Innovator’s Dilemma at Coinbase

Coinbase faces a dilemma in the battle to own the emerging brokerage layer in crypto.

This quote from Brian Armstrong holds the clue to an underappreciated threat to Coinbase.

…many of the companies we think of as cryptocurrency exchanges were actually brokerages, exchanges, custodians, and clearing houses bundled into one….I think we’ll see the cryptocurrency market structure evolve to more closely resemble the traditional financial world, with these functions being separated out…
Brian Armstrong

TL;DR

Brokerages are an inevitable evolution of crypto-finance, abstracting investors from exchanges.
This is the new battleground in crypto and the winner holds the key to serving users with a full suite of financial products.
Coinbase faces a classic innovator’s dilemma. Their exchange business is a cash cow today, but a liability in the battle to own the brokerage layer and winning the next phase in crypto.

The Opportunity

The $100B opportunity over the next decade is to own the brokerage layer in crypto.

Let’s assume Brian is right and crypto-brokerages emerge. The key to appreciating the importance of this trend is that brokerages, not exchanges, own the end user relationship. And owning that relationship is critical.

That relationship is the key to cross-selling banking, savings, borrowing and investing products, crypto or otherwise. Winners in finance offset high CAC by serving all your finance needs. The brokerage has the customer touch points to understand their needs and market other products.

This is why every fintech company follows a land and expand strategy and why Coinbase is expanding from their core exchange business.

The Dilemma

Brokerages own the customer relationship

Coinbase’s strength today, their exchange, may be severely impacted in the battle to own the brokerage layer.

Brokerages execute customer orders at the best price, thus they operate across exchanges tied to no single source of liquidity. A healthy market for crypto-brokerage products would deteriorate Coinbase’s pricing power and volume.

Today all Coinbase retail orders are funneled directly to their exchange. Competing with other high-quality brokerage products would require Coinbase to provide best execution for customers, distributing their order flow across competing exchanges.

This begs the question, will they sacrifice short term revenue for the longer term prize. It’s easy to say yes in theory but hard to do in practice, even for a private company.

Consider that they just raised trading fees! It’s less expensive for them to offer this service over time, but they chose to offset declining volumes by raising fees. Does that sounds like a company ready to sacrifice short term revenue?

Brokerages make the market more efficient in general which reduces cost. So even if Coinbase doesn’t compete directly with other brokerages, they will feel their emergence via reduced margin.

Are you thinking that Coinbase is the 100 lb. gorilla of crypto and will naturally dominate every layer in the stack? Consider though that only ~50M people hold crypto today. A rounding error. The billions of new users will choose their onboarding path via crypto-native brokerages and banks, not directly with exchanges. So Coinbase’s dominance is far from certain.

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Interview with Crypto Gurus

Interview discussing the future of digitized securities and what it means for investors.

Last week I had the chance to have an in depth discussion with the folks at Crypto Gurus about Fetch, Security Tokens and Open Finance. We delve deep into the thesis that Security Tokens and Open Finance need each other to grow and prosper.

You can view the view embedded below or directly on YouTube. Enjoy!

AWS for Finance

Ethereum is poised to become the enabler of a new way of fully digital finance. Just like AWS did for software backends.

Today, financial innovation is slow, costly and reserved for the few. Often it happens manually in spreadsheets and is available only for the largest of investors. Open source blockchains and digital native assets are changing this, just like AWS and open source did for software development.

Ethereum is the AWS of finance, radically transforming the cost to build and release financial products.

It used to be expensive to buy the servers and software licenses required to release software. Companies raised millions and spent much of it on Oracle licenses and server racks. Two things happened. Open source systems (bye-bye Oracle database) replaced many expensive software licenses, and AWS offered a pay-as-you-go system to replace high upfront costs. As a result, the cost to build and release a software product dropped 10x and massive experimentation blossomed.

Everybody benefits from the great software created as a result. Want an app to help meditate? Maybe find the cheapest gas station? No problem, software has you covered.

This same thing is happening in finance today. Open source systems on Ethereum are replacing the expensive and manual systems (DTCC, clearing, trustee) reducing the cost and time to bring financial products to market. We’re on the cusp of an explosion of more efficient and open financial products.

The Layers of Finance

While investors usually only pay attention to the top of the stack, what products they can access, much of the important work happens under the surface. To appreciate why we’re on the cusp of change, it’s important to understand what’s going on under the covers.

In traditional finance, layer upon layer of administrative (and very often manual) work falls to interlocking players who have not modernized significantly in decades. This creates a baseline of inefficiency and cost that restricts innovation.

Ever wonder why the minimum or cost for a financial product is so high? The reason usually lies in fixed costs or restrictions that come from an intermediary lower in the stack. Tokenized Finance upends this by replacing much of those intermediaries and fees with trustless code, it’s digital at the core. That’s critical because it’s the first step into turning finance into an API, making programmable money a possibility.

A Simple Example

Let’s take securities-based lending as an example. It’s a simple financial product, cash loans using securities as collateral, and growing quickly.

In traditional finance, brokerages and banks offer customers competitive rates with minimums ranging from $50,000 to $250,000 to access a cash loan. That’s not bad and gives investors an opportunity to take a non-purpose loan while still retaining their investment positions.

In Tokenized Finance, the financial product itself is code, protocols built on Ethereum A great example is MakerDao’s CDP which allows investors to deposit their collateral and take a cash-like (DAI) loan. It’s simple and the rates are not too different than what is available in traditional finance.

The big difference is the lack of a minimum. Code just works. It works exactly the same if the amount being deposited is worth $1 or $1M. And because there are no fixed marginal costs from intermediaries, the financial product as code can deliver the same value to the smallest and largest of investors.

Now, this may not seem like a big deal right now. Do you really want to take a $1 loan? Probably not. It does however provide a glimpse into what a future of code-driven financial products can offer.

What’s the Future?

Let’s add up what we know about Tokenized Finance.

Transforms the core of finance into API, similar to how AWS turned software infrastructure into an API.
Removes the fixed costs and antiquated rules of the financial intermediaries, removing barriers to bringing financial products to market and the costs inherent to them.

This means that software teams can now build and release financial products quickly. In addition, without fixed costs to every transaction, they can experiment with business models not before possible.

Today, that’s resulted in Tokenized Finance products that mimic traditional products with lower minimums and costs. MakerDAO for securities-based loans, Compound for money market just to name a few.

What’s more interesting is what will happen as the ecosystem grows.

Permissionless innovation with a reduced cost to bring products to market means rapid experimentation is now possible. This will create financial products not possible or conceived of in traditional finance.

The future is bright.

Wyre Podcast

Chat with team at Wyre about what a brokerage will look like in the future.

Thanks to the team at Wyre for having our me on their podcast last week. We had a great time covering a range of topics from the state of wallet software, regulation to the future of Fetch and financial services.

You can listen to the podcast and there is also a transcript of the conversation on the Wyre Blog.