Crypto Euphoria: Coinbase's L2 Hasn't Gotten The Memo

Summary Coinbase launched Ethereum scaling chain "Base" to address the threat of decentralized exchanges taking share from centralized exchanges. After a strong start over the summer, engagement with Base during the recent crypto run has been disappointing. Coinbase's centralized exchange has seen a surge in volume over the last two months. When I last covered Coinbase ( COIN ) for Seeking Alpha, the company had just launched its Ethereum ( ETH-USD ) scaling chain called "Base." The logic behind Base actually makes quite a bit of sense for Coinbase. One of the core mantras from cryptocurrency advocates since Bitcoin's ( BTC-USD ) genesis block has been "decentralization." Even though Coinbase has been an important figure in the early years of this industry, as a centralized exchange there is a distinct possibility that the company's core business will erode as decentralized exchanges, or DEXes, continue to siphon share from their centralized counterparts. DEX volume Share (TheBlock) Before the 2020 bull run, DEX volume was non-existent. However, even through crypto winter the trend for DEX volume share growth has generally persisted. The big difference this cycle is the DEX protocols are arguably even better than they were just a couple years ago. Early implementations of popular DEX protocols like Uniswap ( UNI-USD ) or SushiSwap ( SUSHI-USD ) have typically not enabled cross-chain swaps. Meaning, Ethereum holders were generally limited to Ethereum-based swaps. To swap ETH to BTC, a token holder either had to swap from ETH to a derivative token like Wrapped Bitcoin ( WBTC-USD ) or do the swap through a centralized exchange like Coinbase. Today, we have cross-chain swap networks like Thorchain ( RUNE-USD ) exploding in popularity. These networks are in direct competition with Coinbase today and in the future. THORChain TVL (Token Terminal) With this as our backdrop for today's update, COIN investors should be rooting for strong user engagement with the company's Ethereum L2 long term. At least during this recent crypto run, an increased level of Base usage hasn't yet manifested. An Updated Look At Base In my August Coinbase article, Base had just a few weeks of transaction history but there were already very promising signs from the network's early adoption. Since then, we've seen usage of the chain essentially collapse even as the broader crypto ecosystem has experienced a resurgence. The 7 day average for daily transactions has fallen from over 1 million at the beginning of October to just over 270k at the beginning of December: Base transactions (Dune Analytics/watermeloncrypto) If the broader ecosystem was in decline, this may not be as concerning. But when adjusting Base transaction volume to network share, we can get a better sense for how poorly Base has performed in recent months: L2 Transaction Share (IntoTheBlock) Base's share of transaction volume between fellow ETH scalers Arbitrum ( ARB-USD ) and Optimism ( OP-USD ) has dropped from a high of 47% on August 12th down to 12.3% on December 4th. From a decentralized finance (or DeFi) standpoint, Base' total value locked (or TVL) on the chain actually appears to have peaked in October: Base TVL in ETH (L2Beat) After chopping around between 340-350k ETH between early-September and October, coins have started to come back out of the chain since. TVL currently stands at 277k ETH - which is down 22% from the high just a couple months ago. The stablecoin footprint on Base is also a cause for concern: Base Stablecoins (DeFi Llama) After peaking at $152.6 million on September 4th, stablecoins on Base have fallen by over 44% down to $85 million as of December 5th. This is all while the broader stablecoin market over that timeframe has increased by over 3%, or roughly $4 billion. If I can say one good thing about Base it's that it remains one of the few profitable chains in the crypto ecosystem. Base Earnings (Dune Analytics/watermeloncrypto) That said, profit has been declining even as revenue has stabilized in part due to higher gas fees on the main layer. It also is important to remember that cumulatively the earnings from operating this network is a tick above $5 million in the 5 months since the chain went live. The point is, if Base is ever to become an important part of the Coinbase's future business, it still has a very long way to go and a theoretically positive macro backdrop isn't helping it. The Core Business Of course, Base is just a single project within the broader Coinbase business. The bread and butter is still the company's revenue from its centralized exchange transaction fees and interest income. At the end of Q3-23, Coinbase reported $674 million in total revenue and had its best quarter from a net income standpoint since Q4-21 after losing just $2.3 million. Data by YCharts A large driver of Coinbase's net income reversal in recent quarters comes from stablecoin revenue that the company shares with Circle. Circle is the issuer of USCoin USD ( USDC-USD ) and the collateral backing those stablecoins is short duration US treasuries. If you believe that the Federal Reserve will begin to cut rates in 2024, the interest on that collateral may ultimately come down. Transaction Revenue (Coinbase) If rates do indeed come down, Coinbase shareholders will need the transaction revenue trend to turn around as well. And that brings us to Q4. We do have some data from The Block that could give COIN shareholders some degree of confidence in this figure rising in the next earnings report. Exchange Volume (The Block) Monthly exchange volume has started to pick back up. In the company's guidance, management noted $105 million of total transaction revenue during the month of October. Using the data from The Block, that revenue came on $31.16 billion in exchange volume. Using that same margin on volume and the $50.4 billion in exchange volume Coinbase just did last month, COIN may have just earned as much as $170 million in total transaction revenue in November. If that estimate is accurate, COIN is already very close to matching transaction revenue from Q3 in the first two months of Q4. Investor Takeaway As I've laid out in this article, I think Coinbase has a fundamental flaw in the current business model. The issue with centralized exchanges is the better the decentralized protocols and networks get, the less need there is for the legacy players. I don't think anyone could or should reasonably expect Base to be a significant driver of Coinbase's revenue story today. But if the company is going to counteract the long term trend of transactions moving directly on-chain, it is going to need a robust on-chain footprint as well. So far, that story is not great and I'd even go as far as saying the lack of user engagement with COIN's L2 solution during what is generally a broad crypto rally may be a cause for concern.