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Cryptocurrency has changed the way we view money and investments. Investing is no longer just about holding cash or stocks, but also about digital assets that can be traded and invested in. Coinbase Global Inc. (NASDAQ:COIN) is one of the leading cryptocurrency exchange platforms that has made it possible for people to buy, sell, and store digital assets. With more than 100 million verified users and $80 billion in assets on its platform, Coinbase is a dominant player in the cryptocurrency exchange space, especially in the United States.
In the face of volatile crypto prices and evolving regulatory frameworks, Coinbase has come under pressure in recent weeks. Coinbase, however, has introduced several strategies to navigate these challenging market conditions. After examining whether these strategies are truly transformative or merely stopgap measures, I have concluded that the majority of Coinbase’s revenue will remain tied to crypto trading for at least another 10 years. This does not make Coinbase a bad bet on the future of crypto by any stretch of the imagination. However, long-term-oriented investors will have to be cautious today for reasons discussed in this analysis.
Moving On From An Eventful 2022
Last year presented a difficult landscape for crypto investors, with cryptocurrencies bearing the brunt of the market turbulence. Bitcoin peaked at $69,000 in November 2021 before spiraling down to approximately $16,000 in December 2022. Multiple factors contributed to the 2022 cryptocurrency market decline, including persistently high inflation and rising interest rates. This market decline was further aggravated by two unforeseeable events. The first was the de-pegging of LUNA in Q2 2022, which resulted in a nearly 60% drop in crypto market capitalization and exposed weak risk management practices, leading to credit-related bankruptcies of Three Arrows Capital, Voyager, and Celsius. The second event was the collapse of FTX in Q4 2022, a fraud-driven disaster that further fueled credit-related bankruptcies.
Along with the recovery of Bitcoin prices, Coinbase stock has staged a tremendous comeback this year with the stock price up more than 80% so far in 2023.
Exhibit 1: The performance of Bitcoin and COIN in 2023
Coinbase’s Q4 2022 earnings report highlighted a 5% sequential improvement in revenue to $605 million. Of this, $322 million was transaction revenue, while $283 million was related to subscriptions and services. Q4 total transaction revenue declined by 12% compared to the previous quarter, driven by lower trading volume. The company did, however, gain overall trading volume market share in the quarter, with a total trading volume of $145 billion, outperforming the global crypto spot market trading volume, which declined by 21% sequentially. Coinbase’s institutional trading volume declined by 6% in Q4 compared to Q3, while consumer transaction revenue came to $309 million, down 11% from Q3. Amid challenges, Coinbase continued to onboard top hedge funds, with roughly 25% of the world’s largest hedge funds using Coinbase as of Q4 2022.
The company’s fourth-quarter financial performance is a testament to how its fortunes are closely tied to crypto trading today despite commendable efforts to diversify into new business areas.
The Other Side Of Revenue Diversification Efforts
Coinbase is diversifying its revenue sources to create a more sustainable business model. Trading fees have been Coinbase’s primary source of income for years. However, the company is aware that trading fees are highly dependent on the volume and price of cryptocurrencies, which can be volatile and unpredictable. To reduce its exposure to these risks, Coinbase is increasingly focusing on non-trading revenue. Staking rewards, subscription fees, and institutional services are a few non-trading revenue streams that the company is exploring.
- Staking Rewards: Staking rewards are payments that users receive for locking up their crypto assets to support a proof-of-stake consensus mechanism. Coinbase offers staking services for several cryptocurrencies, such as Ethereum 2.0, Tezos, Cosmos, and Algorand. According to its latest earnings report, staking revenue represented approximately 3% of net revenue in Q4. The company’s largest staked balance is ETH2, which was approximately $3 billion as of December 2022. In Q4, Coinbase expanded access to ETH2 staking to Canada and Australia, allowing more users to earn staking rewards.
- Subscriptions: Coinbase is exploring subscription fees as a source of non-trading revenue. The company launched Coinbase Pro in 2018, a platform for more advanced and professional traders that charges a monthly fee based on the user’s trading activity. Additionally, Coinbase plans to launch a new subscription product called Coinbase Bundle, which will allow users to access a curated portfolio of cryptocurrencies for a fixed fee. Subscription and services revenues grew over 17x to nearly $800 million in 2022 from less than $50 million in 2020.
- Institutional Services: Catering to institutional investors is another area where Coinbase is expanding its non-trading revenue. The company has seen a growing demand from institutional clients, such as hedge funds, asset managers, corporations, and endowments, who want to invest in or use cryptocurrencies. Coinbase provides these clients with various solutions, such as custody, execution, data, prime brokerage, and lending.
Exhibit 2: Subscription and services revenue
Q4 2022 shareholder letter
These revenue diversification efforts deserve a lot of credit, in my opinion, as these indicate the company’s vision to transform Coinbase into a 360-degree crypto solutions provider at the heart of the global crypto economy – not just a cryptocurrency exchange. That being said, I believe investors should not overestimate the diversification benefits the company will enjoy in the long run. The idea behind these efforts is to reduce the company’s dependence on the strength of crypto trading volumes. However, the demand for subscriptions and related services is likely to be a function of the crypto market strength. Therefore, these diversification efforts will not necessarily set up the company for success in a severe crypto market downturn.
Coinbase’s inability to truly diversify its revenue streams is a structural challenge faced by all crypto marketplaces alike so this certainly has nothing to do with Coinbase or its business strategy. With COIN stock up 80% this year, I fear Mr. Market is overlooking the threats posed by this fundamental challenge, which is one of the reasons why I believe investors should be cautious of investing in Coinbase stock today. The other reasons behind my stance are discussed in the next segment.
Challenges Looming On The Horizon
While diversifying its revenue sources beyond trading fees, Coinbase faces some challenges and risks. Some of the non-trading revenue streams are still nascent and unproven, such as staking. Moreover, some of them may face regulatory hurdles or competition from other players in the industry. One of the major regulatory hurdles that Coinbase faces is the threat posed by the Securities and Exchange Commission, which has been scrutinizing its crypto-staking programs. Staking is a process where users lock up their crypto assets in exchange for rewards, similar to earning interest on a bank account. In 2021, the SEC warned Coinbase that its proposed lending product that allowed users to earn interest by lending digital assets may violate securities laws and threatened to sue the company if it proceeded with the launch of this product. The SEC issued another warning recently over some of Coinbase’s products. Coinbase has received a formal declaration from the SEC in the form of a Wells notice, which warns of potential enforcement action related to certain business practices of the company in the spot market, as well as its Earn, Prime, and Wallet products.
Coinbase is also grappling with a potential new tax reporting requirement for crypto transactions under the U.S. infrastructure bill. The provision would mandate intermediaries like Coinbase, as well as miners and validators, to report sender and receiver information, transaction amount, and date to the IRS. Critics claim the provision is too broad and burdensome, warning that it could limit innovation and competitiveness in the crypto industry. The Senate has already approved the bill, but it still requires approval from the House of Representatives. Some lawmakers have proposed amendments to mitigate the scope of the reporting requirement.
The EU introduced a new regulation last year, called the Markets in Crypto-assets (MiCA) law, which mandates that cryptocurrency firms must obtain a license and implement customer protection measures to issue and trade digital tokens in the European Union. The law provides a “passport” that enables crypto asset issuers and related service providers to serve customers throughout the EU from a single location. Additionally, the law ensures that holders of stablecoins are entitled to redeem them at any time and free of charge by the issuer, with all stablecoins being overseen by the bloc’s banking regulator. This is a step forward in the EU’s efforts to regulate the crypto industry by bringing the industry closer to the broad financial services sector. The increasing involvement of regulators – although necessary – will spook some crypto users as they were drawn to cryptocurrencies because of the lack of an intermediary. The objective of this article is not to determine the level of regulatory involvement that would be ideal for the growth of the crypto economy but what is evident is that increasing regulatory involvement is already proving to be a challenge.
At a roundtable event, Bo Li, the IMF Deputy Managing Director, warned about the potential risks that crypto assets may pose to global financial stability, especially in emerging market economies. He stressed the importance of licensing, registering, and authorizing critical crypto-asset services providers including marketplaces to ensure consumer protection and prevent illegal activities. Furthermore, Mr. Li emphasized the need for regulatory authorities to implement a risk-based approach to crypto regulation that balances the mitigation of risks with promoting innovation and competition in the digital financial sector.
In response to increasing regulatory challenges, Coinbase has taken several steps to protect its interests and influence policy outcomes. One such measure has been the hiring of several former regulators and government officials to its legal and compliance teams, such as Brett Redfearn, a former director of the SEC as its vice president of capital markets, and Faryar Shirzad, a former deputy national security advisor and Goldman Sachs (GS) executive as its chief policy officer. Additionally, Coinbase has been lobbying lawmakers and regulators to support favorable legislation and regulation for the crypto industry, such as the Eliminate Barriers to Innovation Act.
However, these steps may not be sufficient to ensure Coinbase’s long-term success and growth. While diversifying revenue sources and expanding the customer base are important strategies, they come with increased costs and risks. The company’s cost base has materially increased in the last couple of years as Coinbase doubled down on non-trading revenue streams. For the company to break through to profitability again, it would take much higher crypto prices than in 2022 and 2021. Offering non-trading services such as staking and lending may also expose Coinbase to more regulatory scrutiny and potential litigation from customers who may lose money due to technical issues or market fluctuations.
Coinbase is looking for growth opportunities in international markets to overcome regulatory threats in the U.S., and I believe this is the right strategy. However, expanding into new jurisdictions may require Coinbase to comply with different and sometimes conflicting rules and standards, which may limit its operational efficiency and profitability. The company has been exploring new markets where crypto regulations are more favorable or flexible, such as Japan, Germany, Ireland, India, and Singapore. However, it remains to be seen how successful Coinbase will be in these markets, and whether the company will face new regulatory challenges.
Takeaway
Coinbase has a strong foundation with a recognizable brand, loyal customer base, and diversified revenue streams, but it faces significant challenges from intense competition, regulatory ambiguity, and volatile crypto markets. To cope with these challenges, Coinbase has taken several steps to transform its business. However, it’s unclear whether these changes will have a lasting impact on the company.
