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Why Coinbases’ stellar gains aren’t what they seem

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

Early results showed revenue skyrocketed to $ 1.8 billion in the first quarter of 2021 from $ 191 million in the same period last year, with net income climbing to C $ 730 million.

Other numbers that stand out include the service reaching 56 million verified users, a trading volume of $ 335 billion, and its assets worth $ 223 billion, setting the crypto service for a valuation of up to. reach $ 70 billion.

The folks at Twitter quickly forged a consensus that numbers like these prove not only that the Delaware-incorporated company is a profit-making machine, but that crypto itself can no longer be ignored by mainstream finance. .

As John Street Capital tweeted in an illuminating Twitter feed:

But investors should be reminded that the main concern remains that the current framework in which Coinbase is regulated (a money transmission system) is not at all suited to regulate its broader activities, one of which is its trading activity. exchange and its main trading operations.

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

In an upcoming qualitative review of the regulatory status of 16 crypto exchanges, Martin Walker, director of the Evidence Center and fintech consultant, and co-author Winnie Mosioma, the founder of Blockchain Legal Consultancy, argues that these kinds of inconsistencies will need to be closed. if these platforms are to compete in the formal financial sector:

Conventional platforms for trading in securities, forex, derivatives, commodities and other more conventional financial assets are strictly regulated, whether they are officially classified as exchanges or as Alternative Trading Systems (ATS). An ATS, while not strictly an exchange, must follow the regulations that apply to exchanges or brokers based on a number of criteria (varying between jurisdictions), such as volume of transactions and market share. Regardless of the classification, conventional trading platforms must follow strict rules designed to protect investors and prevent destabilization of the financial system. In particular the rules which require a high level of transparency guaranteeing operational resilience.

The background, they note, is the cryptocurrency’s inherent reliance on multilateral exchanges to facilitate price discovery. This contrasts with Bitcoin’s predecessors such as Liberty Reserve or E-gold, which were only to be serviced by third parties willing to exchange digital currencies for the corresponding linked assets for a fee.

Since crypto regulations have largely failed to resolve this dependence, it has led to a patchwork of conflicting regulatory approaches, many of which completely ignore any corresponding trading activity or facilitation.

A typical example is that seven of the largest US exchanges, including Coinbase, operate as Money Services Businesses (MSBs) or equivalent. This classification ensures that platforms must be registered with the Financial Crime Network (FinCEN) in the United States and / or the Financial Conduct Authority in the United Kingdom, but it does not mean that their trading activities are formally supervised.

As the authors note:

Given the lack of meaningful regulatory oversight of actual trading activity, it is probably not surprising that many cryptocurrency exchanges engage in questionable activities, such as offering leverage to their clients. and the washout of trading, all against the backdrop of unexplained system breakdowns in 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 negotiating against their clients in what the economist Nouriel Roubini compared to a casino dealer betting against a player whose cards he has seen.

Coinbase can be an extremely profitable business, but it can also be particularly risky compared to regulated trading platforms such as CME or ICE, which are not allowed to take major positions to facilitate liquidity on their platforms. -forms. Instead, they rely on third-party liquidity providers.

Coinbase, however, is not only known for matching customer transactions on an internalized ‘offchain’ basis (i.e. not through the main blockchain), but also for offsetting unmatched residual positions through bilateral relationships on over-the-counter crypto markets, where it has established itself as a leading player in the market. This is an ironic situation because the clearing processes that are at the heart of this system expose Coinbase to the same risks that real-time raw settlement systems (such as Bitcoin) were supposed to conquer.

According to his S1 deposit, up to 11% of the company’s revenue came from other income, including the sale of crypto assets where Coinbase itself is the principal of the transaction.

As the document explains (our emphasis):

Periodically, to accommodate customers, we may transact with our customers using our own crypto assets. We execute customer hosting transactions using our own assets for orders that do not meet the minimum transaction size for execution on our platform or to maintain transaction turnaround and processing times. customers in the event of unforeseen system disruptions.. We have custody and control of these crypto assets prior to sale to the customer and record the income at the time the sale is processed. Therefore, we record the full value of the sale as income and the cost of the crypto asset in other operating expenses.

The 11 percent figure may seem like a small amount, especially given the cost of capital needed to facilitate it, but its impact on broader profitability is likely to be much larger, as liquidity breeds liquidity. .

Craig Pirrong, a professor at the University of Houston and a recognized expert in commodity and currency regulation, agreed that Coinbase’s core business makes comparisons to conventional exchanges redundant.

As he pointed out to FT Alphaville on Wednesday:

CME and ICE are neutral many-to-many platforms that take no position. Coinbase is a market making entity that takes positions and therefore incurs significant risks that exchanges do not. Comparing the financial performance of such an entity to that of CME without taking into account the substantially different risk profile is completely off base. CME is like the hardware store that sells shovels to prospectors: Coinbase is more like prospectors.

The fact that, by Coinbase itself, “judgment is required to determine whether the company is the principal or the agent in customer-to-customer transactions” speaks volumes about the potential conflicts at hand.

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

A final point of concern is that Coinbase willingly admits in its S1 to engage in prime-broker-type activities, for which it is also not regulated, in particular by offering credit products and services to institutional clients and post-trade credit. In particular, he notes:

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

Again, this is not the kind of activity that a conventional exchange would be allowed to engage in for reasons of conflict of interest. Indeed, just read Michael Lewis’ Flash Boys to understand how such asymmetries could upset traders in the long run.

Plus, when you consider that the bitcoin economy has been sweat-forged by crypto promoters claiming that the permanent system is untrustworthy because it is underpinned by bad credit-based transactions. . . again, this all sounds a bit too ironic. You do not think?

Coinbase did not answer our questions and we will update the post if they do.



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