Recently, the news broke that Coinbase, the digital currency exchange, would make its shares available to the public through a direct listing, a less common path to public status. So naturally, while rumors swirled that the company would debut at a whopping $100 billion valuation, I found myself flipping through their associated S-1 filing.
On a personal note, I’ve struggled to dissect cryptocurrency since 2013. With that in mind, I found Coinbase’s filing to be the perfect way to reflect on all that has happened since then. In many ways, their accomplishments are astounding. However, as I read through the text and the numbers, I couldn’t help but fall back on my old suspicions of the “cryptoeconomy.” That suspicion was no stronger than when I got to this line on page 3 of their filing:
“We power the cryptoeconomy by combining the best of both emerging blockchain technology and traditional finance."
It’s a particularly verbose statement and one that I felt raised more questions than answers.
In regards to blockchain technology, I feel strongly that we are still in the early days of its development. Using the internet as a baseline, which took at least 25 years to go from practical application to societal impact, I question how Coinbase can be so confident in their use of the “best of emerging blockchain technology,” when the best days are most likely still to come.
The statement becomes even more murky when looking at Coinbase’s claim that they use the “best of traditional finance.” The task of defining “traditional finance” alone has filled the pages of many books whereas a glance at the modern financial industry shows that Coinbase has hardly done anything novel.
This is not to say that Coinbase isn’t important or impressive. What Brian Armstrong and his team have built is undeniably both. But its relationship with the “cryptoeconomy,” a word that appears 167 times in their S-1, is much more complex, and merits a deeper look.
Do you know what they overcame?
Without going too deep into the well told story of Bitcoin, Satoshi Nakamoto, and the elegant nine-page white paper that started it all, let’s recall some of the key design principles that originally made the decentralized cryptocurrency so appealing.
One was privacy. Today, it is commonly known that Bitcoin’s earliest use case was the facilitation of illegal activity on the dark web. And while such behavior is most certainly abhorrent, the market need for something like Bitcoin is something that we can all understand from movies and television. From crime dramas to comedies, popular culture has shown us time and again that criminals operate in cash. So as legal commerce moved online with credit cards, illegal commerce found itself in need of a discrete method of transaction that couldn’t be traced back to the authorities.
Another was security. Bitcoin’s use of encryption (a way of protection information), makes it theoretically impossible for one person to duplicate another’s Bitcoin and makes it extremely secure for a single user to authorize their own transactions. But security is a double-edged sword. Over the years some of the real life practices that were required to access Bitcoin created all types of crazy headlines including a $300 million hard drive sitting in a landfill and two former olympians cutting up sheets of paper to put in safety deposit boxes.
So while these wild stories (or idiotic practices) paint an accurate picture of Bitcoin’s secure nature, they also create friction. And where there is friction, there is opportunity.
Enter Coinbase.
Today, Coinbase hands over user data directly to the IRS. This is antithetical to the concept of privacy. They have a “forgot password” feature. That level of security is just one phishing scam away from a breach.
In 2012, the security steps required for the average person to access Bitcoin were daunting. They were unlike anything else on the internet and frankly, unnerving. At the same time, Bitcoin was just starting to make its existence known on a national level. So whether they realized it or not, Coinbase started making Bitcoin more accessible by contradicting the very principles that made it so attractive in the first place. If nothing else, that should force us to recognize how fast and drastically the applications of an emerging technology can change. And it makes me deeply question Coinbase’s ability to continue to capitalize on the next major shifts for blockchain technology, now that they’ve constrained themselves in the success of capitalizing on the first one.
Do you know they rewrote the game?
Of course it is also possible, even likely, that most consumers could not care less about privacy and security. So let’s look at a more basic question: what is the point of cryptocurrency? Or any currency for that matter?
The traditional definition of currency is that it is a medium of exchange - a way for us to transact with others. At one point, Bitcoin’s shady past even found its way into the light. By at least 2017, a few coffee shops and restaurants in New York were taking Bitcoin. Back then, at roughly the midpoint of Coinbase’s existence, it started to seem like cryptocurrency could become a viable option for our daily spending.
But today, we read about the the infamous $200 million pizza paid for with Bitcoin. Massive volatility and a general upward trend in the price of Bitcoin, has changed the cryptocurrency from a payment method for your morning coffee to a ticker in your investment portfolio. It is important to recognize that difference.
When it comes to Bitcoin’s meteoric rise and de-facto reclassification as a tradable asset, Coinbase has undoubtedly been at the center. User adoption of the popular crypto application has been synonymous with Bitcoin’s uptick in price:
I don’t share this graph as if to uncover some hidden mystery, but rather to highlight the simple economic relationship in action. An increase in the number of traders, alongside Bitcoin’s fixed supply and lack of alternative use cases (i.e. no spending), has turned the cryptocurrency into a large game of digital hot potato, with new demand for the asset continuing to drive up the price.
And while Coinbase has claimed to do this by adopting “the best of traditional finance,” it seems rather obvious to me that the only aspects they’ve adopted are the same tactics that have seemed to get their fintech foe, Robinhood, in hot water.
Robinhood vs. Coinbase
Despite all of Coinbase’s claims otherwise, at the end of the day, they are just a brokerage firm. They help people (and institutions) buy and sell. If you learned anything from my last newsletter about how to do that effectively, you’ll remember that Robinhood is also pretty good at this game. One needs to look no further than the home screen of both apps to begin to see how similar these businesses are:
The main elements of each are shockingly similar: the prominent positioning of the portfolio balance, a minimalist design around the other information, and the ability to navigate most of the main features with just five buttons on the bottom of the screen. If you are reading this and you work at Vanguard, please take notes. Seriously. I’m a customer and your app sucks. Please fix it.
More importantly, the similarities are not just cosmetic. Looking under the hood at Coinbase’s financials, we see a similar cost structure to some of the other (formerly) public brokerage firms after consolidating some categories:
Although the numbers don’t line up perfectly, the consistency across their SG&A + Tech expense tells us that the basic operational needs to support these businesses are variable costs that will unlikely come down as Coinbase scales. In fact, scale is probably the biggest driver of the delta across businesses. TD Ameritrade, prior to the acquisition by Charles Schwab, was likely able to produce the highest margins because of their size. Coinbase’s biggest advantage, the high per trade revenues that they reap from an opaque market, strikes me as unsustainable in the long term as more and more players will undoubtedly mimic their success.
In fact, Robinhood was quick to get in on crypto trading when Bitcoin reached a local maximum in 2018. This past month some more prominent players got back in on the fun as well.
All of this is important to keep in mind as we think about what happens after Coinbase’s hotly anticipated market debut. With over nine years in business and over one billion dollars in revenue last year, it is safe to say that Coinbase is an established, grown up business that is ready for the public markets.
That maturity comes with the unshakable realities of their financial situation and position in the market. Regardless of their valuation, which at a rumored 100x revenue (vs. industry averages of 6-7x) does seem eye-watering, Coinbase will need to find ways to innovate and grow with a business model that is highly susceptible to competition. At present, they have a number of things going in their favor, including a rock bottom customer acquisition cost (also similar to Robinhood), but they will need to be careful if they want to live up to the words in their S-1. Which leads us to one last question…
What comes next?
At the beginning of this newsletter I stated that Coinbase’s claim of combining the best of both emerging blockchain technology and traditional finance was dubious. I stand by it. But ironically enough, I believe their future successes lie in embracing that exact statement.
On the blockchain front, just yesterday, a non-fungible token (a blockchain verified asset) sold for $69 million at Christie’s, the famous auctioneer. Although Coinbase violated some of the key founding principles of blockchain, they’ve held true to another: scarcity. Like blockchain technology itself, non-fungible tokens are still in their early days. Coinbase would be wise to stay on the bleeding edge of this new trend, offering advisory services and repeatable processes to any company that wants to create NFTs. If these new tokens proliferate the same way that cryptocurrencies did in the decade prior, there will likely be another handful of necessary services (verification comes to mind) that Coinbase will be best positioned to provide.
On the traditional finance front, Coinbase needs to look no further than Schwab.com for inspiration . The name of the game here is horizontal integration. Coinbase should continue to double down on new crypto products: their new staking product (think high yield savings), pooled crypto investments (think ETFs), and lending are all logical categories for expansion. I would expect Coinbase to establish itself in all three, plus a few others, over the next few years.
Finally, no matter their business lines, Coinbase will have to strengthen its role as a public champion for the crypto space. One thing I’ve hardly mentioned here is the role of regulation and how it will ultimately impact crypto. Coinbase presents that risk clearly in their S-1. They also disclose that “the cryptoeconomy is novel and has little to no access to policymakers or lobbying organizations.” Yet they also mention (twice, in fact), that “we invest heavily in regulatory compliance by working with regulators around the world to shape policy.”
Like it or not, Coinbase will need to continue to persuade government officials around the world to adopt favorable crypto policies that address the regulatory grey areas in the space. Doing so will certainly benefit Coinbase, but I also think that, given their current reliance on other tokens, that this is a situation where their work could end up being positive for many other participants in the cryptoeconomy.
And regardless, the histories of finance and government have overlapped since the earliest days of human civilizations. If Coinbase wants to pursue “the best of traditional finance,” their lobbying and policymaking efforts are perhaps the most important part of keeping that tradition alive.