Why is Coinbase causing concentration risk as an ETF custodian?

• Coinbase provides custody, trading, and financing for ETF issuers;

• Arrangements pose concentration risks and may be subject to enhanced scrutiny.

The debut of a U.S. spot bitcoin ETF has thrust Coinbase Global Inc. into the center of cryptocurrency’s biggest mainstream moment to date. However, the seemingly enviable industry position also carries with it huge risks for the company and its partners.

The first exchange-traded funds that invest directly in bitcoin began trading last week after the U.S. Securities and Exchange Commission gave final approval to applications from nearly a dozen investment firms, including heavyweights such as BlackRock Inc. and Franklin Templeton. The products, which follow years of industry push, were hailed as a key development that will drive wider adoption of the world’s largest cryptocurrency.

Most of these ETF issuers will rely on Coinbase to run their funds in some way, and the digital asset exchange will provide custody, trading and lending services to BlackRock and other firms.

Coinbase’s Dominance

Most Bitcoin ETF Issuers Choose Coinbase as Crypto Custodian

Source: Bloomberg News, Bloomberg LP, U.S. Securities and Exchange Commission

Yet while Coinbase stands to benefit from bitcoin’s push into traditional markets, the arrangements highlight what some see as a potentially dangerous concentration of risk. Meanwhile, the emergence of a slew of funds offering discounted fees on bitcoin investment vehicles poses a separate threat to revenue from Coinbase’s core trading platform.

“By design, our financial market infrastructure is segmented into different roles,” said David Schwed, chief operating officer of blockchain security firm Halborn. “When you have one entity responsible for the entire trade lifecycle, I think that raises concerns.”

Coinbase’s multiple roles are a major concern for the SEC itself, which became embroiled in a legal battle with the company after accusing it in June of operating an unregistered exchange, broker-dealer and clearinghouse that was believed to be trading securities. Coinbase has disputed the charges, claiming the SEC overstepped its bounds.

SEC Chairman Gary Gensler made it clear that the agency does not endorse any of the arrangements with these funds, nor does it "approve or endorse cryptocurrency trading platforms or intermediaries, which are largely noncompliant."

Coinbase is already the world’s largest cryptocurrency custodian and the most popular choice of custody provider for bitcoin ETFs. But according to its risk disclosure, the issuer also noted that the company may have to limit or cut back on some of the services it provides.

“With so many companies using Coinbase as a crypto custodian, there is certainly concentration risk,” said Dave Abner, principal at ETF advisory firm Dabner Capital Partners. “It seems like an unnecessary risk for investors, and I’m surprised issuers wouldn’t require a multi-custodian setup just to protect against unforeseen issues.”

Coinbase Chief Financial Officer Alesia Haas said the company “works hard to avoid conflicts of interest” and that the market structure for traditional securities may not be suitable for cryptocurrencies. A spokesperson added that Coinbase’s custody business “is not at issue in our case with the SEC.”

Coinbase is currently BlackRock’s sole trading agent, and BlackRock will buy and sell bitcoin for its ETF through Coinbase Prime. Its lending business, while a small part of the organization, is another key cog in the Bitcoin ETF machine. Issuers such as BlackRock can borrow bitcoin or cash from Coinbase for short-term transactions.

But Coinbase’s ability to raise funds (from the company’s own balance sheet) could create a bottleneck for such a deal. To be sure, even if it can’t raise funds, BlackRock at least has multiple ways to manage the deal.

Coinbase offers bundled services in custody, trading and financing to provide a seamless process, said Brett Tejpaul, head of institutional at Coinbase. He added that customers who use different providers could end up with more risk.

While Coinbase’s stock price has risen nearly 400% last year as Bitcoin soared, the new ETF may only add 5% to 10% to the company’s revenue, according to a recent Mizuho report. Analysts estimate that the ETF may only add $25 million to $30 million in custody fees and up to $210 million in incremental Bitcoin trading revenue on the platform. This is just a drop in the bucket compared to Coinbase’s total revenue of $2.15 billion for the nine months ended September 30.

Some existing customers may start buying bitcoin through ETFs rather than on Coinbase, which charges higher transaction fees. Even if they don’t, low ETF asset management fees could drive fee compression across the space, including on Coinbase, said Dan Dolev, senior fintech analyst at Mizuho.

Coinbase’s Haas said she doesn’t expect to face immediate trading fee pressure once a bitcoin ETF arrives, though the company could face fee compression in the long run. “We believe a spot ETF will be complementary to the cryptocurrency market and Coinbase,” said Greg Tusar, Coinbase’s head of institutional products.

Custody fees are much lower than trading fees, and they are likely to fall further as competition in that business grows.There are other options beyond Coinbase: Fidelity Investments is using its digital asset unit to secure the bitcoin for its ETFs. Gemini, the cryptocurrency exchange co-founded by Cameron and Tyler Winklevoss, is also looking to play a role and has secured VanEck Bitcoin Trust as a client.

For some, the fact that Coinbase, as a public company, is subject to more scrutiny than many other companies is arguably an advantage — and one that could attract more business in the long run. Matt Hougan, chief investment officer at Bitwise, said his firm chose Coinbase for custody because it is the “largest and most established.”

“They want customers to feel as comfortable and confident trading on Coinbase as they do on Nasdaq,” said Campbell Harvey, a finance professor at Duke University.

For now, Coinbase is enjoying a triumphant moment. With the bitcoin ETF set to debut Thursday, the mood at the company’s sleek New York offices in Hudson Yards on Manhattan’s west side was electric. “None of us slept,” said Emilie Choi, Coinbase’s chief operating officer. “We’re so excited.”

Over time, ETFs may diversify and use multiple custodians as they look to reduce their reliance on a single firm — even if they’re not ordered to do so. Haas is prepared for that possibility. While Coinbase has been a trusted choice for what she called a multitude of other exchange-traded products and regulated funds, she acknowledged that issuers may opt for secondary custodians for “redundancy and diversification” as assets grow. She noted that ETF issuers in traditional financial markets typically have multiple custodians, though she expects Coinbase to keep a large portion of its assets.