Nobody is talking about the drop in market capitalization for USD Coin (USDC 0.01%), and that's a problem.
Okay, that's hyperbole. Management for Coinbase Global (COIN 5.68%) did discuss USD Coin in its letter to shareholders in the second quarter of 2023. So it has come up. But with the company's lawsuit from the Securities and Exchange Commission (SEC), the recent billion-dollar liquidation of Bitcoin, and the scandalous cloud hanging over the industry because of FTX, it's easy to forget about USD Coin and the risk it poses to Coinbase.
To understand why USD Coin is a risk to Coinbase, allow me first to explain what it is and how it works.
What is USD Coin?
USD Coin is a cryptocurrency stablecoin -- the price per coin is supposed to always be stable at $1. To use USD Coin, a person could deposit money into Coinbase and exchange dollars for stablecoins. The dollars then sit in a bank account backing the stablecoin. When a person wants dollars again, they simply exchange the other way.
I'm using the term "bank account" loosely. Like any business, Stablecoin companies hold assets in various short-term investment vehicles.
Stablecoin companies have a sweet gig right now. The reserves backing the coins passively generate interest income. And that's improved substantially because interest rates have gone up at an unprecedented rate.
Effective Federal Funds Rate data by YCharts.
Tether (CRYPTO: USDT) is the largest stablecoin, with a market capitalization of nearly $83 billion, according to CoinMarketCap. USD Coin is the second-largest, with a market cap of $26 billion as of this writing.
Market caps for stablecoins represent the number of coins in circulation. However, since those coins should be backed one-for-one with real dollars, the market caps also represent the size of the bank accounts generating interest income.
The thing is, stablecoin market caps increase and decrease as investors deposit money or cash out. Therefore, this isn't a static number. And right now, it's plunging for USD Coin.
The risk for Coinbase
In 2021, the year it went public, 93% of Coinbase's revenue came from transaction fees for trading cryptocurrencies. However, from the second quarter of 2021 through the second quarter of 2023, overall trading volumes on the platform have plunged 80%, from $462 billion to just $92 billion. In short, the company's most significant revenue source has dried up.
Coinbase's management has long acknowledged the unpredictability of transaction-based revenue. For this reason, it's said that its focus is on growing revenue from subscriptions and services. And it has.
In Q2 2021, Coinbase's revenue from subscriptions and services was a paltry $13.1 million. But in Q2 2023, it came in at a whopping $335.4 million. In fact, revenue from subscriptions and services is now larger than transaction-based revenue.
But there's a big catch. Coinbase generated $151 million in interest income from USD Coin because the company co-created it -- that's 21% of total revenue. Without this boost, Coinbase's financial results would look quite different.
USD Coin's market cap was about $43 billion at the start of Q2. By the end, it was down to $27 billion, and it continues to fall. By contrast, Tether's market cap is increasing, suggesting users are utilizing one in favor of the other.
Until now, Coinbase's stellar interest income has dulled the pain from the drop in transaction revenue. Interest income is also a high-margin revenue stream. Investors didn't see the full impact of the decline of USD Coin's market cap in Q2 because it started the quarter much higher. But if current trends continue, the negative impact of USD Coin's drop could start showing up in Coinbase's financial results quite soon.
What's next for Coinbase?
Fortunately for investors, Coinbase isn't sitting on its thumbs. The company just gained regulatory approval to facilitate transactions on cryptocurrency futures, which is potentially a larger market opportunity than trading cryptocurrencies.
Moreover, a halving event for Bitcoin should happen in the first half of next year. These halving events have historically triggered a cryptocurrency bull market, so maybe trading is poised to take off again sooner than later.
That said, Coinbase's biggest savior during this so-called crypto winter has been interest income from USD Coin. The company does have potential, but new revenue streams will take time, and transaction-based revenue has yet to regain steam. For this reason, investors will want to keep monitoring USD Coin's market cap because it could substantially alter Coinbase's financial results over at least the next couple of quarters.
