In-depth Analysis of Coinbase: The Path of Open Financial Systems, Coexisting Glory and Risks

Author: Baize Research Institute

Coinbase is the most popular consumer-facing cryptocurrency exchange in the United States and has gained significant recognition in the consumer/trading space among crypto enthusiasts.

In May 2021, Coinbase once again topped the charts in the Apple App Store. Although its time at the number one position was brief, Coinbase's popularity soared, positioning itself as a "safe haven" among cryptocurrency exchanges and the "gateway for mainstream crypto investors." Additionally, Coinbase has aggressively pursued compliance with existing regulations and enforcement, placing its business in a legally sound position—this is a "huge asset" in the crypto industry, which still urgently needs regulatory guidance.

This helped Coinbase secure nearly $540 million in equity financing from some major venture capital firms, catapulting the company into the ranks of "crypto unicorns." Coinbase went public on NASDAQ in April 2021, with a direct listing opening price of $350 per share, $100 higher than its reference price.

While Coinbase is known for its cryptocurrency trading business, its ambitions extend far beyond helping people buy and sell crypto assets. The company's goal resonates with the ultimate vision of crypto enthusiasts: to create an "open financial system." However, for now, Coinbase resembles a traditional financial services company, earning money by charging brokerage and trading fees, holding user funds like a bank, and deciding which crypto assets can be listed on its trading platform.

This raises the question: Is Coinbase still interested in encouraging the adoption of crypto assets to build a new financial system, or is it primarily focused on driving the growth of its trading business?

In this article, we will delve into how Coinbase operates from the perspectives of its strategy, funding history, product offerings, business plans, threats, and challenges, as well as its efforts to promote blockchain technology.

Overview of Coinbase's Business

Today, Coinbase operates in over 100 countries, with its 21 products categorized into three main business lines:

• For individuals: Coinbase, Wallet, USD Coin

• For businesses: Prime, Commerce, Exchange

• For developers: Cloud, Connect, WalletLink

Coinbase Prime: Enables institutional investors to buy, store, and trade crypto assets at scale.

Coinbase Commerce: Allows businesses to accept crypto payments using the Coinbase Commerce platform.

How Coinbase Makes Money

Coinbase's revenue reached $1.3 billion in 2020, but this figure pales in comparison to its financial performance in 2021. The company reported $2.2 billion in revenue and $1.6 billion in net income in just the second quarter of 2021. This money comes from three different revenue streams.

The first is trading revenue from retail and institutional investors. Coinbase charges trading fees ranging from 0.5% to 3.99%, depending on payment type, user’s country of residence, account type, transaction value, and more. In the second quarter of 2021, Coinbase reported retail trading fee revenue of $1.8 billion and institutional trading fee revenue of $102.4 million.

The second revenue source is subscription and services revenue. This $102.6 million in revenue includes custody fees, blockchain rewards, interest income, and other types of services.

The third revenue source is the sale of crypto assets owned by Coinbase. The company may sometimes sell its own assets to customers and record this as revenue. In the second quarter of 2021, this revenue was nearly $195 million.

While the company's revenue still heavily relies on retail trading fees, it has seen early success in increasing other revenue sources. For instance, it grew revenue from institutional investors (such as hedge funds and family offices) from $8 million to $102.43 million in a year.

Source: Coinbase SEC filings

How Coinbase Became the King of Crypto?

Coinbase has become the "King of Crypto" in the eyes of investors, largely benefiting from the "evolution of crypto assets into investment tools." Coinbase's excellence in security, regulatory compliance, and ease of use has helped drive user growth.

Driving Adoption

While Coinbase initially committed to "instant payments and widespread adoption" of crypto assets, progress has been slow. However, Coinbase is taking steps to make crypto assets a more acceptable payment method. To this end, the company partnered with payment giant Visa to launch the "Coinbase Debit Card" in the U.S., U.K., and EU, which can be used for payments and cash withdrawals from ATMs. In June of this year, Coinbase announced that customers can now link their Coinbase Debit Card with Apple Pay and Google Pay for easier crypto payments.

Compliance

It is well known that crypto assets have a history of use in black markets, initially with Bitcoin and now primarily with some privacy coins (like XMR and Zcash). Coupled with the nascent state of the crypto industry, regulators worldwide have been striving to define, legislate, and tax crypto assets.

Coinbase has invested heavily in regulatory licensing and compliance, distinguishing itself from other exchanges. Coinbase has explicitly complied with state Money Transmission Laws and is one of the few companies holding a "crypto asset license" in New York, which comes at a high cost.

Additionally, Coinbase operates its exchange in 32 countries, including the U.K. and Switzerland. Coinbase states that it is "committed to obtaining legal licenses in the countries where it operates."

Overall, Coinbase's focus on compliance provides reassurance to investors and regulators.

Collaboration with Law Enforcement

Similarly, Coinbase works closely with law enforcement. Coinbase follows strict verification procedures to comply with regulations such as KYC (Know Your Customer) and AML (Anti-Money Laundering) and tracks and monitors the transfer of crypto assets.

As a result, Coinbase is a boon for regulators and law enforcement agencies deciphering black market activities. Some blockchain tracking companies, such as Chainalysis, have collaborated with Coinbase (and other exchanges) to assist in anti-money laundering enforcement. As U.S. Treasury Secretary Steve Mnuchin stated in a recent interview, "If you have a Coinbase wallet with Bitcoin, then Coinbase has the same obligation as a bank to know your identity, and we can track your crypto asset activity."

At the same time, Coinbase has pushed back against what it perceives as government overreach.

Recently, Coinbase CEO Brian Armstrong detailed on Twitter how the Biden administration's proposed infrastructure bill (aimed at taxing crypto transactions) could harm innovation in the crypto industry and potentially "push innovation overseas."

While crypto assets remain a largely unregulated space so far, the bill aims to implement stricter taxation on cryptocurrency transactions by treating them as capital gains and losses, similar to stock trading. This provision is expected to generate $28 billion in revenue for the government over the next decade.

Support from Numerous Investment Institutions

Although Coinbase reached a target valuation of $100 billion on its first day of trading, its market capitalization in September 2021 was $54 billion. To prove its initial valuation was justified, Coinbase will have to outpace competitors and become the largest crypto exchange in the world.

Looking back at past investors, Coinbase has attracted numerous venture capital firms and corporations. Since 2012, Coinbase has raised nearly $540 million through 15 rounds of equity financing (including its seed round). Notable venture capitalists—Union Square Ventures and A16z—got in early and continued to participate in the company's subsequent funding rounds.

In January 2015, major financial institutions such as the New York Stock Exchange and USAA became part of the company's $75 million Series C funding round. According to a press release from the New York Stock Exchange, the Series C funding would help "Coinbase learn from the NYSE's global distribution capabilities and expertise in expansion."

In August 2021, Coinbase opened channels for business in Japan through a partnership with Mitsubishi UFJ Financial Group (which had previously invested in Coinbase), a banking group with 40 million customers in Japan. Coinbase offers five cryptocurrencies to the bank's users—Bitcoin, Ethereum, Litecoin, Stellar, and Bitcoin Cash—and plans to add more crypto assets available for trading in Japan.

The Future Path of Coinbase

Nevertheless, the question remains: Is Coinbase simply profiting from the crypto market bull run, or is it building on the initial vision of an "open financial system"?

Expansion Strategy

Coinbase CEO Brian Armstrong recently stated that the company's core mission is to "increase economic freedom in the world." To achieve this mission, Coinbase will execute a "three-pronged" expansion strategy, upgrading the positioning of crypto assets as "investment tools, a new financial system, and an application platform."

The "three-pronged" strategy will guide the company for the next five years or more. This strategy is based on three pillars:

• Crypto assets as an investment. Crypto asset trading remains Coinbase's core business, and it plans to add new crypto assets to its platform at a faster pace. Coinbase will also provide sophisticated trading tools for professional traders, similar to traditional markets. At the same time, Coinbase plans to continue expanding into countries where it currently does not operate.

• Crypto assets as a new financial system. Coinbase will develop new products to help cryptocurrency holders access the DeFi space.

• Crypto assets as an application platform. Coinbase believes that crypto innovation is not limited to DeFi; the company will also help its users discover new crypto applications and will fund applications through Coinbase Ventures (Coinbase's investment arm).

Acquiring Crypto Startups for Its Own Use

Since early 2018, Coinbase has acquired 19 crypto startups, bringing the total to 21. These acquisitions help Coinbase execute its expansion strategy.

For example, in August 2021, Coinbase acquired Zabo, an account aggregation startup that allows users to view balances and transaction histories of third-party accounts within the Coinbase app. Zabo's API can extract data from multiple crypto exchanges, protocols, and wallets.

Coinbase also acquired Skew in 2021. This U.K.-based crypto startup provided a platform for real-time tracking and visualization of the crypto market, helping Coinbase further improve its offerings for institutional investors.

In 2019, Coinbase acquired the crypto startup Neutrino, which aimed to simplify the mapping and tracking of crypto transactions, enabling Coinbase to prevent theft and investigate ransomware attacks.

As Coinbase seeks to diversify its revenue sources and reduce reliance on retail trading fees, we are likely to see more acquisition news in the coming years.

Massive Investments in Crypto Companies, Even Competitors

Coinbase Ventures (CV) is the venture capital arm launched by Coinbase in 2018. As of August 2021, CV had invested in over 150 companies and was the third most active venture capital firm in the first half of 2021. As expected, most investments were targeted at a range of crypto startups, including:

• Taxbit: A tool for automating crypto tax payments

• Zora Labs: A crypto marketplace

• Arweave: A provider of digital storage services

• Opensea: Currently the largest NFT marketplace

In addition, to secure space that may challenge its core exchange products in the future, Coinbase has also invested in many DeFi companies, such as Vega, Saddle, and Uniswap, as well as some centralized exchanges similar to its products, such as Pintu, Bitso, and CoinDCX. Coinbase's President and COO Emilie Choi stated that investing in competitors is a policy strongly supported by co-founder Brian Armstrong.

Challenges and Risks

Similarly, Coinbase faces competition from many participants in the trading business as well as emerging decentralized exchanges while expanding.

Competition Among Peers

Coinbase faces direct competition from many legitimate crypto exchanges. Bitfinex, Bitstamp, Kraken, and bitFlyer are major competitors of Coinbase, along with traditional brokerage firms like Robinhood (which now supports crypto trading in all U.S. states except Hawaii and Nevada). At the same time, Coinbase has expanded its crypto trading business to 42 countries, including the U.S., Canada, India, Brazil, and South Korea. Therefore, the company is now also competing with Binance, the exchange with the highest trading volume (with daily trading volumes reaching $25 billion).

Another competitive angle comes from decentralized exchanges. While decentralized exchanges are more technologically advanced and harder to use, they effectively have no central point of attack, thus providing higher security. Nevertheless, trading volumes are still limited compared to major centralized exchanges, allowing Coinbase to respond to this threat over a longer time frame.

Coinbase also faces custody competition in the digital asset custody space from firms like Gemini, BitGo, PAXOS, and NYDIG.

Market Risks

Like crypto investors, Coinbase also faces risks from the crypto market. Exchanges are particularly vulnerable to market demand. If the market is sluggish, Coinbase's revenue could plummet.

Secondly, if regulatory crackdowns lead to market assets fleeing and being exchanged for fiat currency, Coinbase may face liquidity issues. In other words, large-scale sell-offs could make it difficult to find buyers.

Additionally, large-scale sell-offs in the crypto market would negatively impact multiple business lines of Coinbase. For example, revenue from staked crypto assets would decrease, and the rationale for using collateralized lending or using the Coinbase wallet would diminish, while institutional investors may become more conservative in using crypto assets to diversify their portfolios.

Regulatory Risks

Since its inception, Coinbase has been committed to building good relationships with regulators, and these efforts have paid off.

However, regulatory advantages also come with risks. Laws may change, as legislative processes can be difficult to influence. For example, Coinbase and the entire crypto community were unable to influence the Senate's changes to the infrastructure bill, which could drive wallet developers, app developers, and miners away from the U.S. due to settlement issues.

The U.S. Securities and Exchange Commission (SEC) has also dealt a blow to Coinbase. The SEC warned Coinbase that its proposed crypto lending product, which would allow users to earn interest by collateralizing crypto assets, poses security risks. In response, Coinbase delayed the launch of the product.

Moreover, other crypto-friendly countries are also drafting new crypto regulations, but the impact on Coinbase has yet to be disclosed. For example, the European Commission is working on legislation aimed at establishing rules for crypto asset issuers and service providers in the EU.

Reflective Summary

In the face of these challenges, Coinbase continues to expand its core business and explore broader opportunities, such as establishing an NFT marketplace; to hedge against other exchanges, Coinbase plans to add support for more crypto assets. Doing so will not only enrich the company's revenue but also allow a larger user base to explore innovative applications of crypto/blockchain technology.

With Coinbase going public in April 2021, the company now has the resources and expertise needed for accelerated expansion. However, achieving its goals requires not only navigating the crypto market effectively but also establishing communication channels with regulators and lawmakers worldwide. As the momentum for crypto/blockchain technology continues to grow, it becomes increasingly important for policymakers to engage with the crypto industry.

The story of Coinbase also reflects the broader crypto industry. Bitcoin and several other major crypto assets are closer to mainstream adoption but have yet to reach the status that crypto enthusiasts desire. Coinbase should better understand its current and future position and strive to find solutions that allow the entire crypto industry to thrive while maintaining its trading business as a mainstay.