DEEP DIVE is a series of in-depth articles on FinTechtris that explores a particular fintech unicorn, discussing its history, products / services, and how it has grown to be an industry leader. 

Coinbase’s MISSION:

“… create an open financial system for the world.”

Cryptocurrency exchanges seek to diversify investments and add additional currencies that are not controlled by central governments. With over 10 years of bitcoin being readily available, crypto has made a firm stand in the financial community — and Coinbase is ensuring it stays the popular option both in the US and globally.

Coinbase is a US digital currency exchange (or cryptocurrency exchange) built on financial technology (FinTech) and based in San Francisco, CA. Operating since 2012, the company allows users to buy, sell, and store cryptoassets, like bitcoin, ethereum, litecoin, and XRP. The company is now valued more than $8B and has over 30M active accounts (as of July 2019), gaining significant visibility with consumers over the last 5 years in a sector that was once belonged to industry enthusiasts only.

Coinbase has soared in popularity as the top cryptoasset exchange in the US by turning itself into THE on-ramp for mainstream crypto investors and safe harbor among other marketplaces (never being hacked since its launch). Driving strict compliance of existing regulations and law enforcement, has helped boost its reputation in the industry among institutional investors and pave the path towards legitimacy and adoption of digital assets in finance.

Here’s a closer look at the history of the crypto unicorn, how the platform works, its products, and industry impact.

HISTORY OF COINBASE

Among the first-to-market in the cryptocurrency sector, Coinbase’s timeline isn’t typical of other fintech startups. The company has quickly grown with the industry since 2012, leading the charge on mainstream adoption through acquisitions, increased selection of digital assets, and consistent compliance with governing authorities.

2012 - Coinbase was founded in June by Brian Armstrong and Fred Ehrsam. Ben Reeves (Blockchain.info co-founder) was also an original founding member, but parted ways with the team due to a management difference in how the wallet operates. In the summer, Brian and Fred enrolled in Y-Combinator (a well-known startup incubator program in the Bay Area). By October, Coinbase launched services to buy and sell bitcoin through bank-to-bank transfers.

2013 - In May, the company received a $5M Series A round from Union Square Ventures. An additional $25M investment came in December a group featuring Andreesen Horowitz and Ribbit Capital.

2014 - Coinbase put its funding to work through acquisitions of Blockr (a blockchain reader service) and Kippt (a web bookmarking company). The company had grown to 1M users and added insurance to protect the value of bitcoin stored on servers. There was also a focus on key partnerships with branded online merchants, such as Overstock, Dell, and Expedia, who now accepted bitcoin payments. Additionally, bitcoin payment processing was added to traditional payment providers such as Stripe and PayPal.

2015 - In January, Coinbase received a $75M investment, comprised of Draper Fisher Jurvetson, New York Stock Exchange, USAA, and multiple banks. The company also launched a U.S.-based exchange for professional bitcoin traders called Coinbase Exchange, and started to expand services into Canada in 2015 (which it would later stop in August 2016 due to their online payments provider closing in the country).

2016 - In May, Coinbase Exchange rebranded to Global Digital Asset Exchange (GDAX). In July, retail clients were now able to exchange Ether.

2017 - In January and March, Coinbase obtained the BitLicense and the ability to trade in Ethereum and Litecoin respectively, from the New York State Department of Financial Services (DFS). In November, Coinbase was mandated by the IRS to report any users who had at least $20,000 in transactions annually. Bitcoin Cash was added as a new currency option on December 19. Due to abnormal price fluctuations of the new offering, there was an investigation of insider trading.

2018 - In February, Coinbase notified 13K clients that their personal information and transaction history (between 2013 - 2015) would be given to the IRS (per the ordinance in 2017). In April, Coinbase launched an early-stage venture fund, Coinbase Ventures, that invested into blockchain and crypto-related companies — the first investment came in May, of Compound Labs (smart contracts). Tim Wagner (Amazon executive) joined the company as VP of Engineering in August.

2019 - In January, Coinbase ceased trading on Ethereum Classic due to suspicion of a network attack. Another acquisition was made in February of Neutrino (blockchain intelligence platform based in Italy). In April, Coinbase UK reported that non-U.S. revenue increased by 20% to €153 M in 2018 for a net profit of €6.6 M. [At the time, this was 1/3 of the company’s total global revenue.] In August, the company publicly informed announced a failed hacking attempt in which there was no compromise of the network or losses. The attack was made in mid-June involving phishing, social engineering, and vulnerabilities in the Firefox web browser (allowing for higher access and host privileges).

what coinbase is and how it WORKS

Coinbase resembles a traditional financial services player by charging transaction fees for its exchange. Similar to the NYSE or NASDAQ, the company also takes custody of user funds and lists a variety of cryptoassets (bitcoin, ethereum, bitcoin cash, litecoin, and many others) to buy and sell with fiat currencies in over 32 countries.

For users, Coinbase requires a link to a bank account or card in order to purchase cryptocurrencies. Bank accounts allow for higher limits (while cards have lower limits), but take longer to verify transactions (2 - 4 business days) due to the speed of the card network versus banking’s ACH network. There’s also an option to sell Bitcoin to your PayPal account and cash out instantly.

The actual exchange of digital currencies requires a trading platform and an intermediary to communicate with the blockchain network. GDAX provides the internal platform to transact and send information about transactions out to the blockchain network to be verified. Storage is also needed, so Coinbase also acts as a wallet for storing digital currencies. The company has served over 10M customers and exchanged more than $50B in digital currency.

Despite offering decentralized currencies, Coinbase is a not a decentralized ledger. Ultimately, its a centralized on-ramp to a decentralized ecosystem designed for retail investors and advanced traders who want to avoid the complexities of accessing networks on their own. The disadvantages of using this type of platform are lack of anonymity (personal information and transactions can be tracked and reported to government authorities) and uncertainty of transactions being posted on the blockchain (i.e. intermediaries, like Coinbase, determine this).

For security, Coinbase stores 98% of client funds offline (disconnected from the internet) along with personal data. Offline data is encrypted and transferred to drives and paper backups, then distributed in vaults.  The remaining 2% is held online and insured in the event of a breach. Fiat currency held in Coinbase USD wallets is also protected by FDIC insurance up to $250K (the same coverage as bank deposit accounts). For customers keeping large balances of crypto or USD on Coinbase, there is a vault product with additional layers of protection, such as time-delayed withdrawals and multiple approvers for a debit transaction. 

Users are encouraged to follow proper protocols of their own to protect login and password access (including two-factor authentication) — account takeovers due to compromised accounts will not be reimbursed by Coinbase.

COINBASE PRODUCTS

As an overview, Coinbase customers are either investors or transactors (of cryptoassets). Investors are offered the ability to transfer funds offline (into “cold storage” vaults disconnected from the internet) to increase security and reduce the risk of hacking. For transactors (actively trading on multiple exchanges), users can on-ramp and off-ramp funds between Coinbase and other wallets.

For investors and transactors, Coinbase has four product lines that are live in 32 countries:

• Coinbase - the user-facing, retail brokerage service that most customers are familiar with — investors can make their own transactions based on mid-market prices set by traders on GDAX. Brokerage fees are 1.5% - 4% (based on payment method); credit cards are more expensive than bank (ACH) transfers and have a higher risk for chargebacks. The interface resembles what a user would see on a trading platform like E*Trade;

• GDAX - an order book exchange that stands for Global Digital Asset Exchange; this is for advanced traders (such as cryptoasset hedge funds and family offices) to transact cryptocurrency at a mid-market price and pay a a fee for the service (a lower price than retail customers on Coinbase). Since the brokerage buys from GDAX (instead of an external exchange), there’s an independent source of liquidity that’s secure, reducing the likelihood of being compromised;

• Custody - A product for institutional investors (such as asset managers, hedge funds, and pension funds) interested in adding digital assets to their portfolio. At a setup cost of $100K and annual management fee of 10 basis points, this service requires a $10M balance. Other crypto exchanges have already launched a similar product (such as Circle, Gemini, and Genesis Trading), in addition to traditional exchanges offering futures trading like the CME and CBOE (Chicago Board Options Exchange);

• Toshi - a long-term project (launched in April 2017) that allows users to access decentralized applications (dApps) built on top of the Ethereum blockchain. As a mobile app it provides a directory of dApps, ethereum wallet, and a management system for identity. The goal of Toshi is to pave the way for other use cases of crypto beyond investing and transacting. Examples are in social media (Leeroy) and think forums (Cent), in which quality user activity earns crypto. Critics are skeptical of Toshi due to the centralization and monitoring that Coinbase provides. Despite offering branded exposure and funding from the crypto unicorn, developers must adhere their platforms to policies and changes from Coinbase, which may negatively impact performance and user experience in the future.

Separately, Coinbase also offers an API for developers and merchants to build functionality of accepting payments in cryptocurrency.

Industry COMPLIANCE for crypto exchanges

With over a decade of usage, cryptocurrency has remained an alternative to traditional fiat currency. Initial use (with bitcoin, then privacy coins such as monero and zcash) was in illegal activities of black markets. Lack of government regulation and oversight, have kept the crypto sector in a state of infancy. Exchanges and companies are treading carefully to avoid regulatory action. Taxation of gains from trading is key concern that has slowed legitimacy and mass adoption.

As an industry leader, Coinbase aggressively seeks to be as compliant with all government agencies and regulations — continuously investing in all applicable licenses to build a positive, compliant reputation globally. The company has obtained money transmitter licenses (MTLs) for every state and New York’s Bitlicense for virtual currency (which is considered as being cost prohibitive for companies in New York). Additionally, Coinbase has registered as a money service business (MSB) with FinCEN. Outside of the US, there are no required licenses for Coinbase to register for.

Compliance also includes adherence to enforcement regulations for identity verification such as KYC (Know Your Customer) and AML (anti-money laundering), Bank Secrecy Act (requires Coinbase to keep up to 5 years of transaction records and report suspicious activity), and the Patriot Act (which extends anti-laundering provisions to prevent terrorist financing). The same obligations a bank has to reporting and preventing criminal activity, apply to exchanges with wallets. Coinbase and other marketplaces also have 3rd party support to assist in AML surveillance efforts from blockchain monitoring companies (such as Chainalysis).

For customers with privacy concerns, the heightened level of compliance is not a welcomed benefit. Users know that Coinbase is able to report previous gains to the IRS when notified, and that such reporting may cause future tax burdens. As a key example, the company did its best to dispute the mandate to hand over 14K records from 2013 - 2015 of an IRS request, but ultimately it had to give in at the end 2017.

what’s next for coinbase and cryptocurrency exchanges

Coinbase is firmly in the middle of the debate between currency and investment, shifting from a value prop of currency to that of investment. The initial position was of cryptoassets as a value exchange with an alternative payment system. As the price of Bitcoin skyrocketed from 2013 to 2018, it didn’t make sense to keep spending a coin that scaled up in value. For merchants, pegging retail prices proved challenging due to historic volatility.

Current perspectives are of digital currency as an investment opportunity, with Coinbase’s messaging reflecting an updated value statement to buy and sell digital currency. As a brokerage platform, this stance aligns well with its primary revenue stream of facilitating trades.

Upcoming challenges that Coinbase and the cryptocurrency sector is facing:

• Competition from other (fiat to crypto) marketplaces, such as Bitstamp, Robinhood, Kraken, bitFlyer, and Bitfinex;

• Building end-user support teams to handle high-volume servicing issues such as platform downtime, and access to funds;

• Success is directly tied to price levels — while this generated tremendous gains up to 2018, a flat or downward market makes it difficult to sustain revenue year-over-year;

• The ability to merge fiat banking services with digital coins through crypto-based deposit accounts;

• Increased partnerships with financial institutions and industry giants, such as Coinbase and Visa launching cards backed by crypto;

• Uncertainty over future regulatory headwinds may strongly favor or hinder cryptocurrency exchanges;

• Tough economic conditions around the world may increase the global interest in digital assets.

The next decade for cryptocurrency and Coinbase will be dramatically different as the global community continues its slow pace of acceptance and exploratory usage. Adding use cases beyond banking transfers (towards non-financial industries), and supportive regulatory frameworks would catapult adoption and legitimacy. What’s clear is that Coinbase will be at the forefront of the industry movement as the top cryptocurrency exchange in the US.