Don't Play When It Come To My Base
Coinbase's business model is changing before our eyes. And the company isn't battling DEX protocols. It's a far more savvy approach to potential retail volume erosion.
I had a really great question from a reader about Coinbase’s Ethereum scaling network Base. As fate would have it, I was already working on a L2 fee article for my fellow Heretics so I’m going to do my best to fully answer the Base question here.
The immortal words of Masta Ace.
don’t play when it come to my bass
In my work for Seeking Alpha, I’ve made the case that Coinbase COIN 0.00%↑ launching an Ethereum L2 chain (Base) is part of a proactive strategy to combat what I view as significant long term risk to the company’s centralized exchange business. When I initially published that theory, Coinbase was primarily competing with centralized exchanged peers like Binance ($BNB-USD) in addition to all the decentralized exchanges operating on top of the blockchain networks themselves.
In addition to both centralized and decentralized exchanges, there is now a third enemy combatant type to Coinbase’s centralized exchange business that I’ll detail shortly. First, let’s go over the difference between centralized exchanges and decentralized exchanges.
Centralized Exchange
The centralized exchange is the most straightforward way to buy crypto. The user interface is typically simple and buyers generally link a bank account or credit card to start buying and selling coins. Most centralized exchanges practice strict KYC/AML compliance - meaning they’re permissioned platforms that require opening and maintaining an account.
The user is generally at the mercy of the company that owns the platform and there are built in trust assumptions pertaining to security and custody that the user expects for simplicity. The major tradeoff is not ultimately controlling the crypto that is held on the exchange unless they send it to their on-chain address from the exchange, doing so generally comes with a network fee.
While it’s by far the largest US-based exchange, Coinbase is generally a top 5 exchange by total volume as Binance, Upbit, and OKX often beat Coinbase globally. In addition to a UE more similar to a traditional brokerage, trading via centralized exchange can be far cheaper than trading through DEX protocols because users only pay network fees if they “take custody” of the assets they’re buying. For example, one can buy Bitcoin ($BTC-USD) or Ethereum ($ETH-USD) through Coinbase, hold the coins there for 4 years, and then sell them back without ever actually depositing to their on-chain wallet.
Think of on-chain wallets like a physical wallet that you’d buy to hold paper cash. You can generally do everything you want to do with physical cash directly from a bank account. But the tradeoff there is the bank can tell you they don’t actually have your money when you want it. This is what happened with Celsius ($CEL-USD), FTX ($FTT-USD), Voyager ($VGX-USD), and BlockFi in 2022. But with an on-chain wallet, you’re essentially choosing software operating on top of a network rather than an account with a company. Most wallet applications integrate with numerous blockchain networks. It’s a bit like holding paper USD, CAD, and EUR in the same physical wallet in your pocket.
Analog version:
If you can’t hold it, you don’t own it.
Digital version:
Not your keys, not your coins.
For many crypto advocates, self-custody (or holding assets on-chain) is the better approach to owning cryptocurrencies because the user shifts security to themself and to the network where the asset lives rather than any single company. For instance, there turned out to be far less risk in holding a US Dollar stablecoin on Ethereum than holding dollars on FTX in late 2022.
Decentralized Exchange (DEX)
If one is adamantly opposed to centralized custodian risk, the user can instead turn to DEX protocols like Uniswap ($UNI-USD) or SushiSwap ($SUSHI-USD) and trade directly on the blockchain. In contrast to the centralized exchange, DEX protocols like Uniswap are permissionless and don’t exercise KYC/AML compliance.
Rather than creating an account, users “sign-in” to the protocols with their wallet address rather than an email address. Trading this way is theoretically safer for the user because the DEX never actually has custody of the assets being traded. It’s more like a marketplace that connects buyers and sellers in the same way that eBay EBAY 0.00%↑ is a marketplace intermediary rather than a traditional store.
Using a DEX hasn’t been overtly designated as illegal activity (yet) in the United States, but trading with them doesn’t eliminate the obligation to pay the Don his tribute on capital gains. Generally speaking, these blockchains are all absolutely horrendous for personal privacy and it’s incredibly easy to track who is doing what. So the tax avoidance angle from those against DEX trading doesn’t really hold up.
It is fair to acknowledge that DEX share of total crypto trade volume did actually decline year over year in April. However, the long term trend still points to an erosion of centralized exchange volume from the DEX insurgents like Uniswap over time. This all brings us to Coinbase’s business model. Because if DEX protocols steal volume share from centralized exchanges, Coinbase is theoretically a loser in that environment.
Coinbase’s Business Model
While theoretically more complex to use today, DEX trading is certainly a risk to Coinbase’s long term business as DEX applications will only get better from a UE standpoint over time. During the first half of 2022, roughly 80% of Coinbase’s total revenue came from consumer transaction revenue. Think of this as the “retail” crypto buyer:
During the second half of 2023, revenue from retail traders was closer to 50%. Interestingly, the overwhelming majority of Coinbase’s transaction volume comes from institutional clients rather than retail clients:
Retail volume has historically been a fraction of institutional revenue. Obviously, this is telling us the margin on the retail volume is significantly better than the margin on the institutional volume. And this brings us to our third enemy combatant to Coinbase’s retail exchange business… ETF managers.
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