Coinbase — the The NYSE + Goldman Sachs + AIG + Paypal of crypto?

[disclaimer: Although 10Ks and S1s are snapshots of the company in question, We are interested in the nature of the business and economics of the industry / sector. These articles will not go into financial analysis of companies but highlight interesting business models, macro and microeconomic insights of the industry and companies, interesting accounting issues, risks and any interesting tidbits we can discern. These are not recommendations to buy or sell any securities of the company in question.]

Coinbase is going to be one of the biggest IPOs of 2021. The company started in 2012 as an exchange for retail investors to buy and sell crypto currencies, today it broadly describes itself as a provider of end-to-end financial infrastructure and technology for the entire crypto economy. As we write this article the two preeminent crypto currencies Bitcoin and Ethereum have hit all time highs of approximately USD 60,000 and USD 2,000 respectively. You will see the year 2020 has been a spectacular financial success for Coinbase. It is however ironic that a centralized provider / exchange / wallet (we will use the term platform going forward) like Coinbase is everything that the decentralized finance and blockchain economy set out to disrupt.

Here are some insights from their S-1

Learnings about the Industry / Sector

• The entire modern crypto-economy began with the 2010 Bitcoin whitepaper published by the anonymous Satoshi Nakamoto.
• The overall market capitalization of crypto assets grew from less than $500 million to $782 billion between December 31, 2012 and December 31, 2020, representing a compound annual growth rate, or CAGR, of over 150%. (As a comparison to the $782B crypto assets, the entire S&P 500 today is about 40x that around $31T)
• Competing with centralized platforms like Coinbase, Kraken and Gemini there are a significant number of decentralized platforms that have recently been developed and released, including on Ethereum, Tron, Polkadot, and Solana, and many such platforms have experienced significant growth and adoption.

Learnings about the Company

• Coinbase captures 11% of the crypto market today.
• The Coinbase platform serves 43M verified users (2.8M are monthly active), 7,000 institutions, and 115,000 ecosystem partners in over 100 countries.
• The platform manages 90B of assets on the platform a 432% annual increase.
• Revenue is primarily generated largely from transaction fees that are earned from volume-based trades on the platform by retail users and institutions. Coinbase generated $1.27 billion in 2020.
• The platform has seen trading volume increase from $17 billion to $21 billion to $38 billion in 2018, 2019, and 2020, respectively.
• The company swung from an operating loss of -$45M to an operating profit of $408M from 2019 to 2020, primarily a result of the huge trading volumes generated by the exponential increase in the price of Bitcoin in 2020.
• As seen below Bitcoin (BTC) represents 70% of the assets held by the platform in 2019 and 2020 despite doubling the types of crypto assets in the years.

• As of December 31, 2020, the total value of crypto assets on Coinbase represented 11.1% of the total market capitalization of crypto assets, increasing from 8.3% and 4.5% as of December 31, 2019 and December 31, 2018, respectively.
• Coinbase is rapidly building out its platform moving away from just trading to effectively a full stack investment bank / insurer / payment provider in the crypto economy. See the stack illustration below
• The founders Brian Armstrong and Fred Ehrsam retain 21% and 9% of the voting power. The venture / private equity firms Andreessen Horowitz, Union Square Ventures, Ribbit Capital and Tiger Global were early investors and own significant economic interests [Ref page 184 S-1 ].

Potential Red Flags

• Needless to say Coinbase’ future is entirely tied to the future of the crypto-economy. The 432% annual increase in assets under management is entirely tied to the exponential growth of the price of Bitcoin and the consumer / institutional frenzy it has generated.
• If the SEC decides to regulate BTC and ETH as securities, Coinbase will have to comply as a broker-dealer operating an alternate trading system and all the regulatory burdens that come with it.
• The high concentration of Bitcoin (BTC) as a proportion of assets, makes Coinbase highly vulnerable to the Bitcoin economy.
• Coinbase is expected to be valued at an astronomical $90B to $100B, with an annual revenue of $1.27B. In comparison stock exchanges like Nasdaq trade at a market cap of $24B and revenue $4B and the Intercontinental Exchange has a market cap of $64B and revenues of $8.2B. As seen these trade at considerably low market caps v. their revenues. However we must keep in mind Coinbase is not just a trading exchange anymore it is effectively trying to become the NYSE + Goldman Sachs + AIG + Paypal of the crypto world.
• Coinbase has fast moving competition in the form of well funded crypto companies like Kraken, Gemini, other fintech companies like Paypal, Square and many new US and non US exchanges.
• The company is fully cooperating with certain investigations with the CFTC, SEC and certain state attorney general offices [S-1 Ref. page 154]

Conclusion

We are looking at the IPO of a full stack financial powerhouse for the crypto economy. If you believe in crypto and its staying power there is no doubt that Coinbase could become a multi hundred billion perhaps even a trillion dollar company one day. However this is by definition a high risk high reward situation. The modern crypto-economy is barely a decade old, it is truly the wild wild west and the technological and regulatory unknowns are massive. We are personally bullish on crypto as an emerging asset class. However as always with new fangled ideas it is best to stay on the sidelines or bet amounts of money that you would not miss if it all went to zero.