Why Coinbase’s stellar earnings are not what they seem

Coinbase, one of the most popular crypto exchange and wallet services operating in the regulated financial sector, shared its first-quarter earnings on Tuesday ahead of its Nasdaq direct listing on April 14.

Top line results showed revenues sky rocketing to $1.8bn in the first quarter of 2021 versus $191m in the same period last year, with net income climbing to c$730m.

Other stand out numbers included the service reaching 56m verified users, trading volume of $335bn, and its $223bn worth of assets, setting the crypto service up for a valuation of up to $70bn.

Twitter folk quickly forged a consensus that such figures prove not only that Delaware-incorporated company is a profit-minting machine but that crypto itself can no longer be ignored by traditional finance.

As John Street Capital tweeted in an illuminating Twitter thread:

But it’s worth reminding investors that the stand out concern remains that the current framework under which Coinbase is regulated (a money transmission one) is not at all suited to regulating its broader activities, among them its exchange activity and principal-trading operations.

This is important because if Coinbase’s regulatory status were to change (and regulatory ambiguity is clocked in the company’s S1 risk factors) the company could be forced to drop many of these hugely profitable activities or be forced to operate at a much higher capital cost.

In an upcoming qualitative review of the regulatory status of 16 crypto exchanges Martin Walker, director at the centre for evidence based management and a fintech consultant, and co-author Winnie Mosioma, the founder of the Blockchain Legal Consultancy, argue that these sorts of inconsistencies will have to be closed if these platforms are to compete in the formal financial sector:

Conventional platforms for trading securities, foreign exchange, derivatives, commodities and other more conventional financial assets are strictly regulated, whether they are officially classified as exchanges or Alternative Trading Systems (ATS). An ATS, while not strictly a stock exchange, has to follow the regulations that apply to either exchanges or broker-dealers depending on a number criteria (varying between jurisdictions), such as the volume of trades and market share. Whatever the classification, conventional trading platforms have to follow strict rules designed to protect investors and avoid destabilisation of the financial system. Particularly rules that require a high level of transparency guaranteeing operational resilience. 

The context, they note, is cryptocurrency’s inherent dependency on multilateral exchanges for facilitating price discovery. This contrasts to bitcoin predecessors such as Liberty Reserve or E-gold, which only needed to be serviced by third parties prepared to exchange digital currencies for the corresponding linked assets for a fee.

Since crypto regulations have largely failed to address this dependency, this has led to a patchwork of conflicting regulatory approaches, many of which entirely ignore any corresponding trading activity or facilitation.

A case in point is that seven of the most prominent US exchanges, including Coinbase, operate as licensed Money Service Businesses (MSBs) or equivalent. This classification ensures the platforms must be registered with the financial crimes enforcement network (FinCEN) in the US, and/or the Financial Conduct Authority in the UK, but it does not mean their trading activities are supervised in any formal manner.

As the authors note:

Given the lack of significant regulatory oversight of actual trading activity it is probably no surprise many cryptocurrency exchanges carry out questionable activities, such as offering leverage to their clients and wash trading, all against a context of unexplained system outages during times of market instability. Reasons for regulatory intervention in the conventional world. Few exercise any form of mitigation against market abuse, while some have even been accused of trading against their clients in what economist Nouriel Roubini has compared to a casino dealer betting against a gambler whose cards they have seen.

Coinbase may be a hugely profitable business, but it may also be a uniquely risky one relative to regulated trading venues such as the CME or ICE, neither of which are allowed to take principal positions to facilitate liquidity on their platforms. Instead, they rely on third party liquidity providers.

Coinbase, however, is not only known to match client transactions on an internalised “offchain” basis (that is, not via the primary blockchain) but also to square-off residual unmatched positions via bilateral relationships in crypto over-the-counter markets, where it happens to have established itself as a prominent market maker. It’s an ironic state of affairs because the netting processes that are at the heart of this system expose Coinbase to the very same risks that real-time gross settlement systems (such as bitcoin) were meant to vanquish.

According to its S1 filing, up to 11 per cent of the company’s revenue was sourced from other revenue which includes the sale of crypto assets where Coinbase itself is the principal in the transaction.

As the document explains (our emphasis):

Periodically, as an accommodation to customers, we may fulfil customer transactions using our own crypto assets. We fulfil customer accommodation transactions using our own assets for orders that do not meet the minimum trade size for execution on our platform or to maintain customers’ trade execution and processing times during unanticipated system disruptions. We have custody and control of these crypto assets prior to the sale to the customer and record revenue at the point in time when the sale is processed. Accordingly, we record the total value of the sale as revenue and the cost of the crypto asset in other operating expense.

The 11 per cent figure might sound like a small amount, especially given the cost of capital necessary to facilitate it, but its impact on broader profitability is likely to be far more wide reaching, given that liquidity breeds liquidity.

Craig Pirrong, a professor at the University of Houston and established expert on commodity and exchange regulation, agreed that Coinbase’s principal-based activities make comparisons with conventional exchanges redundant.

As he noted to FT Alphaville on Wednesday:

CME and ICE are neutral many-to-many platforms that do not take positions. Coinbase is a market making entity that does take positions, and hence incurs substantial risks that exchanges do not. Comparing the financial performance of such an entity to CME without taking the substantially different risk profile into account is completely offbase. CME is like the hardware store selling shovels to the prospectors: Coinbase is more like the prospectors.

The fact that by Coinbase’s own admission “judgment is required in determining whether the Company is the principal or the agent in transactions between customers” speaks volumes about the potential conflicts at hand.

Coinbase downplays these risks by stating it does not bear inventory risk from its principal trading activities because it is “not responsible for the fulfilment of any crypto asset”. But that can also be interpreted to mean that Coinbase only engages as a counterparty with its own customers when it pays for them to do so, undermining the argument that its principal trading activity is always in the interests of its clients.

A last point of concern is that Coinbase readily admits in its S1 to engaging in prime-broker type activities, for which it is also not regulated, notably by offering credit-based products and services to institutional customers and post-trade credit. In particular, it notes:

We introduced post-trade credit whereby we advance funds and settle on behalf of credit eligible customers, removing a key point of friction by allowing customers to instantly trade on credit and settle within a few days.

Again, this is not the sort of activity a conventional exchange would be allowed to engage in due to conflict of interest reasons. Indeed, one need only to read Michael Lewis’ Flash Boys to understand how such asymmetries might upset buyside operators in the long run.

What’s more, when you consider the bitcoin economy was forged through the sweat of crypto-promoters claiming the standing system is not to be trusted because it is underpinned by evil credit-based transactions . . . again, it all feels a little too ironic. Don’t you think?

Coinbase did not reply to our questions, and we will update the post if they do.