Stakes Done? Coinbase Pressured To Halt Earnings Program In 4 States


What Happened

On July 14, Coinbase
COIN
announced that customers in four states will no longer be able to stake tokens on the exchange. Users in California, New Jersey, South Carolina, and Wisconsin are restricted from accessing Coinbase’s staking services, which allow customers to temporarily pledge their cryptocurrencies to earn additional tokens. This policy only applies to new tokens, and assets already staked by clients in these states can remain.

The action was taken in response to a U.S. Securities and Exchange Commission lawsuit against Coinbase that alleged the retail staking services are securities under law. In response to the suit, securities regulators in 10 states instituted their own proceedings against Coinbase; and four also issued preliminary orders requiring the company to limit staking services in their states.

Coinbase said it would fight the charges. “Staking is a core part of ensuring that the cryptoeconomy functions for hundreds of millions of users around the globe,” it said in announcing the changes. “Staking services are just one part of Coinbase’s existing business. But because staking is so fundamental to the crypto industry, Coinbase is committed to protecting access to staking for everyone.”

Broader Context

Staking is the process of earning token rewards by pledging cryptocurrencies as collateral and contributing to the security of a blockchain network by validating transactions. Through its Earn program, Coinbase offers staking for 90 digital assets, including ether, solana, cardano, polkadot and cosmos. The Earn program offers yields as high as 10%, paid out in the networks’ native tokens.

As of the end of Q2, the cumulative value of all staked assets was $68 billion, a 61% increase from the previous quarter. Annualized staking rewards reached $5 billion, up 66% from Q1. Liquid staking, a recent construct that allows investors to continue using their tokens in other ways while they are staked, is accounting for an ever-increasing percentage of the market. It makes up 44% of the $45 billion of total value locked of ether (ETH) in all decentralized finance (DeFi) offerings.

Under the leadership of Chairman Gary Gensler, the SEC has taken a regulation by enforcement approach while telling Congress that it does not need new laws or statutory authority. Industry participants see this as antagonistic and suggest the agency is not willing to interact with the crypto industry in good faith.

Coinbase is not the first exchange to enter the sights of regulators in the U.S. for a staking product. In February, Kraken, the country’s second-largest crypto exchange by trading volume, reached a $30 million settlement with the SEC, requiring the company to cease offering staking services to its U.S. retail clients. Kraken’s offering was structured differently from Coinbase, with the exchange taking a more active role in managing rewards and promising fixed yields. Coinbase’s product serves as a more straightforward pass-through program where the yields are variable and the exchange takes a cut of the rewards it stakes on behalf of clients.

In addition to trading fees, staking is one of Coinbase’s main revenue streams. In Q1, staking generated $73.7 million, 9.5% of Coinbase’s revenue. This is larger than Coinbase’s institutional custodial service, Coinbase Custody, which makes up just 2.2% of total revenue.

The lion’ share of Coinbase’s sales come from trading fees, comprising 49%, but that is down from 87% a year earlier, when staking was only 7%. This points to Coinbase’s efforts to diversify its revenue streams, in the face of increased exchange competition and trading fee compression.

Coinbase shares have recovered from the crypto winter of 2022, almost tripling year-to date, far better than the 77% rise posted by bitcoin. Much of this positive performance has been driven by Ripple’s recent partial court victory in its own suit by the SEC, in which a judge ruled that cryptocurrency transactions are not always necessarily sales of securities. The ruling may be appealed and is not binding on other courts, but for now Coinbase’s core business model is being regarded as safe.

Source: TradingView

Key Quote

Speaking about the future market structure of liquid staking, Boris Revsin, Managing Partner at Tribe Capital, commented, “As the on-chain user experience for liquid staking continues to improve, I see more and more cold storage and institutional ETH being staked off of centralized exchanges, or at the least in a non-custodial way on those exchanges.”

“Lido [a Tribe Capital portfolio position] is currently the front-runner across all key metrics, and they are also the most capitalized. The argument that Lido is centralizing liquid staking by being the largest provider is missing the forest for the trees — it is simply a response to market dynamics which value security, governance, ease of use and scale.I expect the entire market to grow, for Lido to retain the largest market share, and begin to roll out additional strategies and products in the months to come.”

Key Stat

Coinbase’s staking program comprises about 11% of the ether liquid-staking market, with 1.17 million ETH staked ($2.2 billion). Lido is by far the largest with 80% market share, followed by Coinbase, Rocket Pool, Frax
FRAX
Finance and Stakewise.

Source: Dune Analytics

Outlook and Implications

Coinbase’s announcement has not had a large impact on the amount of assets staked on its platform though it could be too soon to notice a difference. An important indicator to look out for is whether Coinbase starts to see a different pattern of withdrawals than other staking competitors.

Since launching its liquid-staking program for ether in June 2022, Coinbase’s amount staked has been steadily increasing, and the current balance of 1.17 million ETH represents an all-time high.

Source: Dune Analytics

Total ETH staked and the amount staked through liquid-staking protocols such as Lido, Rocket Pool, Frax Finance, Stakewise and Ether Fi have been steadily increasing. ETH delegated to liquid-staking protocols exceeds 10.6 million ETH ($19.7 billion), representing 8.9% of the total network supply. Currently, 24.7 million ETH is staked, representing about 20% of the supply.

Depending on how the upcoming legal battles play out and if Coinbase can avoid having to pause new deposits in other states, the exchange may continue to play a central role as a gateway for unsophisticated retail investors to stake their assets due to the convenience and ease of use. However, if Coinbase loses in the courts, investors will likely flock to decentralized liquid staking services that possess their own forms of risk.

While some users may choose to use more decentralized platforms such as Lido, these come with their own issues. For instance, the dominance of Lido as the largest liquid-staking service for ether is becoming a source of concern among crypto enthusiasts, even if it is ostensibly decentralized. If there are bugs in the code or exploits emerge, user funds may be at risk, with 8.2 million ETH delegated to Lido today ($15.3 billion).

Furthermore, Lido’s liquid staking token, stETH, is intertwined with many DeFi protocols enabling the exchange, lending and yield farming of the token. If Lido were to fail, it would have cascading effects on other platforms in the Ethereum
ETH
DeFi ecosystem.

Decision Points

Investors seeking to stake their assets and earn token rewards should be cognizant of the tradeoffs inherent to various staking options. Centralized staking such as that offered by Coinbase provides the greatest convenience, but is more acutely subject to local laws and regulations, and providers collect data on all users. Liquid-staking protocols possess smart contract and tokenomics risks but allow for lower minimums and reduce the technical overhead of getting started when compared with solo stakers.

The safest way for holders to stake their assets is to run their own validator nodes. This requires access to hardware and a degree of technical knowledge. However, solo stakers always retain custody of the private keys that provide access to their assets and are only subject to protocol level risk, as opposed to trusting liquid-staking pools where users must deposit their assets.

Investors may also purchase the governance tokens of leading liquid staking protocols, if they want to bet on their price performance. The governance tokens of Lido and Rocket Pool, ldo and rpl, have performed well this year rising 99% and 46% respectively.

Source: TradingView

If Coinbase is able to win key legal battles against state regulators and the SEC in the coming months, its shares could extend their gains. Investors should track key developments in the legal cases closely.

The outcome of these court cases may have larger ramifications for the industry as they set precedents for which types of assets and products are to be considered securities. The SEC has identified several tokens as such in its lawsuit against Coinbase. These include sol, ada, matic, fil, sand, axs, chz, flow, icp, near, vgx, dash and nexo.

The prices of these assets plunged upon the announcement of the lawsuit but then rebounded upon Ripple’s partial court victory on July 13. A Coinbase victory in the SEC suit could bring further gains.



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