Coinbase: The Staking Business Is At Risk (COIN)

Coinbase Global, Inc. (NASDAQ:COIN) stock plummeted 14% yesterday (Feb. 9) with rumors that surfaced regarding a potential SEC ban on crypto staking in the United States. These rumors were triggered with the popular crypto exchange Kraken agreeing to pay $30 million to settle SEC allegations that its staking products were violating securities laws in the United States. As part of the agreement reached with the SEC, Kraken will also discontinue its staking products in the U.S. but these products will be available to international traders via a subsidiary of the company. With the SEC promising to tighten its grip on the crypto industry in light of risks associated with many crypto products, investor fears stemming from Kraken’s settlement with the SEC seem justifiable. This analysis aims to shed light on how crypto staking works, the importance of Coinbase’s staking business, and the outlook for this business segment.

What is Crypto Staking?

From a trader’s perspective, staking is the practice of locking up some or all crypto assets owned by an investor in exchange for a percentage-rate return. Every cryptocurrency uses a consensus mechanism to validate and verify transactions to add them to the blockchain. There are two widely-used consensus mechanisms.

1. Proof of Work – used by Bitcoin (BTC-USD).
2. Proof of Stake – used by Ethereum (ETH-USD), Cosmos (ATOM-USD), Cardano (ADA-USD), Solana (SOL-USD), etc.

For staking to be allowed, traders need to own cryptos that use the Proof of Stake consensus mechanism, which is why Bitcoin does not facilitate crypto staking.

Transaction verification through Proof of Stake works via crypto investors staking their cryptos to validate these transactions in exchange for rewards in the form of cryptos. The functionality of crypto staking, therefore, is similar to crypto mining. Becoming a staking validator requires substantial investments in hardware and technical knowledge but major crypto exchanges in the world offer simple staking products where traders can stake their holdings in just a few clicks in exchange for potential rewards.

Exhibit 1: The dynamics of crypto staking

Ethereum shifted to a Proof of Stake consensus mechanism last year, and this decision boosted the staking business of many crypto exchanges worldwide. Illustrated below are the yields associated with different cryptocurrency staking projects in the United States.

Exhibit 2: Yields of different crypto staking products

The SEC believes some of these staking programs need to be registered as securities offerings because of their characteristics, and the SEC alleged that Kraken failed to do this.

Coinbase CEO Defends the Company

In a statement announcing Kraken’s settlement, the SEC quoted its Chair Gary Gensler saying:

Whether it’s through staking-as-a-service, lending, or other means, crypto intermediaries, when offering investment contracts in exchange for investors’ tokens, need to provide the proper disclosures and safeguards required by our securities laws. Today’s action should make clear to the marketplace that staking-as-a-service providers must register and provide full, fair, and truthful disclosure and investor protection.

The SEC’s issue is with staking-as-a-service providers who design contracts that resemble traded securities but avoid registering them with the SEC. In a statement to Bloomberg, Coinbase chief legal officer Paul Grewal said:

Coinbase’s staking program is not affected by today’s news. What’s clear from today’s announcement is that Kraken was essentially offering a yield product. Coinbase’s staking services are fundamentally different and are not securities.

Coinbase CEO Brian Armstrong took to Twitter to claim that he has been hearing rumors of the SEC prohibiting retail traders from participating in crypto staking programs in the future and claimed that such a decision will harm consumers and also pose a threat to national security.

Exhibit 3: Brian Armstrong’s Tweet

Mr. Armstrong went on to say that new technologies should be encouraged to grow in the U.S. and urged regulators to come up with “sensible solutions”.

Hester M. Peirce, who serves as a Commissioner on the SEC, released a statement yesterday criticizing the regulator’s decision on Kraken’s crypto staking program. She makes the case for using an effective regulatory framework to promote new technologies while protecting consumers.

We have known about crypto staking programs for a long time. Although it may not have made a difference, I should have called for us to put out guidance on staking long before now. Instead of taking the path of thinking through staking programs and issuing guidance, we again chose to speak through an enforcement action, purporting to “make clear to the marketplace that staking-as-a-service providers must register and provide full, fair, and truthful disclosure and investor protection.” Using enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating. Moreover, staking services are not uniform, so one-off enforcement actions and cookie-cutter analysis does not cut it.

The SEC, regardless of the fightback from the likes of Coinbase’s CEO, seems laser-focused on investigating the crypto staking industry.

Undermining the SEC’s Threats Could be Fatal

Investors should be wary of dismissing the threat posed by the SEC to Coinbase’s future as a crypto staking business. The argument made by Coinbase executives is that its staking process does not involve transferring the title of ownership of crypto assets from an investor to any other entity. Although this seems a valid argument, the SEC might still ban the practice of crypto staking, in which case Coinbase will have no option but to discontinue this business.

If Coinbase begins a battle with the SEC over its decision on Kraken, it would not be the first time the company gets in a fight with the watchdog. Back in September 2021, Coinbase CEO Brian Armstrong, in a series of Tweets, accused the SEC of “sketchy behavior” as the regulator did not approve Coinbase’s proposed crypto lending product. Coinbase eventually had to scrap its crypto lending product later that month as the SEC found these products to be too risky for retail investors.

The Staking Business of Coinbase

In the September quarter, Coinbase generated $62 million in revenue from staking services, which was close to 11% of the total revenue the company reported for the quarter. Amid the continued decline in trading revenue, Coinbase investors have found solace in the company’s efforts to diversify its revenue by promoting the use of non-investing products such as staking. The company, on the other hand, has regularly highlighted the importance of this business segment to its future as a 360-degree crypto solutions provider. Below are some of the remarks of CEO Brian Armstrong in his Q3 letter to shareholders.

While staking monetizes at a lower rate compared to trading, we are pleased by the growth in absolute revenue as compared to the prior crypto winter when our staking products did not exist in earnest.

In Q3, Blockchain rewards benefited from increased participation in staking – both in terms of number of users and an increase in the number of native units staked across all assets supported on our platform – compared to Q2. Staking user growth was driven primarily by Solana, which we began supporting in June.

In Q3, we launched Institutional staking for Ethereum globally and while adoption is still in its early days, we are optimistic about the long-term opportunity.

It is abundantly clear that Coinbase views the rising popularity of staking as an opportunity to meaningfully diversify its revenue streams. The characteristics of the staking business bode well for Coinbase’s long-term strategy of reducing the volatility of revenue.

With the SEC continuing to probe into the business practices of major U.S. crypto exchanges offering staking programs, decentralized finance apps such as Lido, Rocket Pool, and StakeWise stand to gain the most. According to data from Dune, Lido is already the market leader in the Ethereum staking business, well ahead of Coinbase which is in the second position.

Exhibit 4: ETH stakers by the amount staked

Decentralized apps such as Lido are thought to be immune to regulatory headwinds because of the autonomous and anonymous features of these platforms. Commenting on how SEC’s crackdown could turn out to be a windfall for these platforms, Henry Elder, the head of decentralized finance at Wave Financial, said:

This is a huge gift to decentralized staking providers like Lido, Rocket Pool and StakeWise. Their competitive advantage is an innate resistance to regulatory action — something that mattered little in the absence of such action.

Investors and traders are likely to choose decentralized apps over Coinbase in the short term amid the dark clouds hanging over the staking programs offered by crypto exchanges. The SEC’s probe, therefore, could have a long-lasting impact on Coinbase’s staking business.

Takeaway

Investing in Coinbase stock, in my opinion, remains the best way to get exposure to the crypto industry assuming that COIN’s positive correlation with Bitcoin prices will eventually decline along with the success of the company’s non-investing business. The company’s staking business, however, is likely to attract regulatory scrutiny, which might push stock prices lower in the short term.