Coinbase’s imminent stock market debut has been a long time coming. It’s a fortuitous time for a crypto exchange to go public; at US$2 trillion (at time of writing), crypto-assets’ total market capitalisation is at an all-time high. The frothy market makes people trade with abandon, bestowing lucrative transaction revenue and custody fees (c. US$1.8 billion in Q1 2021) to Coinbase. In good times, it’s easy to overlook the risk factors listed on Coinbase’s S-1 filing. “No risk, no reward” is the mantra of the day.
Fluctuation in the crypto-market is the obvious risk to Coinbase’s profitability. As a keen follower of the decentralised finance (DeFi) space, I’m interested in delving into the following risk factor:
We compete against a growing number of decentralized and noncustodial platforms and our business may be adversely affected if we fail to compete effectively against them.
Coinbase’s SEC Form S-1
Decentralised exchanges
Apart from enabling buying/selling of crypto-assets, centralised exchanges (CEXes) like Coinbase also act as custodians; they store and secure users’ crypto-assets. CEXes are arguably the weakest link of the crypto-economy with a history of high-profile hacks. Decentralised exchanges (DEXes) aim to solve this problem by enabling users to trade crypto-assets directly from their non-custodial wallet, removing the need for intermediaries.
In addition to the main benefit of bypassing intermediaries, DEXes offer the following advantages over CEXes:
- More trading pairs – Coinbase has a rigorous listing process; it takes time for new crypto-assets to be supported and some tokens may not pass Coinbase’s requirements. In contrast, DEX users do not need permission and can trade any tokens; the caveat being that esoteric trading pairs may suffer from poor liquidity, causing slippage (i.e. the trade is executed at a different price than expected).
- Lower fees (potentially) – On Coinbase Pro, users pay trading fees ranging from 0% to 0.5%, depending on trade size. On its platform for beginners, Coinbase charges a much higher trading fees. In contrast, DEXes have lower trading fees as they do not have the same operational costs as a CEX. However, users on DEXes also have to pay fees to blockchain miners/validators. On the Ethereum blockchain, for example, miner fees have been sky-high in recent months due to network congestion, making small trades uneconomical.
Automated market makers
DEXes have to overcome two main hurdles: 1) scalability, and 2) liquidity.
The earliest DEXes replicated the “order book” approach used by CEXes. At the most basic level, order books pair buyers and sellers by the price they wish to trade at. Order books rely on market makers, who continuously and actively provide a buy and sell price, to provide liquidity.
This approach is not efficient and scalable on blockchains with a low throughput (e.g. Ethereum). There have been work-arounds using “off-chain” (i.e. off the blockchain) order books to increase the speed and number of orders but these rely on centralised entities, somewhat sacrificing the decentralised aspect of a DEX.
Currently, some of the most popular DEXes use variants of the “automated market maker” (AMM) approach. In this approach, market makers are replaced by liquidity pools i.e. pools of crypto-assets which users can trade against. This approach is more scalable as it negates the need for market makers continuously providing buy/sell quotes on slow blockchain networks. Asset prices are dynamically set using a pre-defined model that’s linked to order size and the quantity of assets available in the pool. As a result, AMMs need to have large liquidity pools to prevent slippage.
Liquidity providers (LPs) take on a significant risk (watch Impermanent Loss Explained) when they contribute to liquidity pools. To incentivise LPs, DEXes share trading fees with the LPs and reward them with governance tokens.
There are now a multitude of DEXes and DEX aggregators on various smart contract blockchain platforms. The trading volume on these DEXes has been on the rise, indicating increased activity and usage. At the height of DeFi Summer (the DeFi craze in the summer of 2020), the daily trading volume on Uniswap, the most popular DEX on the Ethereum blockchain, surpassed Coinbase’s.
Threat to Coinbase 🤷♂️
Coinbase is in the business of providing a regulated, trusted, and user-friendly bridge between fiat currencies (e.g. USD, GBP, EUR etc.) and crypto-assets. In this narrowly defined but important market segment, Coinbase is currently dominant and has a near monopoly.
DEXes are not currently a competitive threat to Coinbase in this market segment for the following reasons:
- No support for fiat currencies – Fiat currencies cannot be used on DEXes. While DEXes support stablecoins (the value of which is soft-pegged to a target fiat currency), it’s not quite the same because the average user does not own stablecoins or know what to do with them. As Central Bank Digital Currencies (CBDC) gain traction in the long term, it’s not inconceivable that DEXes may support them.
- Non-custodial is a double-edged sword – The average user sees self-custody as a bug, not a feature. Most users do not want the responsibility that comes with self-custody of their crypto-assets; it’s easier and more convenient to use a trusted custody service provider. However, this may change as users’ knowledge and experience level up.
Trust and ease of use will be as relevant in ten years as they are today… We may not always move the fastest, or offer the lowest prices, but if we accomplish our goal of being the most trusted and easiest to use, customers will continue to choose our products and services now and in the future.
Brian Armstrong, Coinbase CEO
As at end March 2021, Coinbase had US$223 billion worth of crypto-assets under its custody, representing c. 11% of the total crypto-asset market capitalisation. That is a tremendous amount of trust placed upon Coinbase, and a honeypot for cyber criminals.
To paraphrase Warren Buffett, it takes years to build trust but one security breach to ruin it. If the relatively short history of centralised exchanges is anything to learn from, cyberattacks and the resulting loss of customers’ crypto-assets present a material risk to Coinbase’s business.
The bottom line: Coinbase has built a valuable brand known for providing a regulated, trusted and user-friendly fiat on-ramp to the crypto-economy. Decentralised exchanges (DEXes) built on smart contract blockchain platforms do not currently pose a competitive threat to Coinbase. However, DEXes provide a clear benefit; they remove the need to trust intermediaries in trading and storing crypto-assets.
Disclaimer: This is NOT investment advice/recommendation. I write on this blog in my personal capacity; my own views and opinions are NOT endorsed by my employer or the actuarial profession. DEXes mentioned in this post are the most notable examples to use to illustrate a point. Mentioning a DEX does not imply endorsement or recommendation. Providing liquidity to DEXes or investing in their governance tokens could potentially result in severe financial losses (getting “rekt” in crypto parlance).