Coinbase lays out leverage ambitions with Prime Financing

Coinbase reported earnings yesterday, beating Wall Street's estimates even though some metrics came in lower than the prior quarter. 

Let's start with the financials. 

The second quarter was underpinned by a period of low volumes for Coinbase and the broader spot crypto market, which resulted in a steep decline in Coinbase's transaction-based revenues. This was expected. Total transaction revenue for the quarter came in at $327.1 million compared to $374.7 million in the previous quarter. As for subscription services, a decline in the market capitalization of USDC resulted in a drop of about $40 million in interest income. Circle, which founded USDC with Circle in 2018, shares in the profits derived from the yield the cash pile behind the coin generates.

Still, the beat can be attributed to higher-than-expected interest income and blockchain rewards revenues. Here's JMP Securities:

Subscription & Services revenue of $335M came in well ahead of our expectation ($37M above) and management’s guidance for the quarter (~$300M), driven by better-than-expected Interest Income and Blockchain Rewards revenue. 

Management noted that July transaction revenue was ~$110M, a stronger start to the quarter than we had expected (suggesting a continuation of stronger take-rates). The company also guided to “at least” $300M of Subscription & Services revenue in 3Q, a bit better than we had previously modeled ($287M).

In total, revenue came in at $708 million, down 8% Q/Q.

The firm is also delivering on its promises to operate leaner, bringing total operating expenses, absent impairment, down to $773 million in the second quarter from $884.3 million in the previous quarter. 

Liquor, love and leverage

As for product-related updates, the firm provided several updates on its product suite — specifically, multiple hints that Coinbase seems keen to unleash leverage upon its users. 

It mainly went missed on Crypto Twitter, but hidden in the earnings docs was a mention of a new offering launched in Q2 called Coinbase Prime Financing. Here's the relevant passage from the shareholder letter: 

In Q2, we launched the first of its kind integrated crypto prime finance offering to enable active and complex trading operations for large financial institutions. Coinbase Prime now features a fully integrated trading, financing and custody solution, allowing clients to deploy long and short leverage based on dynamic, risk-based margining aligned with best in class traditional finance principles.

Indeed, this marks Coinbase's latest chapter in its mission to offer a full-scale prime brokerage offering to its institutional clients. That kicked off in earnest when its acquired institutional brokerage firm Tagomi in May 2020. I first heard about Coinbase's efforts to expand its lending capabilities in February. It was pitched to me as a move to capitalize on the gap left in the market after last year's credit crisis, which brought firms like BlockFi and Genesis Capital to its knees. The importance of a proper prime broker — through which hedge funds and family offices can trade across multiple venues — can't be understated.

But there are a few hurdles Coinbase will need to overcome to be successful here. For one, the U.S. Securities and Exchange Commission has already called the firm out for operating a business that bundles together functions that would be separate on Wall Street. The second issue is it might be difficult for Coinbase to offer clients access to the widest range of venues considering they are directly competing with those venues. The third issue is not Coinbase-specific but a broader problem for crypto lending: the age of undercollateralized lending is over. For many institutions, that is a non-starter. 

Offshore derivatives 

There wasn't much additional color on the firm's offshore derivatives exchange Coinbase International. As The Block reported, the Bermuda-registered venue clocked nearly $2 billion in trading volumes in July across its two perpetual swap contracts. In a call with analysts, CEO Brian Armstrong said that the market is still in a beta launch, which was striking to me, considering the volumes are actually quite impressive for a new derivatives market. I haven't checked the chain, but they've probably done more volume in a month than ErisX did in its entire existence (I joke). Anyway, leverage will play an important role here as well. Here's Brian, courtesy of The Motley Fool: 

"Our customers have also asked for features around unified margin and additional kind of financing and leverage-type features. So, those are some of the things on the horizon. You can track -- the data is public just around the volume of the books that we have there live today on our site...We'll also be adding more books."

As per Coinbase's shareholder letter, the market has over 50 institutions onboarded and has traded $5.5 billion in notional contract volumes. Not bad.

Leverage came up again at the end of Coinbase's analyst call, following a very interesting question from Ben Budish of Barclays about the differences between Coinbase's retail users and its more "prosumer" or professional traders. The latter group tends to be less engaged with the platform during less active periods, while the former is more consistently engaged. Armstrong chalks it up that consistency to "simple" traders' dollar-cost averaging, adding that the firm is working on adding more leverage features to keep more advanced traders engaged. Here's Armstrong again:

And so, I think as we mature our product offering around the pro traders, which we still have more work to do, I think, hopefully, we will see that in -- even in up and down markets, we'll see more activity be more sticky there because pro traders, in theory, I think you're right, they should be able to find opportunities to trade whether the market is -- no matter what the market is doing. So, yeah, I think we need to mature our pro trader offering a bit and that may emerge over time.

This first appeared in Frank Chaparro's biweekly The Scoop Newsletter. Sign up now.