Cryptocurrency exchange Coinbase Global (COIN 3.91%) benefits from high prices of crypto assets and benefits from high trading volume. But according to CoinMarketCap, the total market capitalization of the crypto market has plunged from about $3 trillion last year to just over $1 trillion right now. And according to Coinbase's own financial results for the third quarter of 2022, trading volume is down 51% year over year.

With crypto values and trading volume down massively, one would expect Coinbase to be struggling. And while this business is facing headwinds, one lucrative revenue stream just jumped over 1,100% year over year and accounted for nearly 18% of Coinbase's third-quarter revenue. And most importantly, it's surprisingly sustainable growth.

A diversified revenue stream?

One of the strongest bear cases against Coinbase stock is its reliance on trading volume from retail traders. A whopping 88% of the company's nearly $7.4 billion in revenue in 2021 came from charging fees on transactions from retail traders. If trades become cheaper over time -- as they did with stocks -- then Coinbase's business would crumble, highlighting the necessity to diversify its income.

Well, Coinbase has a quick-growing alternative to transaction fees, and it's not what you think. The company generated a whopping $101.8 million in Q3 alone from interest income. That's a massive increase from its interest income of just $8.4 million in the same quarter last year. And it's an enormous 213% jump quarter over quarter.

There's a simple explanation for the rapid rise of Coinbase's interest income: interest rates. The Federal Reserve has been raising interest rates in 2022 at a breakneck pace, and the yield now sits at its highest in over a decade.

Effective Federal Funds Rate Chart.

Effective Federal Funds Rate data by YCharts.

Coinbase ended Q3 with over $5 billion in cash and cash equivalents, and it's now earning more from these reserves. However, just a small fraction of its $101.8 million in interest income came from its own cash.

According to its quarterly filing with the Securities and Exchange Commission (SEC), Coinbase generated Q3 interest income of about $14 million from its corporate cash balance. That was up sharply from the $430,000 it generated in the same quarter of last year. But where did the rest of its interest income come from?

The answer lies with stablecoin USD Coin (USDC -0.00%), or USDC as it's commonly called, which Coinbase co-created with Circle. 

Coinbase's relationship with Circle

Circle -- or, more properly, Circle Internet Financial Limited -- is preparing to go public via a special purpose acquisition (SPAC) company called Concord Acquisition Corp (CND). Most SPAC stocks have been terrible investments. But because it's preparing to go public, we have visibility into how Circle works and its relationship with Coinbase.

Coinbase and Circle jointly own the Centre Consortium -- the technical overseer of USDC -- in a 50-50 relationship. According to CoinMarketCap, USDC is currently the fifth-largest cryptocurrency and the second-largest stablecoin with a $42.7 billion market cap. And every USDC coin issued is backed by a real U.S. dollar in the bank. Those reserve dollars are now making far more money today than they were last year because of higher interest rates.

It's still working out the numbers as part of the going-public process. But Circle estimates it generated just $28 million in interest income in 2021 from USDC. That number is expected to skyrocket to about $438 million in 2022. We don't know exactly what Coinbase's cut is -- some analysts estimate it's around 35%. But we do know that Circle is estimating $163 million in transaction costs and revenue sharing in 2022 directly related to USDC. And Coinbase is the company it would be sharing that revenue with because it's the only other owner.

Here's another encouraging data point for Coinbase shareholders: This jump in interest income appears to be sustainable. Circle is expecting a roughly 400% jump in USDC interest income in 2023 compared to 2022, both from higher interest rates and assumed growth in the number of issued USDC coins. If that happens, investors can hope for comparable growth in Coinbase's own interest income.

Considering it already accounted for almost 18% of Coinbase's Q3 revenue, it's possible that revenue from interest income could approach the size of its revenue from transaction fees. Therefore, those who were hoping that Coinbase could meaningfully diversify away from these fees could have their wish come true within the next 12 to 18 months.

However, as a closing warning, this outlook does assume the continued growth of USD Coin. But its market cap has dropped roughly 20% over just the past three months. Therefore, Coinbase investors need to be watching the adoption of USD Coin and be familiar with the risks of stablecoins in general.