Leon Neal
The war between the Securities Exchange Commission and the entire domestic cryptocurrency industry seems to be hitting a fever pitch after a post-market close Wells Notice disclosure from Coinbase (NASDAQ:COIN) yesterday. In response to the announcement, Coinbase shares traded down 14% after hours Wednesday and opened more than 20% off at the start of today’s session. With this notice, the SEC is telegraphing legal action and Coinbase appears ready for a fight:
We are confident in the legality of our assets and services, and if needed, we welcome a legal process to provide the clarity we have been advocating for and to demonstrate that the SEC simply has not been fair or reasonable when it comes to its engagement on digital assets.
It seems fairly certain at this point that the two sides will be meeting in court and the company is left guessing what the exact battlefront will be. According to Coinbase’s blog post detailing the notice:
Today’s Wells notice does not provide a lot of information for us to respond to. The SEC staff told us they have identified potential violations of securities law, but little more. We asked the SEC specifically to identify which assets on our platforms they believe may be securities, and they declined to do so. Today’s Wells notice also comes after Coinbase provided multiple proposals to the SEC about registration over the course of months, all of which the SEC ultimately refused to respond to.
At this point it isn’t entirely clear what the SEC will be bringing to the table but if we look at other clues, I think it’s reasonable to assume Coinbase’s staking services are going to be the main target.
In addition to the Wells notice disclosure yesterday, Coinbase also informed customers on Wednesday that the company would be ending Algorand (ALGO-USD) rewards through the Coinbase platform. Staking as a service was also the catalyst behind Kraken’s settlement with the SEC earlier this year.
Staking Revenue & Broader Implications
If it is indeed staking products that the SEC takes issue with, that line of business is quickly becoming an important part of Coinbase’s monetization model as it’s grown from just 3% of revenue in 2021 to nearly 9% of revenue in 2022:
| Q4-21 | Q1-22 | Q2-22 | Q3-22 | Q4-22 | 2021 | 2022 | |
|---|---|---|---|---|---|---|---|
| Blockchain Rewards | 102.7 | 81.9 | 68.4 | 62.8 | 62.4 | 223.1 | 275.5 |
| Total Revenue | 2,490.0 | 1,164.9 | 802.6 | 576.4 | 604.9 | 7,354.8 | 3,148.8 |
| Blockchain Rewards % of Total | 4.12% | 7.03% | 8.52% | 10.90% | 10.32% | 3.03% | 8.75% |
Source: Coinbase, millions of $
While staking is certainly not the main source of Coinbase’s revenue, blockchain rewards have been one of only real revenue growth areas for Coinbase outside of interest accrued on USCoin USD (USDC-USD) holdings over the last year:
| Revenue Type | 2021 | 2022 | YoY |
|---|---|---|---|
| Transaction; Consumer | 6,491 | 2,236.9 | -65.54% |
| Transaction; Institutional | 346.3 | 119.3 | -65.55% |
| Blockchain Rewards | 223.1 | 275.5 | 23.49% |
| Custodial fees | 136.3 | 79.8 | -41.45% |
| Interest Income | 25.8 | 327 | 1167.44% |
| Other subscription and Services | 132.3 | 110.3 | -16.63% |
Source: Coinbase, millions of $
The biggest source of the blockchain rewards revenue comes from staking Ethereum (ETH-USD) and that brings us to the broader implications of what could be an important court battle with the SEC.
ETH Stake (Dune Analytics/hildobby)
Coinbase is one of the largest stakers on the Ethereum chain and accounts for 12.7% of the 17.9 million ETH staked. Kraken is also a significant supplier of ETH stake and together they make up nearly 20% of the ETH stake. The Shanghai upgrade is expected any week. Shanghai will allow the beginning of ETH deposits to be withdrawn from stake. If it is ultimately determined by a court that Coinbase can’t continue to offer its ETH staking service, it is almost certainly going to have an impact on the broader crypto ecosystem. We’re still probably a long way from that being decided, but it is something that COIN holders and ETH holders should keep in mind.
Why These Services Exist
I think it’s important to note that there is a key difference between what Kraken’s staking service was offering and what Coinbase’s staking services offer. Kraken’s product was more similar to what companies like Celsius (CEL-USD) and Nexo (NEXO-USD) typically offered customers. Those products were marketing set yields on deposits with less clarity on how the yield was being generated. For Coinbase, the product is more straightforward.
Proof-of-Stake blockchain validation requires staked assets directly on the chain rather than dumping capital into expensive mining machines that consume a lot of energy. However similar to the high cost associated with running a mining rig operation, many of these PoS blockchains require staking minimums that are too onerous for everyday users who want to participate.
Ethereum is a good example of such a blockchain and this problem has led to the rise of on-chain staking-as-a-service protocols like Lido Finance (LDO-USD) and RocketPool (RPL-USD). These protocols allow smaller holders to pool their assets together to generate staking rewards for a fee to the protocol. These pooled asset protocols are very similar to what Coinbase offers, but Coinbase does so through a centralized KYC/AML compliant exchange.
Summary
The Wells Notice is almost certainly foreshadowing a court battle between Coinbase and the SEC. While Grayscale is fighting the SEC in court on a completely different front, there is little doubt in my view that the war between the crypto industry and US regulators is beginning to intensify. That war is probably going to be expensive and it could ultimately result in Coinbase being required to eliminate one of its revenue growth segments. I think it takes some guts to long COIN here and I’d personally rather use Coinbase as a consumer than invest in the business today.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.