To sustain the cryptocraze, Coinbase will need to foster real applications of cryptoassets — and not just speculation.
Coinbase is the most popular consumer-facing cryptoasset exchange in the United States. Operating since 2011, the company allows users to buy, sell, and store cryptoassets, like bitcoin and ethereum.
The company already has significant visibility with consumers in a sector that was once exclusively the province of cryptoasset enthusiasts. In mid-December, the company’s mobile app reached the top spot on Apple’s App Store.
Coinbase has soared in popularity and turned itself into the on-ramp for mainstream crypto investors by positioning itself as a safe harbor among cryptoasset exchanges. The company has never been hacked, unlike many of its competitors. Coinbase has also maniacally pursued compliance with existing regulations and law enforcement, putting it on the right side of the law — another huge asset in a sector that is still in desperate need of regulatory guidance.
This has helped Coinbase secure $217M in equity financing from some of the biggest-name VCs, and vaulted the company into the unicorn club.
However, while Coinbase is best known for its cryptoasset exchange, it has bigger aspirations than helping people buy and sell crypto. The company’s stated goal echoes cryptoasset enthusiasts’ ultimate vision: to create a new, “open financial system.”
For the time being, though, Coinbase looks a lot like a traditional financial services player. Coinbase makes money by charging fees for its brokerage and exchange. It also custodians user funds, like a bank, and decides which cryptoassets to list, like the NASDAQ or NYSE.
Coinbase thus finds itself caught between worlds: it’s the most well-funded blockchain company in the United States, but it’s a centralized company, not a decentralized ledger. The company once advertised cryptoassets as the “future of money,” but now positions itself as a way to “buy and sell digital currency.” In many ways, Coinbase is a centralized on-ramp to a decentralized ecosystem.
This begs the question: how does Coinbase view the assets that it enables customers to buy and sell? Is it still interested in encouraging crypto adoption to build a new financial system, or primarily occupied with encouraging the speculation that fuels its core lines of business?
In this report, we examine Coinbase’s strategy, financing history, product offerings, business initiatives, threats and future opportunities. We dig into how Coinbase operates, how it’s capitalizing on cryptoasset speculation, and what it’s doing to push forward blockchain technology.
TABLE OF CONTENTS
- WHAT IS COINBASE?
- Coinbase & GDAX
- Hosted wallets
- COINBASE AS KINGMAKER
- From currency to investment
- User metrics
- Regulatory compliance
- The Coinbase effect
- VALUATION & INVESTORS
- THE ROAD AHEAD: AN OPEN FINANCIAL SYSTEM
- Challenges & Risks
- CLOSING THOUGHTS
Style notes: “Cryptoassets” includes all coins, tokens, and digital assets traded on cryptoasset exchanges. “Bitcoin” refers to the Bitcoin ledger, or protocol, while “bitcoin” refers to the asset or a unit of account on the Bitcoin ledger. This is reflected for all cryptoassets in this report.
Cryptoassets like bitcoin, ethereum, and litecoin are primarily obtained in one of two ways: through mining or through an exchange.
Mining has high barriers to entry. Participating in a mining pool or operating mining “rigs” can be expensive and complicated. For the more novice consumer, fiat-cryptoasset exchanges and brokerages – like Coinbase, Kraken, and Bitstamp – have established themselves as the primary on-ramps to this asset class. These allow consumers to trade fiat (e.g. USD, GBP) for cryptoassets (e.g. BTC, ETH, LTC).
There are a couple of important terms to understand when discussing exchanges.
- First, the “trading pair” (or, “currency pair”) is the product being traded. In the above screenshot the product is ETH, and the “quote currency” is USD. This means that traders are buying and selling the cryptoasset ethereum, priced in dollars.
- The order book shows all the bids and asks at a given time. A “bid” is the price at which a buyer will buy, and an “ask” is the price at which a seller will sell. The order book also shows the aggregate amount of asks and bids (supply and demand) at a given price, called the “market size.”
- The “depth chart” is another way to visualize the order book, showing cumulative bid and ask orders over a range of prices. Coupled with volume — or, the total amount traded over a given time period — the depth chart provides a good way to measure “liquidity.” Liquidity describes how easy it is to turn an asset into cash. For instance, if ethereum suddenly saw a massive sell-off, there might not be enough buyers, or enough “liquidity,” for sellers to sell to.
- Lastly, the “mid-market price” is the price between the best “ask” price and the best “bid” price. It can also be defined as the average of the current bid and ask prices. The “price” of an asset (as quoted on Yahoo Finance or Bloomberg, etc.) is a direct function of the bids and asks in the market, which in turn reflect supply and demand.
What is Coinbase?
Coinbase was founded in July 2011 by former Airbnb engineer Brian Armstrong and was first funded by Y Combinator. In 2012, co-founder Fred Ehrsam, a former Goldman Sachs trader, joined the company, after which Coinbase launched services to buy, sell, and store bitcoin.
Today, Coinbase operates in 32 countries and can be divided into four primary lines of business:
COINBASE & GDAX
Coinbase operates both an order book exchange, called the Global Digital Asset Exchange (GDAX), and a brokerage, called Coinbase.
More advanced traders (including small institutional players, like cryptoasset hedge funds and family offices) buy and sell cryptoassets on GDAX and determine the mid-market price. Coinbase (the brokerage) then allows retail investors to buy and sell cryptoassets at these mid-market prices, and charges a fee on top.
In practice, retail investors can buy and sell directly from Coinbase’s brokerage, like they might buy a stock from Scottrade or Charles Schwab. Coinbase’s brokerage fees range from roughly 1.5% to 4.0% depending on the user’s payment method; due to increased risk, credit cards come with higher fees than bank transfers. Traders on GDAX pay significantly lower fees.
Of note, Coinbase’s brokerage buys cryptoassets from GDAX, instead of from an outside exchange. This gives the company a secure in-house source of liquidity. Given how often exchanges are hacked or otherwise compromised, this is quite important; Coinbase’s brokerage doesn’t have to rely on anyone else for liquidity.
A common mantra found in the cryptoasset community is “be your own bank.” Accordingly, Bitcoin enthusiasts promote what they call “private key management solutions,” which means storing a long string of random numbers or letters offline, either on a piece of paper or on a dedicated storage device (a “hardware wallet”). Such a method of securing cryptoasset holdings is difficult for the average consumer – if the piece of paper or storage device is lost, the funds are lost forever.
Flaunting this mantra, Coinbase offers hosted wallets alongside its exchange and brokerage. These allow users to safely store cryptoassets on Coinbase, which custodians the assets. As of Coinbase’s last reporting, in late November 2017, the company had 13.3M users and 45.2M wallets (users generally have more than one wallet, each for a different cryptoasset).
Coinbase’s customers typically fall into one of two groups: (1) investors, and (2) those transacting with cryptoassets. For investors, Coinbase encourages transferring funds into its “cold storage” vaults, which it guarantees against Coinbase hacking. These vaults are disconnected from the internet and offer increased security. For those transacting (or trading on other exchanges), Coinbase allows users to send funds from Coinbase to other wallets.
Institutional investors — hedge funds, asset managers, and pension funds among them — have expressed interest in cryptoassets as their overall value climbed this past year. In order to capitalize on this sidelined institutional money, Coinbase announced “Custody” in November.
Custody provides financial controls and storage solutions for institutional investors to trade cryptoassets. The service is geared toward larger players on Wall Street and costs $100,000 in initial setup fees, a management fee of 10 basis points monthly on AUM, and a minimum balance of $10M. Coinbase plans to launch Custody early this year.
Custody is not the first mover in the space. Digital Currency Group’s Genesis Trading has offered institutional players OTC (“over the counter”) trading in cryptoasset markets since 2013, while the Winklevoss Capital-backed Gemini was founded in 2015. Other major OTC providers catering to institutions include Circle, which has raised $136M in venture financing, and DRW’s Cumberland.
Additionally, traditional exchanges like the Chicago Board Options Exchange (CBOE) and CME now offer futures trading for cryptoassets, with the CBOE also recently filing for a bitcoin ETF. Lastly, investment trusts – like Grayscale – offer tradable securities on top of cryptoassets. These often trade at a premium to exchange prices, but are operationally easier for institutional investors to hold.
While Coinbase remains focused on its core brokerage and exchange businesses, one of the company’s longer-term projects is Toshi. Toshi is a mobile app for browsing decentralized applications, an ethereum wallet, and an identity and reputation management system. At a high level, the aim with Toshi is to give users broader access to decentralized applications built on top of the Ethereum blockchain. In this way, Coinbase hopes that Toshi could allow for the building of viable crypto use cases, beyond speculation.
Some current examples include Leeroy, a decentralized social media platform where users earn money for likes, and Cent, where users can ask questions and offer bounties for the best answers. Toshi launched in April 2017, and early traction has been limited; the app counts under 10,000 installs in the Google Play Store.
Critics of Toshi point to the app’s centralization. Toshi is built, maintained, and effectively controlled by Coinbase, which might discourage developers from building on top of it.
To use an analogy that illustrates the downsides of centralization, consider an Amazon merchant. If Amazon were to change its search algorithm or fee structure, that merchant might be adversely affected. Decentralization, according to proponents, presents an alternative that makes developers less subject to the whims of the platform they build on.
On the flipside, and as a function of centralization, Coinbase can make quick changes to Toshi without community consensus. Coinbase also has a significant number of existing users, brand recognition, and money to spend, which could bode well for Toshi’s future adoption.
Coinbase as kingmaker
Coinbase has emerged as something of a cryptoasset kingmaker for investors, as assets listed on its exchange have seen substantial price appreciation.
This development is largely a result of cryptoassets evolving into an investment vehicle. Coinbase’s excellence in security, regulatory compliance, and ease-of-use has helped drive up user numbers. When Coinbase give its “stamp of approval” to a given cryptoasset, millions of users can then trade it, which often drives up prices.
FROM CURRENCY TO INVESTMENT
Where bitcoin and other cryptoassets were once considered a “means of exchange” and an alternative payments system, they are now more often called a “store of value” and an investment opportunity.
Scaling issues have contributed to this shift, as core developers remain locked in debate over how best to scale Bitcoin into an effective payments network. Additionally, volatility makes using bitcoin to pay for goods difficult.
Fred Wilson of Union Square Ventures pointed to this volatility in a recent blog post, writing: “This was a Bitcoin t-shirt I bought in the summer of 2013 [for .18 BTC]. At today’s prices, that t-shirt cost me $830 […] You can’t keep spending something that goes up as much as Bitcoin has.” That number is considerably higher today.
Thus, while Coinbase initially promised “instant payments [and] widespread [bitcoin] adoption,” bitcoin has seen limited adoption among merchants and consumers; users haven’t meaningfully transacted with bitcoin like they might with dollars or euros.
Coinbase has overhauled its messaging and user experience to capitalize on this trend, with the company’s homepage now encouraging users to “buy and sell digital currency,” where it once welcomed users to “the future of money.” This makes a lot of sense as a brokerage: Coinbase brings in revenue on every trade (based on volume), and is therefore incentivized to encourage frequent trading and investment.
Astounding user growth validates Coinbase’s messaging shift. According to data aggregated by Alistair Milne of Altana Digital Currency Fund, Coinbase was adding users in November at a rate of 100,000 per day. Although Coinbase has stopped publishing real-time user metrics, its site claims over 10M customers served and over $50B in cryptoassets exchanged.
Assuming an average 3% fee for Coinbase transactions and $50B exchanged, total revenue of the company (since inception) would be $1.5B. Of course, that number could be much higher or lower depending on the company’s true fees and total volume.
According to recent reports, Coinbase made $1B+ in revenue in 2017 alone. At the end of Q3’17, the company was projecting a 2017 total of just $600M, well under its actual.
Although cryptoassets themselves are quite secure, exchanges have a long history of hacks, exit scams, and lost funds. The most well-known hacked exchange was Mt. Gox, which lost 850,000 bitcoins to hackers in early 2014, worth $450M at the time. Today (in early January 2018), those coins would be worth close to $10B. Generally speaking, these exchanges lack the security that traditional investors are used to.
Coinbase is the exception to this rule. Coinbase has continued to make security a top priority, and it’s paid off. The company has operated since 2012 and has never been hacked, establishing significant trust with consumers.
Investments and funds are held and insured by Coinbase, with the majority of cryptoassets stored offline in cold storage vaults, and the remainder insured by Lloyd’s of London. Funds held in USD wallets on Coinbase are covered by the FDIC and insured up to $250,000.
Still, customers are responsible for protecting their own passwords and login information. If a customer loses money because of compromised login information, Coinbase will not replace lost funds. Coinbase recommends that customers turn on two-factor authentication and place funds into cold storage in order to thwart would-be hackers.
As mentioned, exchanges that handle fiat-cryptoasset trading pairs (e.g. BTC/USD, BTC/GBP) are the primary consumer on-ramps to cryptoassets. Cryptoassets have a history of use in the black market, first with bitcoin, and now with privacy-focused coins, like monero and zcash. Coupled with the sector’s nascency, regulatory bodies have struggled to define, legislate, and tax cryptoassets.
In this regard, Coinbase has differentiated itself from other exchanges by spending substantially on licenses and compliance. Coinbase has made a point of complying with state-by-state money transmission laws, and is one of a few companies to hold a New York Virtual Currency License, or “BitLicense.” A common critique of the BitLicense is its prohibitive cost; over ten companies moved their headquarters from New York to other locales in 2015 after the license was announced.
Other regulations that Coinbase complies with include registration as a Money Services Business with FinCEN, and the Bank Secrecy Act and Patriot Act. Coinbase operates its exchange in 32 countries, including the UK and Switzerland, as mentioned. According to the company, “no license is required to operate a digital currency business in any other country [outside of the US] where Coinbase operates.”
Taken as a whole, Coinbase’s focus on compliance offers safety and assurance for consumers and regulators alike.
Relationship with law enforcement
Similarly, Coinbase has cooperated heavily with law enforcement. Coinbase follows strict identity verification procedures to comply with regulations like KYC (Know Your Customer) and AML (anti-money laundering), and to track and monitor cryptoassets sent to and from its site.
As touched upon earlier, the company complies with the Bank Secrecy Act, which the company says “requires Coinbase to verify customer identities, maintain records of currency transactions for up to 5 years, and report certain transactions,” and the Patriot Act, which has famously been criticized for making it easier for the US government to intercept people’s phone conversations.
Coinbase is therefore a boon for regulators and law enforcement in deciphering decentralized black market activity. Blockchain tracking companies, like Chainalysis, work with Coinbase (and other exchanges) to assist in AML enforcement. As US Treasury Secretary Steve Mnuchin put it in a recent interview: “If you have a wallet to own bitcoins, that company has the same obligation as a bank to know [you as a customer, and] we can track those activities.”
At the same time, Coinbase has pushed back against what it sees as government overreach. In one public instance, the IRS requested customers’ records for the period between 2013-2015. November 2017 court documents from the case nicely summarize the dispute: “That only 800 to 900 taxpayers reported gains related to bitcoin in each of the relevant years and that more than 14,000 Coinbase users have either bought, sold, sent, or received at least $20,000 worth of bitcoin in a given year suggests that many Coinbase users may not be reporting their bitcoin gains.”
Coinbase refused to hand over records, and ultimately won a partial victory in court by reducing the number of customers and scope of data provided. The company has since agreed to give the IRS records on 14,000 users, a somewhat unsatisfactory outcome for Coinbase users with strong privacy concerns.
Accusations of insider trading
Cryptoasset trading remains largely unregulated and is something of a “wild west” for speculators. Pump-and-dump schemes and fraudulent initial coin offerings are rampant. Additionally, and as we’ve explored in prior reports, large initial coin offerings run the risk of overcapitalization; raising too much money could disincentivize founders from building the product in question, turning founders building companies into money managers.
Although Coinbase has generally kept its brand reputation clean, recent events have spurred rumors of insider trading and “front-running.” According to numerous reports, the price of bitcoin cash on global exchanges spiked in the hours leading up to Coinbase’s launch of bitcoin cash trading. Such a price movement is certainly suspect.