Chainlink is one of our favorite long-term plays for a ten-year holding period or more. The number of stocks our firm has held without interruption since the day we launched our site in July of 2019 is very few, not even Microsoft makes that list. But, Chainlink does.

The company is a reliable source for off-chain data across all blockchain networks and blockchain apps. Chainlink’s interoperability causes its oracle networks to be leveraged and trusted across competing blockchains. Customers that require the highest level of security, such as bank transfers, rely on Chainlink’s oracle price feeds and the other off-chain data that Chainlink supplies.

To understand the problem that Chainlink solves, it’s important to discuss the overarching issues the blockchain faces. There are three necessary tenets to a fully developed blockchain protocol: security, decentralization and scalability. This trifecta is often called the “trilemma” as blockchain technologies can typically solve for two of these problems, yet struggle to solve all three. Instead, current blockchain technologies excel at two of the three, and then must experiment to solve the third with sidechains, sharding and other nascent attempts at solving the third requirement.

The analysis below discusses how Chainlink solves some of the toughest pain points in blockchain development by enabling the third, missing pillar – whether that be security, decentralization or scalability. Because Chainlink is both middleware and a Layer 2 technology, its oracle networks are utilized across nearly all leading blockchain networks plus hundreds of applications. By offering must-have solutions early-on, Chainlink is proving it can become a frontrunner for the day when blockchain reaches critical mass.

I realize the information below can be technical, and thus I’d like to provide a 10,000 foot overview of what is being described in the deep dive.

Summary:Summary: Chainlink has the key ingredients to become a front runner in blockchain technologies because:

• it can serve nearly all Layer 1s and Layer 2s for the ultimate addressable market
• Chainlink’s suite of technologies solve some of the hardest problems that blockchain technologies faces today 
• An oracle network for offchain data can form a moat — as the quality of its security and decentralization increases– it will be harder to disrupt as time goes on. Blockchain technologies will not want to take a chance on a new entrant ten years from now. I foresee a duopoly of sorts for oracle networks.
• The finance sector has essentially adopted two blockchain technologies: Bitcoin as a store of value, and Chainlink for its ability to facilitate transfers with offchain data. Given there have been thousands of blockchain technologies, it’s clear to see front runners are being adopted by the savvy $6.4 trillion banking sector.

Section 1: How Chainlink Solves Blockchain’s Trilemma

Bitcoin’s network has prioritized security and decentralization, while sacrificing scalability. The network sends 7 transactions per second and can take up to 10 minutes to confirm a transaction. The upside is the network’s security is bullet-proof with a hash rate of 460 Exahash per second. It’s impossible today for a super computer to crack the Proof-of-Work encryption.

When you add the fact there are thousands of nodes globally, a Proof of Work system is truly decentralized whereas a Proof of Stake (PoS) system could still concentrate itself through “whales,” those who own a disproportionate amount of a single token. This results in the wealthiest crypto holders having a higher concentration in what is essentially a lottery system of validators. If a person has a thousand lottery tickets compared to a person with only ten, the person with 1,000 tickets (or nodes in this case) is more likely to be chosen to validate the ledger. This could lead to corruption and ultimately does not fit crypto’s ethos that those with a higher concentration of wealth are allowed to be more trusted and have more authority.

It’s been generally understood for some time that Ethereum has prioritized security and decentralization over scalability. Despite scalability being the primary problem Ethereum has left to solve, there are solid debates that Ethereum is not as secure or decentralized as it once was following the merge to Proof of Stake (PoS). To understand these concerns, consider that Ethereum has seen up to 70% of its supply held by whales in 2021, although the latest report is that 43% of ETH supply is held by whales. The concentration is staggering as six of the top crypto wallets have 98% of their wallets allocated to the Ethereum blockchain, according to TechCrunch.

When looking more closely at Proof of Stake (PoS) validators for Ethereum, Lido is the largest Ethereum validator at 33% stake and Coinbase is at 15%. To help illustrate how unusual this concentration is, consider that the Nakamoto Coefficient for Ethereum is 2, which means it takes only two nodes to control the blockchain. Truly, it’s beyond belief the coefficient is this low for the world’s top blockchain Layer 1. Bitcoin’s is estimated to be as high as 9601. The highest Coefficient beyond Bitcoin is 236 for a network called Humanode, and its goal is to increase the coefficient over time. The last time Solana’s was reported in 2023, it stood at a coefficient of 31.

Also consider that PoS requires 32 ETH, or about $96,000 per node, whereas Proof of Work requires a mining setup of less than $10,000. This means Ethereum is far less democratized. There was also a report in May of 2024 that one whale staked about $500 million to the network. There is also some centralization by the very fact Lido has such a large pool of validators at 33%.

Solana receives less criticism as it offers Proof of History (PoH) which offers a high throughput of 65,000 transactions per second on GPUs although other blockchain networks have a higher time to finality. Solana accomplishes this without second layers or side chains by using the Proof of History (PoH) consensus mechanism. PoH creates a historical record that proves an event has occurred at a specific moment in time. Rather than validators agreeing on a time, Solana validators maintain their own clock by encoding the time with a cryptographic hash function (SHA-256). This circumvents the need to wait for confirmation, thereby resulting in a higher throughput.

The purpose of this discussion is to say that many Layer 1s need Layer 2s or middleware to solve for the third tenet of the blockchain. For Ethereum, this is scalability (yet some critics also point toward a lack of decentralization compared to what other Layer 1s offer). What is unique about Layer 2s is the addressable market may be higher than a Layer 1, as the space is heavily fragmented with many Layer 1s competing. The very best middleware and Layer 2s can solve a critical pillar for these competing Layer 1s with little to no fragmentation.

Quick Primer on Smart Contracts

Decentralized systems require contracts if a system is to be created where all data, all messages, all token transfers, and all users are validated. Machines need contracts to offer ultimate security and decentralization as contracts ultimately allow for a revocation if a request is found to be fraudulent. In this case, the machine can shut the request down or otherwise deny the user/token transfer/data/message to move forward. The bilateral nature of contracts allows for a validation process to where nodes can determine if the action is trustworthy.

To put it simply, without contracts, trusted systems cannot truly exist as otherwise there is no penalty. This is why Web2, which is not based on smart contracts, is rife with bad actors. One centralized system can create thousands of bots, or a centralized tech company can push its agenda to the top of a newsfeed. There is no contract, and therefore, there is no revocation for unethical behavior.

Chainlink solves the critical issue of supplying trusted contractual data for smart contracts. Oracles are trusted third-parties that retrieve off-chain information and push that information to the blockchain at predetermined times. Technically, oracles introduce a potential point of failure, and this is why Chainlink’s ultimate goal is to maintain a good reputation. With a good reputation, the network effect will take care of itself since blockchain developers will be attracted to whichever oracle network is the most reliable.

Solving for Decentralization with Oracles:

Decentralization for the blockchain is achieved by having backend code on a decentralized network instead of a centralized server. Developers use a blockchain like Ethereum for data storage and use smart contracts for the app logic. The Ethereum blockchain is run off of thousands of nodes. These nodes are constantly computing the transactions within the blockchain from around the world, making it nearly impossible to hack as well as regulate.

Decentralized applications (Dapps) rely on smart contracts. Dapps deployed on the Ethereum network are controlled by logic written into the smart contract and cannot be altered by the developer. Smart contracts function like APIs (this was also discussed in the Chainlink webinar). This allows applications to build on one another similar to the way applications use APIs today; except blockchain applications build on smart contracts.

Chainlink was primarily built for off chain data for non-currency smart contracts. The principal is the same where there is a set of rules which self-execute – the more common analogy is that it operates like a vending machine to where there is no middleman. When you use a vending machine, you’re inputting a payment and terms (like pushing the buttons #D5) and the output is a bottle of water; the exchange did not require a gas station clerk. Smart contracts are similar in that terms are defined, and when those terms are met, there is an output.

The front-end application can be written in any language with calls made to the backend. The main qualities are that the applications are decentralized, can perform any action given the required resources (whereas Bitcoin is not Turing complete – more on this below) and are executed in a virtual environment such as the Ethereum Virtual Machine. The virtual machine acts as a buffer to where if the application is faulty, it does not affect the blockchain network.

Sounds great, but There’s One Problem …

The concept of decentralization sounds great in theory, yet the problem remains that even if a network is decentralized and secure, the data the applications use may not be decentralized or secure. If banks use the blockchain to drive down costs associated with money transfers, where will the banks get secure foreign exchange data that can’t be tampered with?

Where the Bitcoin protocol differs from networks like Ethereum, Solana, Cardano, Polkadot, Avalanche and others, is that the Bitcoin protocol has only one purpose – which is to transfer and store Bitcoin. Bitcoin is not intended to function like an operating system, and developers cannot develop dencentralized apps (Dapps) for the Bitcoin protocol. Due to having a single purpose, the Bitcoin protocol does not introduce or rely on off-chain data.

As we stated in our 2019 writeup, it’s the world’s most secure network, and in fact, is more secure than 10,000 banks combined. This inherent quality is a primary thesis to the investability and moat of Bitcoin:

“Bitcoin is based on the most secure network in the world, and this solves a very real need for the financial system – which cannot be automated without a decentralized blockchain solution. Technically speaking, bitcoin is also the world’s most secure financial network. The transfers eliminate 3% in processing fees and hedges against inflation. This can, and should be, worth as much as a search engine, enterprise software, a social media network, warehouse fulfillment (AMZN) or iPhone hardware.

Apple, Google, Microsoft and Amazon reached market caps of $1 trillion because their products scale to global populations and are required on a daily basis. Bitcoin not only scales to the global population but it also protects their livelihood – a necessity rather than a convenience. In fact, we see populations who are not necessarily tech savvy most enthusiastic about bitcoin, and this is a strong signal that it will scale beyond the reach of $1 trillion market cap.”

Bitcoin is very different from other blockchain networks because it’s not Turing complete, which means the Bitcoin protocol is not intended to perform computations or to solve complex problems. By limiting its functionality, Bitcoin’s protocol is highly secure. Bitcoin Script verifies transactions but is not programmable for general-purpose computations. Rather than offer scripting capabilities, Bitcoin Script offers a restricted set of operations that apply only to transactions.

The Turing incomplete design offers the ultimate security rather than seeking the functionality of a general-purpose platform. There are about 50,000 distributed Bitcoin nodes, as well, that help to verify and record transactions with a decentralized architecture.

Bitcoin’s goal is very different from Web3 technologies, and this distinction is important. Ethereum’s Solidity programming language is designed to facilitate smart contracts on the Ethereum blockchain. It’s considered “Turing Complete” as it has key features such as reading and writing to memory, branching to move the machine forward and looping to restart execution.

Yet, decentralized applications will require some data, so how can a network claim to be decentralized if the data itself is not originating from a decentralized network?Yet, decentralized applications will require some data, so how can a network claim to be decentralized if the data itself is not originating from a decentralized network?

Swift is a system used by banks and institutions for money and security transfers. Currently, 11,000 banks use SWIFT across 200 countries, and it’s the largest and most streamlined payment system for international transfers. SWIFT facilities secure and efficient communication between institutions with 45 million messages sent in 2022. The reason Swift is looking to innovate with blockchain technologies is to avoid becoming disrupted. The company charges between $15 to $50 on average for a transfer and it can take hours or days for the transfer to be completed. The security and decentralization of a blockchain network is attractive to Swift, yet there will be issues if the pricing data used by the blockchain for settlement is not accurate.

In this example, Chainlink provides a pricing oracle for Swift’s smart contracts and for many other financial applications that need accurate pricing information for settlements. The pricing information needed for foreign exchanges, cryptocurrency swaps, stock prices and other assets is sourced from decentralized data.

Oracles assist in helping blockchains use off-chain data.

Chainlink has built a decentralized oracle network (DON) that aggregates independent node operators, reliable data sources and also oracle networks for accurate, decentralized data. For example, Chainlink will determine crypto pricing by combining many sources from price data aggregators (like Coinbase and dozens of others like Coinbase), with node operators (there are hundreds), and with oracle networks like Ethereum or Solana. By aggregating many data sources and many types of data sources, the pricing feed eliminates a single source of failure.

Solving for Scale: Chainlink Securely Enables Rollups

Blockchain seeks to disrupt nearly every industry, and yet, it’s unfathomable for some investors to envision this outcome when it’s costly and slow to transfer tokens and data. Ethereum’s primary issue is scale as the Layer 1 has seen exorbitant gas fees. There was an outlandish case where someone bought a NFT for 1 ETH, or about $2600, and was charged $70,000 due to high gas fees. Yuga Labs has seen gas fees of up to $176 million for $285 million in sales prior to the merge to Proof of Stake. Gas fees are a result of Ethereum having low transactions per second (TPS) in the 20-40 transactions range. Once the limit is reached, the remaining transactions compete, resulting in higher fees.

Proof of Stake (PoS) relies on a few key technologies to drive down energy consumption, such as staking with validators for decentralization purposes, shards that break tasks into a subset, a dispersed network of nodes to increase efficient processing using the Beacon chain, and Rollups where hundreds of transfers can be rolled into a single transaction. With Rollups, the smart contract verifies all of the transfers in the Rollups. The goal is to reduce computing and storage resources by reducing the amount of data held in a transaction.

Ethereum offers ZK Rollups, or Zero-Knowledge, which we’ve covered here. However, rollups are a dedicated instance, and therefore can be customized and are interchangeable with other networks. A company called Cosmos released Rollkit and other developer tools that increase time to market for developers while seeking to lower the cost of zero-knowledge proofs.

Therefore, the development and functionality are separate from the Layer 1. This is especially attractive to enterprises that do not need a specific Layer 1 (like Ethereum) to reach scale since they already have a customer base. We touched on Coinbase using Rollups for the Base Layer 2 stating it offers “1 cent, 1 second transactions.” SAP has recently minted USDC on a Layer 2 solution with a statement it’s “getting close to that one cent cost basis.”

The Optimistic Collective developed a network and stack that Coinbase’s Base uses for its Rollups. This means that CB’s Base settles on Ethereum’s network for security purposes, yet uses the OP stack to execute Rollups outside of Ethereum. This is ideal as Coinbase can switch blockchain Layer 1s at any time. The amount of development that has occurred on Layer 2s since Rollups and the merge to PoS on Ethereum is staggering. For example, according to Chainlink, there are “approximately 48X the amount of on-chain calls from dApps to Chainlink Data Feeds over the past 12 months compared to Ethereum’s baselayer.”

Offchain Labs created a Layer 2 called Arbitrum that directly competes with CB’s Base and is currently ahead of Base on a few key metrics, although Base’s growth has been more rapid and will likely surpass Arbitrum. According to the writeup and data from Token Terminal, Arbitrum’s fees are much lower than Base, which is a distinct advantage in utility, yet Base is leading on gross profits at $30 million estimated compared to Arbitrum’s $9.5 million.

With Rollups, Chainlink’s purpose has expanded to where Chainlink nodes are used to do computations and verifications before posting a bundled transaction. This means an app built on a Layer 2 like Arbitrum or Base only has to use the main chain when necessary.

Layer 2 chains and rollups have a separate ledger, and there’s a chance a malicious actor forks a Layer 2 to create a parallel chain to mint new assets or burn assets on the Layer 1. Decentralized oracle networks like Chainlink prevent this from happening by offering Oracle Network Governance, or a trusted source, for routing upgrades to L2/Rollup chains, importing the ledger state, resolving disputes, and helps facilitate L2s that are forked.

Rollups provide an easier path to development as enterprises can avoid having to build a complex Layer 1 chain, while also providing much faster and cheaper transactions. This is ultimately a catalyst for Chainlink to become the oracle network for enterprise dApps. For example, Sony Group’s venture arm recently announced the company is using Chainlink to launch a developer platform that delivers consumer blockchain applications. Similar to Base, Sony will also use Optimism for its scaling layer, while using Chainlink for Data Feeds.

There are 200 protocols that operate on Base (and growing). Chainlink Automation allows developers to offload tasks that require high computational power to the Chainlink Network for a reduction in fees by 90%. Chainlink’s Cross-chain interoperability allows for currency and data transfers between blockchain networks, which can help with Base’s goal of having low cost, yet fast transfers.

Section 2: How Chainlink is Becoming a Blockchain Frontrunner

Here are some of the technologies that Chainlink is using today to quietly become a frontrunner in the crowded and complex Blockchain space:

Chainlink is an abstraction layer, which means it’s agnostic and works across all major chains, such as Polkadot, Avalanche, Binance Smart Chain, Polygon, Optimism, Arbitrum, and more, which eliminates vendor lock-in. This is incredibly important given how nascent the Blockchain ecosystem is, and how the rate of failure is already high and will remain high as blockchain technologies continue to mature.

Chainlink is also future-proofed, which refers to being compatible and scaling even as the blockchain is continually developed. Amazon Web Services (AWS) offers a Quickstart for Chainlink to where DevOps teams can quickly launch a Chainlink oracle node on AWS to sell real-world data. The framework is future-proofed because Chainlink continually updates the integration for data providers to sign their data and broadcast it to the blockchain. For example, NOAA hosts weather data on Google Cloud, which can then be accessed on Ethereum’s blockchain, which in turn powers crop insurance agreements.

Trust-Minimized Oracle Computation: As enterprise apps grow in complexity, Chainlink not only offers trusted off-chain data through decentralized oracle networks (DONs) but the company also offers developers a path in performing off-chain computations. These off-chain computations are gasless and as fast as native hardware. For example, if a developer wants to make a conclusion based on historical weather data, there would be multiple steps in taking the API data and performing a computation. These computations can be done on behalf of smart contracts in a trust-minimized manner. Chainlink Functions is a serverless developer platform that offers compute runtime to test, simulate and run offchain logic for Web3 apps, similar to how AWS Lambda offers serverless solutions.

Chainlink Automation: Automation uses oracle computation to run predefined conditions and to trigger smart contracts, for example, when stock or token limit orders are hit on a decentralized exchange. The decentralized network of nodes performs the off-chain computation of the contract’s logic that is then verified on-chain.

According to Chainlink, there are three key benefits to using the company’s smart contract automation. The first is that the company removes any centralized point of failure through decentralized oracle networks (DONs). Secondly, DevOps time is reduced by leveraging LINK’s Automation-compatible contract infrastructure. Third, developers enhance the security of their protocols by removing the need for centralized servers.

Secondly, rather than investing time and resources in creating scripts for on-chain monitoring and triggering smart contract execution, developers can plug into Chainlink Automation’s optimized infrastructure by simply creating an Automation-compatible contract and registering it. This saves time, reduces the DevOps workload, and allows developers to focus on writing more great code. 

Lastly, by using Chainlink Automation, developers can enhance the security of their protocol. Developers no longer have to risk exposing their own private key when initiating transactions from centralized servers—the nodes on the Chainlink Automation Network will sign on-chain transactions.

Cross-Chain Interoperability Protocol (CCIP): Blockchains are fragmented and there is too much friction in payment transfers and information exchanged between applications. Web3 must function seamlessly like Web2 to where the infrastructure (AWS, Azure, GCP), the protocols (TCP/IP, SMTP) the operating systems (Windows, Linux, MacOS, Android, iOS), the applications and the software are seamlessly working together without friction. In the majority of these cases, the user is unaware of the systems that support the user experience.

Chainlink’s CCIP sets out to solve this by providing a bridge between blockchains and DeFi applications. The protocol was launched in July of 2023 to solve the pain point of seamlessly transferring data and currencies across various blockchain networks. At launch, it was integrated with Ethereum, Avalanche, Polygon and Optimism. This allows users to use any decentralized application (dApp) on these blockchains for liquidity purposes and connectivity.

Chainlink is uniquely positioned to solve the problem of bridging blockchains and popular applications because it has built a secure oracle network. CCIP extends the idea of an oracle network, which was originally designed to on-load off-chain data, to also offer decentralized oracle computation for performance histories and to monitor for malicious activity. Off-Chain Reporting (OCR) is used to aggregate a report from many validators, which reduces congestion.

Please note: The deep dive 2023 Chainlink Update: Interoperability for Blockchains, Bullish SWIFT Partnership goes into more detail around the importance of CCIP.2023 Chainlink Update: Interoperability for Blockchains, Bullish SWIFT Partnership goes into more detail around the importance of CCIP.

Price Feeds: Chainlink Price Feeds provide smart contracts with access to financial market data. Decentralized Finance (DeFi) is a $100 billion+ market and whichever oracle network is deemed most reliable will carve a deep moat for itself. Price Feeds are used for on-chain currency transfers where a reliable token or currency amount is needed. Chainlink’s data feeds and price feeds currently secure tens of billions in value across DeFi.

Chainlink SCALE: Chainlink’s SCALE program was launched to help newer blockchains to cover the cost of decentralized oracle networks initially before decentralized apps (dApps) can cover these costs. This helps to reduce the operating costs of oracles while allowing Layer 2s to access higher volumes of data and more advanced applications. This helps to incubate apps where startup costs would otherwise be prohibitively high.

Chainlink Verifiable Random Function (VRF): Blockchain engineers use random number generation for cryptographic keys to prevent tampering. Private and public cryptographic keys are used today to encrypt and decrypt data, and are used across domain name systems (DNS), application security and zero-knowledge trust. There is a similar need for private and public cryptographic keys for blockchain applications. Chainlink VRF is the most widely adopted random number generator (RNG) in Web3, and has generated over 21 million request transactions for thousands of smart contracts.

Chainlink’s Ecosystem:

Chainlink launched on the Ethereum mainnet on May 30th, 2019. We covered the altcoin for the first time in August of 2019. Prior to launch, Chainlink signed 30 partnerships. By 2020, when we covered Chainlink a second time, total value secured (TVS) had grown from $254 million to $6.3 billion, or 23,000% growth in TVS. At crypto’s peak in Nov of 2021, Chainlink had $75 billion in total value secured across up to 1500 protocols and hundreds of DeFi applications. This has declined to $25.5 billion today and $31 billion in the past 30 days, yet the TVS from 2021 is important as it shows Chainlink is capable of securing $75 billion without a hack. As the CEO stated at SmartCon:

“Right now, the Chainlink Network has provided the most cryptographic truth in history.”

According to CoinDesk, the transaction value of data points that Chainlink has delivered on-chain stands at $15 trillion, up from $9 trillion at the start of the year. As stated, there’s been no hacks or otherwise any tokens lost through Chainlink’s secure network.

The predominant use of Chainlink is for market data for DeFi apps. DeFi apps have grown in total value locked (TVL) from $700 million in December of 2019 to more than $90 billion today. With the launch of CCIP, Chainlink can use its strong track record in securing DeFi blockchain smart contracts to expand to cross-chain smart contracts.

Update on SWIFT Partnership:

Perhaps where Chainlink is most promising in the near-term is the SWIFT Partnership as Swift facilitates $50 billion in transactions every year.

SWIFT stands for the Society for Worldwide Interbank Financial Telecommunications (SWIFT) and is the system used by banks and institutions for money and security transfers. Currently, 11,000 banks use SWIFT across 200 countries, and it’s the largest and most streamlined payment system for international transfers. SWIFT facilities secure and efficient communication between institutions with 45 million messages sent per day in 2022.

When we last covered the SWIFT partnership, a test had been completed using Chainlink’s CCIP to facilitate transactions with tokenized assets on public and private blockchains using back-end systems. This will allow financial institutions to integrate blockchain technology into the existing infrastructure. You can read more about this on Swift’s website here.

This month, it was announced the testing phase has been complete and the Swift partnership is now in the pre-production phase.

Tokenomics:

One area where critics find fault with Chainlink is the tokenomics. The monthly growth in Chainlink’s circulating supply is at 1.4% per month on average. Over the course of a year, this can dilute token holders 10 to 15%, on average.

Chainlink’s fully diluted market cap tracks 2.1X higher than its current market cap. There is a circulating supply of 568M tokens yet a max supply of 1 billion tokens.

Of the 1 billion tokens, at the initial coin offering, a little more than one-third was to go to node operators, a little more than one-third was sold in the public sale, and a little less than one-third went to the company to be held in reserves. The 350 million held at the company can be released anytime, which dilutes token holders.

When more of Chainlink’s supply is in circulation, there is likely to be stronger price action. About 63% is in circulation now, and so look for Chainlink’s price to be less volatile in 2 years if we assume the 1.4% per month rate in circulating supply continues.

Conclusion:

The blockchain is needed to decentralize information to where the global population is not dependent on Big Tech companies for data and inputs. I’ve boldly stated that if people are not concerned by this today, they are not paying attention. The internet is broken as tech companies, media companies and other corporations are full of self-interest and have proven they can’t be trusted. The internet has gatekeepers, and there is ample reason to remove these structures.

Looking beyond information from search and social media, of which there is a great dependency, there is also a dire need for the decentralization of loans, interest-bearing accounts and credit. Imagine if you could make the 20% APR that Chase makes off loaning for credit cards, yet to do so by using the blockchain for ensuring the borrower has a high credit score (or collateral) and through a smart contract to where the collateral is retrieved if the borrower does not pay you. Instead, we are offered 4% interest rates on money market accounts and CDs, and this is rare — for the past decade, it’s been as low as 0%. Finance is broken today, as it’s highly centralized and skewed in favor of a few.

There is also the upcoming need over the next decade to improve automation as machine-to-machine communication is not truly possible unless it encompasses the three tenets of the blockchain (security, decentralization, scalability). As the AI era evolves, this will become a driving force for blockchain use cases.

A Note on Crypto …

Last year, I was on a Real Vision interview where they asked me what my investment framework for crypto is and I said: “Technicals, technicals, technicals.” If you want to buy Apple or Microsoft without using technicals, and hold over a long period, that will probably work out just fine. But to participate in these extraordinary companies at an early stage, it’s of ample importance to carefully consider technicals.

We lead with technicals on crypto given it’s early-stage tech. This is different than stocks, where fundamentals lead. The good news is that crypto is sentiment driven, and so it respects price and technicals quite well when managing these positions. With that said, crypto is high risk, high reward and requires an active stance – it is not for those who are new to investing or coming to grips with the ups and downs of the market. We believe there will be extraordinary returns on Chainlink, yet there will also be extraordinary drawdowns.

Our history with Chainlink is quite good – we bought at $1.50 and trimmed in the $25 to $50 range, and then began buying again much lower in the $7 to $11 range. We plan to actively manage Chainlink moving forward. Please join Knox’s weekly webinars on Thursdays at 4:30 p.m. Eastern to hear more on how we plan to manage Chainlink, with a special emphasis this week on crypto.

Recommended Reading:

• Cloudflare Q3 24: Soft Q4 Guide as Company Transitions on Billing Terms
• Crypto and AI Opportunity: Real Vision Video Interview
• Real Vision Video Interview: Will Nvidia Continue to Dominate AI?
• 2023 Chainlink Update: Interoperability for Blockchains, Bullish SWIFT Partnership

Coinbase missed on the top and bottom line, with revenue of $1.205 billion missing estimates by 3.2% and adjusted EPS of $0.28 missing estimates of $0.42. Adjusted EBITDA was 37.1% or $449 million and is the bottom line number Coinbase tracks most closely to due to unrealized losses from owning crypto assets. The company has $8.2 billion on the balance sheet in cash and cash equivalents.

This quarter marked a QoQ decline in revenue of (16.9%) and a decline of (27%) QoQ in transaction revenue. Looking forward, October transaction revenue numbers were in line with Q3 at $190 million, or $570 million if we assume a similar trend continues. Q3’s transaction revenues were $572.5 million.

Broadly speaking, the crypto market was softer in Q3 than in Q2. Total crypto market capitalization flat QoQ while the average crypto market capitalization decreased 10% QoQ. Crypto asset volatility, a key driver of trading volume, was down 5% QoQ and the total trading volume for the United States spot market declined 18% QoQ. Trading volume for the US spot market is where the majority of Coinbase’s revenue is derived.

Our firm is working with Wealth Umbrella to put out a note on Bitcoin this week for the free newsletter with an outlined trading plan. It’s a must-read. There is also a similar trading plan for Coinbase, which if confirmed, the charts indicate would move in lock-step with the leading crypto asset. Knox will review this trading plan in the Oct 31st webinar. This stock has a leading allocation in our portfolio, and thus, we are watching the technicals closely as Coinbase is largely dependent on volatility and asset prices, and is not tied as much to the results of an earnings report. Should Bitcoin not extend, there is risk management plan for that, as well.

Revenue

Coinbase reported revenue of $1.21 billion in Q3, for YoY growth of 78.9% and a QoQ decline of (16.9%), driven lower by a (27%) QoQ decline in transaction revenue. This marked a deceleration from the 104.8% YoY growth rate recorded in Q2, and also fell shy of the consensus estimate for $1.25 billion in revenue.

Coinbase said that “average crypto market capitalization decreased 10% Q/Q over the same period,” with lower average crypto prices, while “crypto asset volatility — a key driver of trading volume — declined approximately 5% when comparing the Q3 average with the Q2 average.” This drove an (18%) QoQ decline in both US spot trading volumes and Coinbase’s internal trading volumes in Q3.

Despite the more challenging market conditions for revenue generation and QoQ growth, Coinbase noted that it is working to drive revenue through diversification, including stable coins, derivatives, international expansion and custody solutions.

Moving forward, Coinbase’s quarterly revenue growth rates are expected to continue decelerating, with Q1 seeing a YoY decline of nearly (16%) as Coinbase begins to lap difficult comps. As stated in our deep dive last month, it’s nearly impossible to predict crypto prices and volatility this far in advance. Thus, Coinbase typically sees heavy revision activity on a 3M and 6M basis:

The bottom line is even more unpredictable:

Key Segments

As previously mentioned, Coinbase’s trading volume was $185 billion in Q3, down (18%) QoQ but up 143% YoY on low comps from when Bitcoin and crypto traded at depressed prices in 2023.

Consumer trading volume moderated slightly in the quarter, coming in at $34 billion, down from $37 billion in Q2. Transaction revenue in Q3 was $572.5M, up 98.4% YoY and down (26.7%) QoQ.

What’s notable here is that despite a single digit decline in consumer trading volume on a QoQ basis, from $37 billion to $34 billion, consumer transaction revenue declined (27%) QoQ to $483 million. Coinbase gave three reasons for the outsized sequential decline in transaction revenues versus trading volumes:

• Share of US fiat-crypto trading volume, which drives a majority of consumer transaction revenue, was “largely steady Q/Q.”
• Stablecoin pair trading volume increased significantly QoQ, which carries little to no fees. Tether was 15% of trading volume.
• Non-trading revenues decreased, including “decentralized trading through Coinbase Wallet and miner fees.”

The CFO further explained in the Q&A: “First is mix shift where we saw more stable pair trading. Second is we did not see as much revenue in Q3 from the nontrading transaction types. And so as those 2 drivers that led to change in the blended average fee quarter-over-quarter, but no underlying changes to the fees per product, mix and the nontrading revenue changes.”

However, institutional trading volume slipped further, falling to $151 billion, down (20%) QoQ and more than (41%) lower than Q1’s $256 billion. Institutional transaction revenue declined (13%) QoQ to $55 million, largely due to the decline in institutional trading volume.

Base revenue, reported in Other transaction revenue, was $34 million, down 35% QoQ due to lower Base fees – these lower fees drove a sharp uptick in Base transactions, which rose 55% QoQ. Coinbase expects adoption of Base to increase with lower fees.

Coinbase added that October transaction revenue was ~$190 million, which is in line with Q3’s monthly average; however, management cautioned against extrapolating this across the quarter as asset prices and volatility could rapidly change.

Subscription and Services Revenue

Coinbase’s subscription and services revenue came in at $556 million, on the lower end of its guided $530 – $600 million range, for YoY growth of 66.3% and a QoQ decline of (7%). Native units in staking and custody grew QoQ offsetting lower average crypto asset prices.

Management highlighted that this segment was $1.4 billion last year and is tracking $2 billion this year, for growth of 42.8%.

For Q4, Coinbase guided to a wide range of $505 – $580 million for subscription and services revenue, or 44.5% YoY growth at midpoint. This would mark a more than 20 percentage point QoQ deceleration for the segment.

Within subscription and services revenue:

• Stablecoin revenue rose more than 43% YoY and nearly 3% QoQ to $246.9 million, driven primarily by “higher average USDC on-platform balances” and higher USDC market capitalization, offset by lower effective interest rates.
• Blockchain rewards were $154.8 million, up nearly 108% YoY but down (16%) QoQ. Coinbase said that lower average crypto prices, primarily for Ethereum and Solana, drove the QoQ decline.
• Interest and finance fee income was $64 million, up almost 51% YoY but down (8%) QoQ.
• Custodial fee revenue was $31.7 million, up just over 100% YoY but down (8%) QoQ.
• Other subscription and service revenue was $58.7 million, up 100% YoY.

Margins

Operating margin shrunk again sequentially, with Coinbase reporting a 14.1% operating margin in Q3, down from 23.7% in Q2. However, this did mark a notable improvement from an (11.8%) margin in the year ago quarter.

Net margin improved sequentially to 6.3% in Q3, up from 2.5% in Q2, as Coinbase reported $75.5 million in net income, more than doubling the $36.1 million reported in Q2. Coinbase added that net income “included $121 million in pre-tax losses on our crypto asset investment portfolio — the vast majority of which were unrealized — as crypto prices were lower” at the end of Q3 relative to Q2. The losses were $92 million after reflecting the tax impact. Due to the company having 25% of their net cash in crypto assets, the company places emphasis on adjusted EBITDA.

Regarding crypto assets, per the CFO: “The fair market value of our crypto investments was about $1.3 billion at the end of the third quarter. You can see more detail in our filings, but we hold Bitcoin in addition to Ethereum and a mix of other crypto assets.”

Stock-based compensation remained elevated in the quarter, at $248 million, or 20.6% of revenue. For Q4, Coinbase said that they “expect a modest Q/Q decline in stock-based compensation, driven primarily by roll-off of non-recurring multi-year awards.”

Earnings and Adjusted EBITDA

Despite the sequential improvement in net income, Coinbase fell short of earnings estimates, reporting $0.28 in GAAP EPS, compared to the GAAP consensus of $0.38. For Q4, Coinbase is expected to report $0.67 in GAAP EPS, a strong sequential improvement but still down nearly (36%) YoY. Adjusted EPS of $0.28 also fell short of estimates for $0.42. This is due to the $121 million in pre-tax losses on crypto assets mentioned above, and the $92 million when including the tax impact.

Adjusted EBITDA was $449 million, or a margin of 37.1%. This compares to adjusted EBITDA of $595.6 million, or 41.1% of revenue, in Q2, and $178.3 million, or 26.5% of revenue in Q3 2023. This is the company’s 7th consecutive quarter of positive adjusted EBITDA.

Cash Flow and Balance Sheet

Operating cash flow remained exceptionally strong in Q3, with Coinbase reporting OCF of $696.5 million, or 57.8% of revenue. OCF more than doubled YoY from $313.9 million, or 21.4% of revenue.

Cash was $7.72 billion, up from $7.23 billion at the end of Q2, while debt remained flat at $4.23 billion. Given its strong cash flows and strong cash position, Coinbase’s management authorized a $1 billion share buyback in October.

Earnings Call:

More on Consumer Transaction Volume Decline:

When asked if the transaction volume decline was being driven by stablecoins or retail spot trading, the CFO clearly stated it was from the higher mix of stablecoins.

The CFO stated:

“We are not breaking out or quantifying specific volume. But what I'll say is that if you exclude stablecoin impact, the mix of advanced volume was slightly higher in Q3 versus Q2. And so we did not have any change in market share, as I mentioned earlier, was relatively steady in our fiat to crypto trading volume, which is like the core of our revenue engine in here in the U.S. And so backing out stables, a little bit more on the advanced side, but the stablecoin impact was the most material contributor to that change in rate this quarter.”

Altcoin Volume:

Notably, altcoin volume declined by about 10 points in Coinbase’s overall volume, with the CFO stating this was due to lower volatility and also an increase of focus on Bitcoin and Ethereum since the ETF launches. We had looked more closely at this in the September deep dive.

Growth Markets:

The CEO highlighted the following key growth markets on the call. These growth utilities have helped to double the number of stablecoin payments and transactions volume from $10 trillion last year to over $20 trillion already this year. The market cap of USDC stablecoin has grown from $25 billion at the start of 2024 to $36 billion today, for growth of 45% YTD.

• Stablecoins, which are useful for period of high inflation. Stablecoins are also useful for moving money quickly and for cheap payments. USDC is the most popular stablecoin, yet EURC is a Euro backed Stablecoin that Coinbase now supports, extending stablecoins beyond the dollar to include Euros.
• Smart wallets, which removes the need for complicated password keys. This reduces friction and fees. Users can onboard in 8 minutes compared to 2.5 hours in the past for traditional wallets.
• Base Layer 2, which is scaling quickly and enabling 1 cent, 1 second transactions. We covered this in depth here. Base is now the #1 Layer 2 solution. It was stated that “The transactions increased 55% on Base quarter-over-quarter. It's a pretty incredible pace of growth right now.”

Legislation:

Coinbase is on the precipice of having more support in Washington. There are over 350 politicians with pro-crypto stances, causing Coinbase’s management to expect “the most pro-crypto congress ever” following the election. I’m making a note here to revisit this for our Members after the election and into 2025.

Conclusion:

For investors paying attention, Coinbase has many promising segments. However, its financials are lumpy and not for the faint of heart – but, neither is crypto. On the fundamentals side, COIN has staggering cash levels and an adjusted EBITDA margin that is quite strong. The revenue will track crypto prices, and thus, one has to consider that earnings reports lag real-time crypto asset prices and volatility.

Our strategy for this position is to use technicals. If you are interested in this stock, consider joining Knox on his webinar October 31st where he will discuss the upside setup we hope materializes, and the risk management we have in place if it does not. Also, keep an eye out for the free newsletter with an updated trade setup on Bitcoin hitting inboxes on Friday, to which Coinbase is closely correlated.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

• Coinbase Q3 Earnings Preview: Focus Shifts to Regulatory Changes
• Fabrinet: Datacom, Nvidia Driving Optical Revenue Growth
• AMD Q3 2024: GPU Revenue at 22%, and AI PCs have a Leader
• AMD Q3 Earnings Preview: AI Revenue Estimated to be $5 Billion

The I/O Fund recently entered Coinbase primarily based on technicals. Coinbase offers investors a rare glimpse into the fundamentals of a crypto-related company, yet it’s clear to see Coinbase’s fundamentals are not a reliable indicator of future performance. Rather, asset prices and volatility in crypto are more important than traditional fundamentals for Coinbase because the company charges trading fees for each transaction.

Below is a clear picture that Coinbase trades in lock-step with Bitcoin. Due to it being a publicly traded stock, Coinbase can exceed Bitcoin at crypto peaks due to the ease of trading a stock compared to crypto assets.

Coinbase has primarily been a spot trading exchange, to where crypto traders buy the asset at current market prices. In November of 2023, Coinbase added derivatives trading which will help the exchange participate in a higher percentage of trading activity. Derivatives trading is roughly 2/3 of all crypto trading compared to spot trading at 1/3. Sometimes, derivatives trading is as high as 70% or even 75% of crypto trading volume, which means for the first time this year, Coinbase is able to participate in this lucrative space.

Equally as important (if not more so), Coinbase has launched a Layer 2 called Base over the past year, which has been growing in popularity and ranks #6 across both Layer 1 and Layer 2 chains in terms of total value locked (TVL). At one point, Base surpassed Solana in its first year of launching. Base facilitates faster and cheaper transactions, which is the most critical problem for the crypto complex to solve. If Coinbase has truly solved this pain point with Base, and it appears it has, then the company is setting up a nice future for itself by not only diversifying away from asset prices and crypto volatility, but is also opening up a new revenue stream that theoretically could eclipse platform revenue once the blockchain ecosystem is fully mature.

Before we sound the bull horn, Coinbase has an important hurdle to clear. Bitcoin ETFs are impacting Coinbase’s core business model of charging high fees for crypto transactions. It’s clear from the data we pulled below that ETFs are not additive for Coinbase, which is the opposite of what management had promised earlier this year. Instead, Coinbase is participating at a lower percentage when comparing to the last time Bitcoin reached an all-time high.

We look at these key points below. Please note, crypto is highly volatile. The I/O Fund plans to trade Coinbase as a momentum play and this stock is for Advanced Members only. Should Coinbase break key levels, we will close the position with no hesitation. As stated, technicals carry higher importance than fundamentals for crypto, and this is true for Coinbase due to its correlation with Bitcoin. You can find critical notes from Knox on his trading plan below.

Coinbase Overview

Coinbase is best known as a crypto trading platform, which accompanies high volatility and an overabundance of competition. The company charges transaction fees for each trade with fees up to 0.50% up to 4.5%. This is quite high when you consider money managers typically charge on average a 1% recurring fee to manage an entire account. The high fees are further brought into focus when you consider that equities, including ETFs, no longer charge transaction fees.

Coinbase’s success is tied to trading volumes, as higher volumes lead to higher fees for Coinbase.  Even though we are seeing Coinbase successfully diversify their revenue, trading volume still accounts for the bulk of their revenue, and likely will for the time being. The arrival of Bitcoin ETFs is impacting Coinbase’s primary source of revenue, as ETFs offer an easy alternative to Coinbase’s fee driven trading platform. The ways in which Coinbase successfully pivots and differentiates its trading platform will be crucial for its ability to grow in the crypto space as the high trading fees will continually become disrupted.

We are seeing Coinbase’s trading platform to evolve to meet these challenges. Advanced Trade, previously called Coinbase Pro, is a platform for more advanced crypto traders that offers staking, decentralized app wallets, the ability to trade crypto derivatives and even a Coinbase credit card.

As discussed, the ability to trade derivatives on Coinbase is new this year. Derivatives are a large portion of daily crypto market activity. According to CoinDesk, derivatives were at 68% of the market in March of 2024, reaching a high of $6.18 trillion of $9.12 trillion in total trading volume. This is when Bitcoin was at all-time highs of $73,000+. Last month, CoinNess reported that derivatives reached a total of $5.22 trillion with $3.68 trillion or 70% being from derivatives trading.

Spot trading (which is your typical crypto trading) accounted for $1.54 trillion of crypto exchange volumes last month, or about 30% of volume. In March, spot trading reached a peak of $2.94 trillion for the highest monthly volume since May of 2021.

Coinbase reported a decline in spot trading volume of 28% QoQ citing volatility in crypto pricing. This quarter will be important for spot trading volume growth and derivatives growth as competitors Crypto.com have been reporting growth MoM on spot trading and up to $1 billion in open interest in derivatives, up 4X since January. Crypto.com has significantly lower trading fees of 0% to 0.075%, so it’s not too surprising it's gaining market share while Coinbase is struggling considering that spot traders will often use whichever platform offers the most competitive trading fees. Binance offers 0.1% fees on spot trading.

Coinbase One is a subscription plan that removes trading fees for $29.99 a month for the first $10,000 traded every month. This can work for investors who dollar cost average every month, yet is unrealistic for most crypto investors. One of the premiere features of Coinbase One is that it offers up to $1 million in insurance under certain terms and conditions.

The offer for no trading fees (or “gasless transactions”) is accomplished through Base, which is a Layer 2 built on the Ethereum network. Base offers 1 cent, 1 second transactions with the company currently seeing $20 billion per week in USDC transactions. By bundling hundreds of smaller transactions and processing them as one large Ethereum transaction with Ethereum as the settlement layer, Base reduces the transaction fee. The OP stack that Base is built on helps to deploy Rollup blockchains. We’ve discussed Rollups before in an Ethereum analysis as a key feature for the merge to Proof of Stake. Rollups allow hundreds of transactions to be rolled into one.

Base is compatible with the Ethereum Virtual Machine (EVM), which is the runtime layer that executes smart contracts on the Ethereum network. By being an EVM-compatible Layer 2 chain, Base offers interoperability with other EVM-compatible applications and the security and decentralization of Ethereum’s Layer 1 while improving on the Ethereum network’s scalability issues. We’ve covered the scalability issues in a previous analysis that discussed high gas fees on the Ethereum network. Due to lowering transaction fees, Base saw 300% QoQ growth in the number of transactions last quarter.

Due to Base resulting in faster transaction times, lower fees and offering compatibility with Ethereum, the Layer 2 chain is open sourced for developers to utilize these features for custom decentralized apps (dapps). The plan is to increase Base’s revenue potential after building a developer ecosystem around Coinbase’s unique ability to develop a Layer 2 that addresses gas fees: “We believe that this growth will then add users to develop products, we'll add developers and apps on Base. And that in turn will drive transaction volume and will drive down sequencer fees, and we will then see revenue as a result of those efforts.”

Coinbase is the sequencer, which manages the collection and publication of user transactions. For now, Coinbase controls the transactions, which will need to change in the future to adhere to blockchain’s ethos of decentralization. Coinbase is clearly profiting from Base with an estimated $52.5 million in the current quarter – exceeding even custodian ETF fees. By combining many transactions into one payment, Base can collect an arbitrage between the transaction fees and the network gas fees. There is also interest income from USDC on Base.

The Coinbase Developer Platform is a much larger initiative to become the backbone for financial-based decentralized apps (dapps). The platform offers APIs such as: building programmable crypto wallets to transfer crypto between two parties, or the ability to send, receive, trade and stake crypto. There are software development kits (SDKs) that help to integrate onchain AI, trading bots or automated payouts.

Bitcoin ETFs Having a Negative Impact on Coinbase

This year, the SEC approved 11 spot Bitcoin ETFs on January 10th, opening the door for more investors to gain exposure to Bitcoin without directly holding it. We stated at the time that the approval and subsequent widespread access for institutions and retail investors would shape up to be one of the most bullish fundamental moments in Bitcoin’s history.

Our paid research site has been anticipating this moment since 2019 when we stated: “One of the biggest hurdles for institutions, however, is not the idea of a world run on digital currencies, but rather the decentralization concept and the need for cryptocurrency storage. Institutional investors need to know the assets are secure, insured, and under the care of a trusted third party, per SEC rules, which requires advisers to keep client funds with a qualified custodian.”

Due to ETFs, the demand for Bitcoin has increased. Spot Bitcoin ETFs have seen a surge in net inflows, surpassing more than $30B AUM in mid-April after amassing $17B in funds in less than two months after a launch in mid-January. Trading volume on the ETFs nearly tripled in March, reaching $111 billion – for an asset class that had launched only two months prior, that’s a significant figure.

By mid-July, BlackRock Bitcoin ETF (IBIT) surpassed Invesco QQQ in year-to-date net flows despite total assets in IBIT being only a fraction of the Qs at $22 billion compared to $287.2 billion. At the time, two Bitcoin ETFs were in the top 10 including Fidelity.

In late August and early September, investors pulled roughly $1.2 billion or 3% of total assets from Bitcoin ETFs in the “worst string of outflows yet.” At eight of the eleven ETFs, this was the most consecutive days of net outflows that ETFs have experienced since the Jan 2024 launch. The 3% shows resiliency and may be leading to higher lows for Bitcoin, given the ETF outflows were not higher.

Since then, Bitcoin ETFs have seen their second consecutive week of inflows while Ethereum ETFs are seeing outflows. Since Ethereum ETFs were listed, Bitcoin has seen $5 billion of inflows while ETH products have seen $500 million of outflows (from Grayscale).

In the first eight months of the year, Bitcoin recorded its highest ever trading volume to-date, exceeding even the crypto bubble of 2021.

Source: CoinDesk and Kaiko

The most recent data from Dune shows Bitcoin ETFs having cumulative onchain holdings of $59.2 billion with BlackRock having 38% market share with $22.5 billion.

At the time of the ETFs launching, our team covered Coinbase and Robinhood in an analysis where we examined the impact of spot ETFs. Coinbase’s management team stated at the time:

Q: “Will Coinbase consider reducing transaction fees to make them more competitive with other platforms where ETFs are being traded at significantly lower prices?”

A: “We have no current plans to reduce transaction fees because of ETFs. If you just zoom out a little bit, spot ETF should be a positive catalyst for the entire crypto space. They should add credibility to the market, and we should see increased liquidity and market stability as we've seen with other asset classes such as gold.”have no current plans to reduce transaction fees because of ETFs. If you just zoom out a little bit, spot ETF should be a positive catalyst for the entire crypto space. They should add credibility to the market, and we should see increased liquidity and market stability as we've seen with other asset classes such as gold.”

It was our hypothesis at the time that lower volatility would mean fewer transactions for Coinbase, resulting in ETFs having a net impact on Coinbase.

In the Q4 call, Coinbase’s management team also asserted the ETFs will have a positive impact on the company’s revenue: “This will unlock new pools of capital to flow into the crypto space with Coinbase playing a key role here. We are earning revenue, not just on custody, but also on trading and financing.” It was also stated: “And we've always said that ETFs would be a win-win for Coinbase, and we're starting to see that play out on our platform.”

Being even more direct in the Q4 call held in February, it was stated: “For anybody worried about cannibalization, ETFs have been positive for the industry, which has been additive for Coinbase. We're seeing elevated engagement and net inflows across both retail and institutional Q1 to date” and also “ETFs are a massive way to get more capital to come in. So far, we have not seen any cannibalization. As Alesia said, it's been additive for Coinbase, and we're seeing elevated engagement and net inflows on both retail and institutional Q1 to date.”

However, the data we have pulled shows ETFs are not additive, and are instead, having a negative effect on Coinbase.

Source: I/O Fund

Description: Bitcoin hit all-time highs in Q4 2021 and again in Q1 2024. We can see from the data above that Coinbase is participating at a lower percentage of trading volume.

We would want to see higher institutional volume than the last ATH for the narrative that Coinbase is participating in institutions driving forward Bitcoin’s asset price in Q1 2024. Instead, we see it’s flat while consumer is more than 50% lower than Bitcoin’s last all-time high. The interpretation is that Bitcoin ETFs are not an additive for Coinbase at this time.

Similar to volume, we would want to see growth in institutional revenue help to offset a decline in consumer revenue.

Source: I/O Fund

Description: Transaction revenue from institutions was similar between Bitcoin’s previous all-time high, yet consumer is revealing that Coinbase’s fees are not attractive compared to the $0 trade fees from ETFs (albeit ETFs come with management fees).

The custodial fees of roughly $35 million, are up about $20 million since before the ETFs launched but do not help to absorb the combined $1.256 billion difference in transaction revenue between Bitcoin’s last ATH in Q4 2021 and Bitcoin’s ATH in Q1 of 2024.

The Bitcoin ETFs are cheaper to trade on stock trading platforms at $0 fees. As Bitcoin’s reputation has greatly increased with institutional participation, there may also be a psychological hurdle to trading and owning other cryptos, which in contrast, are high risk and have little to no institutional adoption. This would weigh on Coinbase compared to the last crypto boom as Bitcoin’s rising popularity erodes Coinbase’s value proposition to offer tokens that are hard to find on other exchanges.

Keep in mind, if this was purely a fundamentals play, the decoupling of Coinbase’s transaction revenue with the bellwether’s new all-time high would be concerning. However, Coinbase represents a means of trading crypto as a stock, and thus, even with a much lower revenue correlation to Bitcoin’s asset price, we expect Coinbase will continue to trade in lock-step with the bellwether.

ETF Custodian

Coinbase is the custodian for 10 out of 11 spot ETFs and eight of the nine approved Ethereum ETFs. In addition to being paid custodian fees, Coinbase can monetize ETFs through trading fees on the Prime product for institutions and financing for trade settlements.

We only have a two-quarter glimpse at results, yet the custodian fees are not able to offset the losses in transaction revenue. The custodial fee revenue for Q4 was $19.7 million, and grew 64% QoQ to $32.3 million in Q1. However, in Q2, the QoQ growth was only 6.8% QoQ.

Notably, this week, Blackrock has amended its custody agreement with Coinbase to require 12 hour withdrawals. According to the amendment, Coinbase Custody must now process a withdrawal of digital assets to a public blockchain address within 12 hours of receiving instructions from the Trust. This follows social media rumors that Coinbase was not purchasing Bitcoin with funds from ETFs, and was instead, issuing letters of debt. The pushback on these rumors is that Bitcoin’s price has been depressed due to other causes, and that Coinbase settles transactions on-chain even when some wallet addresses are concealed. The outcome is that there will be more liquidity and faster settlements for ETFs and institutions, and it’s likely Coinbase has to follow similar settlement times for consumers, as well.

Coinbase Financials:

Coinbase has tricky financials since it’s a crypto-related company. It would be tough to rely on fundamentals for an entry as it can change quickly in either direction. The metric that tends to track the best with Coinbase’s price action is asset prices and monthly transaction volume for crypto. However, the crypto market is largely dictated by sentiment, and we’ve found that Coinbase’s price is as an extension of this reality. The best indication of Coinbase’s trend is to track Bitcoin’s trend. They have been moving in lockstep since COIN’s IPO.

Coinbase’s forward estimates are meaningless as the estimates require predicting where crypto will trade in any given quarter. This is impossible for any analyst to do. Rather, for investors in Coinbase, importance should be placed on crypto transaction volumes, volatility indicators and pricing.

The company is also cyclical as it laps tough comps more often than a typical growth stock. By virtue of Bitcoin and crypto reaching a new high in March of 2024, the company is expected to see negative growth of (-12.08%) the following year in the March quarter of 2025.

Again, estimates are meaningless. If crypto is trading at all-time highs in March, then Coinbase will report growth – this company has seen growth of 1,100% in one quarter in 2021. During periods of crypto selloffs, the company has reported up to (-75%) revenue decline. As you can probably guess, this was in 2022.

Where Coinbase has seen a remarkable turnaround is with the cash flows, from (-51.6%) in 2022 to 27.7% in 2023. The company is prudent at keeping cash on its balance sheet with $7.23 billion in cash and $4.23 billion in debt for net cash of $3 billion. This is helpful as a stock, yet also helpful given the counterparty risks crypto exchanges carry; with nearly every competitor being private and not regulated by the SEC, the transparency of having $3 billion in cash and reporting quarterly is likely to attract institutional interest.

Revenue:

This quarter, the company is expected to report revenue of $1.28 billion for growth of 89.7%. Due to lapping tough comps, the growth rate is expected to slow considerably in early 2025 with current estimates expecting a bottom in Q1 2025 with growth of (-12.08%).

Notably, on a QoQ basis, Coinbase will be nominally up in revenue from Q4 2024 to Q2 2025 whereas it’s a tough YoY comp from Bitcoin reaching all-time highs in March of 2024.

Last quarter, Coinbase reported revenue of $1.45 billion for growth of 105%, beating estimates by 6.2%. This declined from the March quarter with growth of 112% and revenue of $1.64 billion.

If you look further out, you see that analysts shy away from predicting too much growth in either direction. This is why technicals matter quite a bit with Coinbase:

Pictured Above: Analyst estimates are essentially flat due to an inability to predict crypto trading volumes.

Key Segments:

Coinbase’s trading volume was $226 billion, up 146% YoY yet down (-28%) QoQ. This compares to $312 billion in the March quarter when Bitcoin was at all-time highs.

Coinbase’s transaction revenue was $781 million in the most recent quarter ending in June, representing growth of 138.7% YoY and a decline of (-27%) QoQ. During Bitcoin’s peak in March, the company reported transaction volume of $1.08 billion. Compare this to 2023’s transaction volumes, which were less than $500 million and often down up to (-50%).

Management stated that there is beginning to be a disconnect between revenue and volume due to wallet fees and derivatives being counted as consumer revenue yet do not contribute to consumer volume.

• Within Transaction revenue, Consumer is the main driver at $664.8 million compared to Institutional volume of $63.6 million. The institutional percentage has been growing rapidly from $39 million in H1 2023 to $149 million in H1 2024 for 282% growth. Consumer grew 159% in the same period.
• Base revenue has been moved to Other transaction revenue and was at $52.5 million in the current quarter. From H1 2023 to H1 2024, Base and other transaction revenue grew 145%. This means that Base revenue is higher than custodial fees.
• Management stated they saw $210 million in transaction volume for July, pointing toward mid-$600 millions for transaction volume. This compares to $110 million for July of last year in the same period.
• What we’ve extrapolated above is that Coinbase is not a beneficiary of Bitcoin ETFs as both trading volumes and transaction revenue are significantly lower than Bitcoin’s previous all-time highs but that institutions, derivatives and Base may (over time) help make up for consumer-related spot trading losses.

Subscription and services revenue was $599 million, compared to the guide for $525M to $600M, reporting growth of 78.6% YoY and 17% QoQ. This is an all-time high for Coinbase in this segment and helps to diversify from being dependent entirely on transaction volume. The growth was due to stablecoin revenue and a one-time blockchain validator reward of $8 million.

Within Subscription and Services:

Looking forward, subscription and services are expected to be “within a range of $530 million to $600 million.”

• Stablecoin revenue of $240.4 million was up 59% YoY and reached an all-time high. The segment was up 17% QoQ. According to management, they are seeing almost $20 billion per week in USDC transaction volume. USDC is a 1:1 with the dollar and is used for global transfers. Advanced crypto traders and institutions will also settle a high-dollar token swap with USDC rather than token-to-token or transferring into cash to avoid high spreads and high fees.
• Blockchain rewards was at $185.1 million, up 111% YoY and up 22.6% QoQ. This segment opens up an interesting opportunity as interest rates go lower. Staking yields are not determined by FOMC policy; instead, by the participation rate of coins being staked. As demand increases for crypto, yields will increase to entice more coins to be staked. As a non-correlated yield to traditional financial instruments, which are mostly tied to central bank policy, this creates an opportunity for portfolios to diversify incomes in an interesting way, and adoption should increase as rates go lower.
• Interest and finance fee income of $69.4 million, up 34% YoY. This segment is tied to interest rates, as Coinbase offers loans against the coins being held in house. This is unlikely to sustain now that the FED has lowered rates. Yet, segments such as these can help stave off losses since crypto as an asset class tends to underperform in a high interest rate environment.
• Custodial fee revenue was $34.5 million, up 103% YoY.
• Other subscription and services revenue of $69.6 million was up 153% YoY.

Margins:

Coinbase does not provide a gross margin on their income statement. The operating margin fluctuates wildly aligned with revenue fluctuations. Last quarter, the operating margin was 23.7% compared to 46.4% in the previous quarter. A year ago, the operating margin was (-10.4%).

The operating expenses increased 26% QoQ to $1.1 billion primarily due to a loss of (-$31 million) on crypto assets held for operations in Q2 compared to a gain of $86 million in Q1 and Technology & development, G&A, sales & marketing expenses increased by $106 million due to higher USDC reward payouts, performance marketing spend, and policy spending.

Net margin last quarter was 2.5% for $36.1 million in profits. This was down considerably from 71.9% in the previous quarter with profits of 1.18 billion. In the year ago quarter, the net margin was (-13.8%) for losses of ($97.6) million.

Stock based compensation was $217 million or 15% of revenue last quarter. This is down considerably from 28% of revenue last year. However, management stated: “We expect technology & development and general & administrative expenses to increase Q/Q to $700-$750 million, largely driven by the non-linear expense recognition of our stock-based compensation.” This would imply a $40 million increase at the midpoint for $257 million in SBC or about 20% of revenue.

Earnings and EBITDA:

GAAP EPS of $0.14 last quarter compared to GAAP EPS estimates of $0.92. This compared to GAAP EPS of $4.40 last quarter and adjusted EPS of ($0.42) in the year ago quarter.

Adjusted EPS of $0.14 last quarter compared to estimates for $0.80 EPS.

Coinbase is expected to report adjusted EPS of $0.43 next quarter and GAAP EPS of $0.48. The expectation is that Coinbase remains GAAP profitable although this will depend on the level of drawdown seen in any future crypto selloffs.

The company reported adjusted EBITDA of $595.5 million for a margin of 41.1% compared to adjusted EBITDA of $1.01 billion last quarter for a margin of 61.9%.

Notably the company was adjusted EBITDA positive even in Q2 and Q3 of 2023 when it reported negative YoY revenue. At that time, adjusted EBITDA was in the range of 26% and 27% for $188.7 million and $178.3 million. When including stock-based compensation, the company would not be adjusted EBITDA positive as SBC was $199.8 million and $218.2 million, respectively, in those two quarters.  

Coinbase Additional Notes:

More on Derivatives:

As stated, derivatives are about 70% of the trading market for crypto. A derivative contract is an instrument, such as a futures contract, option or perpetual contract, whose price is based on the underlying crypto currency. Unlike spot trading, where you are buying the asset and mostly participating on the long side, derivative trading allows the owner of the contract to speculate on both up and down price movements, hedge a spot position, or add leverage to a position. This allows an investor to bet on the inevitable downtrends in crypto, and therefore allows institutions, or retail traders, to hedge their positions.

Derivatives are a key element to attract savvy retail and institutional investors. Having a user-friendly platform to trade these instruments is an important piece to Coinbase’s evolution with institutional adoption. In the medium-term, derivatives will help to compensate for the lower consumer spot trading volumes on Coinbase’s platform.

Here was a question about derivatives on the most recent earnings call:

Devin RyanDevin Ryan

Great. Thank you. Hi, Brian. Hi, Alesia I just want to ask a question about the derivatives platform and we're tracking just quarter-to-date, a continuation of building volumes there. And I know you're not breaking it out in revenues separately yet, but it sounded like it was a positive contributor in the second quarter.

Brian ArmstrongBrian Armstrong

Yes. So I'll start off and then maybe I'll hand over to you, Alesia on some of the margin questions. So just zooming out, derivatives is about 75% of all crypto trading activity by volume. And so it is the majority of trading volume. Now the take rates are lower on it, but it's really a key part of the market overall. And so I'm really glad that we are now in market, both the U.S. with Coinbase financial markets and then internationally with our international exchange as well

For Coinbase International Exchange, we also expanded our asset coverage quite a lot in Q2. We added 25 additional perpetual futures contracts. The volume has been really good today, actually, on Coinbase International Exchange. So you can check out at international.coinbase.com.

And so you can kind of just see Coinbase following this path of we're not always first-to-market, but we do it the do it the right way. We compliant way, the secure, trusted way. And so we're the trusted counterparty that many of these folks have been waiting for to enter the market. And I think that's going to pay off as a really good long-term strategy. Alesia, anything you want to add?

–End Quote

Base Layer 2

As stated above, the offer for no trading fees (or “gasless transactions”) is accomplished through Base, which is a Layer 2 built on the Ethereum network. Base offers 1 cent, 1 second transactions with Coinbase reporting there is $20 billion per week in USDC transactions taking place on the Layer 2. Base offers interoperability with other Ethereum network-compatible applications, offering the security of Ethereum’s Layer 1 while improving Ethereum’s scalability issues (primarily gas fees). Coinbase’s goal is to decentralize Base to make transactions faster while leveraging the security of Ethereum mainnet.

Total value locked (TVL) for Base was at $8 billion as of July 2024, making Base the second largest Layer 2 by TVL after Ethereum’s Dencun upgrade. Crypto has settled a bit since July, yet Base remains the second largest Layer 2 by TVL with $1.965 billion TVL. Base has seen trading volumes of up to $1 billion per day with up to 3 million transactions per day, whereas Coinbase sees about $2 billion in trading volume and Ethereum sees about 1 million to 2 million transactions per day. This means at the onset, Base exceeds Ethereum in number of daily transactions.

Base is further interesting for I/O Fund Members as the Layer 2 offers Data Streams from Chainlink, which is low-latency data that allows developers to build DeFi apps. Base also offers Chainlink VRF, the leading random number generator across Web3 with more than 21 million transaction requests completed and with a latency of about two seconds. We’ve covered Chainlink automation with up to 90% reduction in gas fees, Cross-chain Interoperability Protocol (CCIP) and Price Feeds in the past here. Our original Chainlink thesis is a must-read for anyone new to the I/O Fund, as LINK is an asset our firm has held since launching our research site in 2019.

Over the past few months, Base has been integrated by Stripe and Shopify, which is an important step forward to see onchain versions of Fortune 500 applications. Stripe uses Base for faster and cheaper money transfers by adding USDC to crypto payouts, and fiat-to-crypto for currency conversions. There is also an integration with Coinbase Wallet to allow users to purchase crypto with credit cards and Apple Pay. Stripe originally offered crypto payments in 2014 but ceased doing so in 2018.

The company has stated its focus is to build a developer ecosystem around Base first and foremost: “Our focus, as I mentioned in my opening remarks, is driving developer activity, we're driving those transaction volumes that we commented on. We're doing this by driving down fees, increasing the scalability and creating a powerful developer platform that's enabling anybody to build these onchain products.

We believe that this growth will then add users to develop products, we'll add developers and apps on Base. And that in turn will drive transaction volume and will drive down sequencer fees, and we will then see revenue as a result of those efforts.

Regulations

For institutions, there is a product called Coinbase Prime. This is a full-service prime brokerage platform, which facilitates trades as well as custodian services for large institutions. Management has stated institutions have maybe 1% to 3% of their funds in crypto. This is a low allocation, which has a lot of potential for growth. However, it is being stymied due to the lack of much needed regulations within the crypto space, which has been fraught with fraud.

For example, On November 11th, 2022, FTX, one of the largest crypto exchanges in in the world, filed for bankruptcy. At the time, it was the 18th crypto exchange to file for bankruptcy, and by far the largest, with an estimated $9 billion lost. One of the many fraudulent practices, which wasn’t limited to FTX, was that FTX would not register an internal transaction until a customer wanted their coins out of the exchange. This led to a scenario where 28 million Bitcoins had been bought with only 19.8 million in supply. Therefore, FTX created a crypto-version of a ponzi scheme that suddenly ended.

There have been a total of 20 crypto exchanges that have failed through 2024. The reason for their failures range from hacking events, mismanagement due to faulty business models, to outright fraud. We’ve even seen exchanges attempt a fractional reserves model where loans were offered based on a fraction of the total coins being held on their exchange.

These exchanges are all private businesses, except for Coinbase, so there is no way to see their financials. Furthermore, there are no mandatory audits to prevent fraud or mismanagement. When you factor in that over 50% of all cryptocurrencies have failed, it’s no wonder institutions managing millions to billions have been hesitant to explore this asset class.

As of now, Canada, UK, Switzerland, El Salvador, and China have regulations around crypto currencies. The United States is expected to follow, as the House just passed a meaningful crypto bill that defines regulations. The 200 page bill helps categorize a cryptocurrency and thus determines if should be regulated as a security by the SEC or as a digital commodity by the CFTC, through well-defined oversight. Furthermore, the bill would remove exchanges from comingling coins, as well as removing conflicts of interest, such as trading as an entity while also acting as a broker between buyers and sellers.

Whether it gets passed by the Senate is yet to be seen. With some of the world’s largest financial institutions now involved in the crypto space through Spot ETFs, it’s only a matter of time before much needed regulations will settle the nerves of money managers looking to diversify into this space. When this happens, it should act as a tailwind to Coinbase’s current business model.

Strong Cash on the Balance Sheet

As stated, free cash flow was $484.2 million or 33.4% of revenue compared to $151.1 million or 21.4% of revenue in the same period last year and 25.1% of revenue in Q1.

Cash was $7.23 billion and debt of $4.23 billion compared to $6.7 billion and $4.23 billion in Q1. The company issued $1.3 billion of convertible notes in Q1 and plans to use the net proceeds of $1.1 billion to repay the outstanding debt at or prior to maturity, depending on the market prices. Management also clarified in the earnings call that the other reasons for maintaining large cash balances were to support the ETF launches and for potential investment opportunities.

Here was a question on the earnings call:

Benjamin BudishBenjamin Budish

Hi. Good evening, and thanks for taking the question. I was wondering if you could give us an update on your balance sheet strategy. We noticed the cash build continues to really grow. And it seems like with the — the business generating cash and spending really kind of ramped down from a few years ago, there may not be as much of a need for it. So any update there? And then kind of along the same lines, you've been generating now a lot of your gross profit from interest income. And just curious, if there's any thoughts around the hedging strategy should rates start to come down. What's your kind of philosophy there? Thank you.

Alesia HaasAlesia Haas

Thanks for those questions. Yes, we're really pleased with the balance sheet strength. We are using cash, as we've mentioned in our prime financing business. A large amount of that cash was used to support the ETF launches in Q1 and Q2 with the Bitcoin ETF and now hopefully be a Ethereum ETF where you can see a lot of day-to-day or week-to-week volatility of those loan balances.

We did grow prime financing fees within the quarter. And so you can see while the balance at the end the end of quarter was down versus of Q2. We saw growth intra-quarter for those balances. So using our cash to support our products is a primary use case for us.

Technical Analysis

Coinbase appears to be working through a very large 5 wave pattern off its early 2023 low.  If this is accurate, any additional weakness will need to hold $113, and then start making higher highs to the 5th wave target between $294 – $217.

As of now, the larger correction that started in March of this year appears to be supporting this. It is a 3 wave correction that has room for one more swing lower to complete. If the current bounce fails to break over $172 – $181.50, then we can see a final drop into the $137 – $127 region. If we can instead breakout above $181.50, the odds will start supporting that the 4th wave low is in, and we will likely be in the early stages of wave 5 to new highs.

This lines up with Bitcoin’s chart, as well. The pattern off the late 2022 low appears to be an unfinished 5 wave pattern. Note the current correction. It is messy, with many overlaps, which is typical of corrections within larger uptrends. The bigger pattern suggests that we should be heading to $78,000 – $85,000 next, which would give us the minimum waves required to complete the 5 wave uptrend. Once we get to this region, or beyond. How we correct from there will determine just how high into the $100,000 region we will go.

For now, the probabilities favor a swing higher. As long as we hold $42,750 on any additional weakness, this remains our expectation from the technical patterns in both Coinbase and Bitcoin.

Conclusion:

Publicly, our firm has become known for our Nvidia AI thesis, and how we have positioned our readers for this trend before 2023. Yet behind the paywall, our premium subscribers are well aware that our active management with crypto since 2019 is equal in terms of its performance. By championing active management for tech investors — which means weighing the probabilities to cut or trim at specific times with the goal of buying lower — the I/O Fund stands out in a crowded, noisy crypto space by offering tools to navigate the volatility in this asset class.

Coinbase’s move into the derivatives market, as well as being a trusted custodian for institutional investors in the crypto space, will continue to entice institutions to their platform. Being a publicly traded company, Coinbase is the only exchange that allows its financials to be analyzed and monitored. This is crucial for investors considering the lack of FDIC and SPIC insurance in this space. These exchanges are businesses that can be mismanaged, and if this happens, all the coins being held there will be appropriated and redistributed to creditors in the event of a bankruptcy. This is a risk that Coinbase offers a solution to through their business model and publicly issued quarterly financials. This makes Coinbase stand out amongst its peers in a way that creates a moat for institutions looking to expand into the crypto space beyond the limited and costly spot ETF options.

Coinbase’s stock pattern lines up with Bitcoin, as both continue to suggest another swing higher is likely. If COIN can continue to evolve with the crypto market, and continue to lead as a trusted institutional platform, it will likely continue to appreciate with Bitcoin over time.

Given Chainlink is becoming a beneficiary of Layer 2s like Base and Arbitrum, you can expect an updated 2024 deep dive on our favorite blockchain asset coming soon!

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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