After media reports that the deal was underway, Coinbase announced yesterday that it purchased the custody business of rival exchange Xapo. Fortune reports that the deal cost $55 million.
Why did Coinbase spend a chunk of capital to pick up the asset? We’ll need to understand what custody means in the universe of cryptocurrency, how lucrative it is or isn’t, and how Coinbase makes money otherwise. Let’s do it.
As the name implies, custody in the cryptocurrency world means taking control of and securing the crypto-assets of others. There are various ways to do this, with Xapo itself making waves for holding customer assets under a mountain.
In the cryptocurrency industry, hacks, thefts, and other security issues are rife. If you control a large chunk of a cryptocurrency, or indeed several different assets, you’re probably willing to pay to ensure its safety. And so, custody, a system by which major players in the crypto-space will hold onto your assets for you, exists.
For a fee, naturally. According to Coinbase Custody — the name of Coinbase’s custody product — charges 50 basis points, or 0.5 percent, per year on held assets, after an “implementation” fee of between nothing and $10,000. Given that the setup fee is by nature non-recurring, we care more about the yearly income generated by storing crypto-assets.
After the Xapo deal, how much cryptocurrency will Coinbase hold in custody for customers? According to Coinbase itself, about $7 billion. That amount of cryptocurrency, at 50 basis points per year, works out to $35 million per year in fees. A nice chunk of change, and a solid revenue item for Coinbase.
A good question at this juncture is why does Coinbase care about driving custody incomes when it has a big trading business? Well, seasonality of a sort.
Coinbase had a cracking 2017. According to Bloomberg, Coinbase’s revenue exploded from $16 million in 2016 to $923 million in 2017, generating a profit of $380 million in the year. That sort of explosive growth saw the firm raise $300 million at a $8 billion valuation in 2018. Tiger Global led the round, with Polychain, Y Combinator, and a16z taking part, among others.
But, Coinbase’s revenue can fluctuate. Reuters, looking at the company’s reported non-domestic revenue, used the figure to estimate that Coinbase collected revenue of $520 million in 2018. A huge number, surely, and an impressive result given its 2016 revenue tally of just $16 million, but no company wants to see their top line shrink on a year-over-year basis.
Coinbase generates revenue from trading fees. When the price of bitcoin slumps, so too does trading volume. That impacts trading revenues for Coinbase and other exchanges.
Enter the custody business, with its regular income based on time. Provided that Coinbase can continue to attract new customers to that portion of its business, the firm may be able to take some variance out of its top line. Investors love predictability, after all. And if the value of the various cryptocurrencies rises the asset base tucked away inside of Coinbase Custody could appreciate in value, boosting revenues from the business.
In short, Coinbase has shown rapid growth and the ability to make money during its life. Today’s Xapo deal should allow the firm to accelerate part of its business that will add revenue, and perhaps some predictability to its growth.
Of course the reverse is also true, if the value of all cryptos fell, it could slow revenue from the custody product. However, as the company’s custody service accepts “90+ percent of crypto by market capitalization” I am presuming that there is some strength to be found in asset diversity.↩