is one theme that comes up repeatedly in quarterly conference calls and annual reports regardless of who’s sitting in the head office.
To be fair to Bakkt, what looks like a lack of clear priorities on the surface has, in many cases, merely been the company’s best attempt to adapt to ever-changing regulatory standards. In April of 2023, Bakkt purchased Apex Crypto, a rival consumer facing crypto trading app, but was forced to cut the number of coins offered on the platform after the SEC cracked down on coins that did not pass the Howey Test. According to a 2023 article in Forbes:
Meanwhile, domestic exchanges have been essentially forced to delist those tokens. Just a couple of months after completing a $155 million acquisition of rival Apex Crypto, the New York–based digital-assets trading and custody platform Bakkt delisted three of the largest cryptocurrencies by market cap that were named by the SEC—solana, polygon, and cardano.
“Those are never easy actions to take. I mean, you're taking revenue off the platform, both for yourself and for your partners,” says Marc D’Annunzio, Bakkt’s general counsel. “But the way that I think about this is it’s a decision that we are making in the short term given how unsettled the environment is, and as the sort of guardrails become a little bit clearer, we intend to relist coins as soon as we reach a point where we're satisfied that we can do that in a compliant way.”
The proportion of delisting’s on U.S.-based platforms has risen to 22% in 2023, up from 8% the previous year, primarily driven by Bittrex and Binance.US, according to crypto data provider Kaiko. Both exchanges have faced charges from the SEC for violating securities laws.
Bakkt Trust, the company’s custody business, was also affected by regulatory shifts in the form of the SAB-121 bulletin. Bakkt leadership offered the following comments on the topic in the company’s Q1 2022 conference call:
Which really – yeah, so as a custodian of the crypto assets, we will need starting in Q2 to gross up our balance sheet for the crypto that we are providing custody services for, and then there's still – the guidance is still being worked on the specific details with the update for accounting purposes, so we are working on getting clarity. There is sort of a haircut aspect to this that relates to – do you need to – I'll call it in my own words, you know hold or reserved for the risk that you're holding and sustaining these assets.
We are waiting for more guidance on that, but I think what's helpful at least from our perspective is, we've had very clean historical performance on managing our crypto currency assets. We are highly regulated; we have all the controls in place that we need, that we believe we need to effectively manage crypto assets.
So we feel like we're in a good spot to adopt this and are well positioned to a strong custodian in the future.
But by Q3 of 2024, Bakkt was looking to exit Bakkt Trust, stating that:
In October 2024, we began investigating a possible winddown and dissolution of Bakkt Trust due to its lack of market traction and high cost of capital due to regulatory requirements. As this process has progressed, we have also worked to find strategic alternatives for Bakkt Trust.
Recognizing the impact of a disjointed US regulatory environment, Bakkt simultaneously shifted its focus to overseas markets and lobbied for clarity in the US. Leadership discussed the impact of regulatory ambiguity during their Q2 2023 earnings call saying:
Thanks for the question. I think when you look overall, I think it still is a tail of the U.S. versus what's happening outside of the U.S. In the U.S., obviously, the ripple decision has been a -- sort of a setback to the SEC with respect to some of the enforcement actions that we've seen against industry participants looking at unregistered securities.
But when you look at it as a whole, I think it will act as a catalyst for where we're going with Congress, and we'll start to see some movement. But when we think about it overall, I think the lack of clarity on how crypto should be regulated is still apparent with where we are.
While I'm hopeful that Congress is paying attention to this, and I'm encouraged by the progress that we've seen, I think the market structure bill in the house is a good example. As I said, there's a long way to go before it or any of the other bills coming for more.
We continue to make our voice heard on Capitol Hill to sort of encourage Congress to resolve the lack of clarity quickly. I think when we look outside of the U.S., I think we're seeing clarity coming to some of the markets that we've spoken about in our prepared remarks and ones that we're excited about, and we see the entry.
But I think here in the U.S., we're still seeing that ambiguity. And it's that lack of clarity that has moved forcing some of the participants to still sit back and continue to watch what's happening with that landscape because without the clarity, they're unsure about what their entry strategy should be.
Absent the regulatory whipsawing Bakkt experienced over the last six years one would have expected the company to succeed. After all, what better pedigree could an upstart exchange have than to be incubated within Inter Continental Exchange? From the very beginning Bakkt had access to a world class trading network and all of the licensing it would need to operate, an advantage that would be very difficult to duplicate in another company. Had the company operated in a clear and stable regulatory environment for the last six years would it have been profitable? Of course there is no way to know, but we may soon find out how Bakkt can perform in a crypto friendly environment.
The 2024 US presidential election offered a variety of choices to voters including a business as usual Harris and a pro crypto Trump. Trump, who headlined the Bitcoin 2024 conference promised never to sell the countries bitcoin and to act favorably toward crypto once elected. Markets participants received the message and Bakkt’s CEO described the elections effect on their platform during the Q3 2024 earnings call as follows:
Before I jump into our third quarter results, I’d like to begin today by discussing Bakkt’s strategic direction and acknowledging the favorable market conditions and increased trading volumes we and the broader market have seen since the U.S. presidential election on November 5. As you will see on Page 3 of our presentation, an example of our prospects of our trading services correlated to the higher crypto prices, we saw a steady ramp up in Bakkt’s notional trading volume over the past three months.
Then in November, leading up to the election and especially following the election, our notional trading volumes dramatically increased. If we look at November’s volumes by day, we saw this increase in reaction to the election results on November 5, and then trading volume went even higher days later along with the broader crypto prices and the new all-time high for Bitcoin.
As of November 12, we’ve already traded $279 million in notional volume, already exceeding October’s total volume by $114 million. Compared to the broader market, we’ve achieved 169% of our total October volume in just the first 12 days of November, while the market as a whole has only reached 78% of its October total, demonstrating our potential for strong performance.
If hopes of regulatory clarity under Trump do materialize then Bakkt may finally get the tailwind it needs to reach profitability. Rumors of a Trump Media bid to acquire Bakkt support the idea as do rallies in Coinbase, Micro Strategy, and other crypto related stocks.
In the near term valuing Bakkt remains a challenge. Even if the regulatory future looks better now than it has in years we still don’t know what the end state will be. Trump Media’s recent move to acquire Bakkt is yet another variable to consider. If the acquisition goes through then Bakkt may not be listed for much longer. It would be an interesting twist of fate if an exchange with so much potential was removed from the market just when the regulatory headwinds shifted to tailwinds.
Personally, I’m still on the sidelines regarding a Bakkt investment. I have no doubt that a well run and licensed exchange is worth more than Bakkt’s current market cap of $177 million but don’t know if or when it’s full potential will be reached. Assuming Trump Media doesn’t acquire it and a long term investment is still possible, then it will be on my short list of companies to watch.
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