Base: Assessing Coinbase’s New L2 Network

In my last article covering Coinbase (NASDAQ:COIN), I focused mainly on what I felt the recent ruling in the Ripple (XRP-USD) case meant for Coinbase’s ongoing lawsuit with the Securities and Exchange Commission. In this article, we’ll look at the latest product offering from Coinbase and estimate to what degree it could generate incremental revenue for the company.

Declining CEX Volume

In a summer that has been eventful for the crypto industry from both news and regulatory climate standpoints, transaction volume on centralized exchanges like Coinbase has been less than impressive. Between May and July, the total transaction volume for the major centralized exchange (or CEX) businesses averaged a little under $450 billion.

By comparison, the monthly average over the same timeframe in 2022 was over $1 trillion. Some of this decline in monthly CEX volume is explainable by more trading volume share going to decentralized exchanges, or DEXes:

In May 2022, DEX share of spot trade volume was 14.6%. That number grew to 22% in May 2023. But the larger reason for plummeting CEX volume is because of less aggregate trading rather than share loss to DEX applications. Despite these declines in CEX transactions, Coinbase has been able to navigate the drying well that has been monthly trading volume by increasing revenue from other segments. In Q2-23, subscription and service revenue made up more than half of Coinbase’s total revenue; up from just 18% a year ago.

Despite the fact that the company has lost money for 6 consecutive quarters, Coinbase was able to keep negative net income under 9 figures for the second straight quarter in Q2-23. I view that as fairly positive given the lack of growth in the company’s traditional line of business. Coinbase is clearly adapting revenue models and with the recent launch of “Base,” COIN shareholders have another revenue stream to consider for future earnings assessments.

What is Base?

Base is yet another Ethereum (ETH-USD) scaling network. However, this one has been developed and launched exclusively by Coinbase. The network is based on Optimism’s (OP-USD) OP stack and there is a mutually beneficial relationship between the two teams given the interoperability. Like Optimism, Base utilizes optimistic rollups to batch transactions on a secondary blockchain layer built on top of Ethereum. The reason these secondary, or L2, chains exist is due to the scaling challenges on Ethereum’s main network.

When the network gets congested, Ethereum’s fees spike and transactions become prohibitively expensive for lower value usage. We saw this happen back in May when the average transaction fee on Ethereum spiked to over $20 per transaction. What the L2 networks do is allow for ecosystem users with smaller value transactions to essentially share the cost of the main layer fee by grouping their transactions together.

This ultimately results in fees for both the main network and the scaling network. But the fee at the individual user level is far less than it would be if they were transacting on the main layer solo. In the graphic above, the figures are shown as an example. So far in practice, the share of transaction fees for Base has been much higher than 20% and we’ll explore those metrics shortly.

L2 Market & Early Base Data

Some of the more popular Ethereum scaling chains include Arbitrum (ARB-USD), Optimism, Polygon (MATIC-USD), StarkNet and zkSync. There is quite a bit of competition in this area but even after launching just a few weeks ago, Base is already competitive with some of the top ETH scaling chains in terms of Daily Active Users:

Base is already averaging about 83k DAUs for the month of August having just launched a short time ago. This already makes Base a top 5 scaling chain by active users:

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Source: Token Terminal, *as of 8/20/23

What often happens when a new chain or application begins is airdrop hunting. This can create large unsustainable surges in usage when a chain launches – that activity level often dissipates after a new governance token is airdropped to early users. From where I sit, this is less of a risk for Base due to the fact that Coinbase is already a publicly traded company and doesn’t necessarily need to create a new asset for platform governance.

From a pure activity standpoint, the early indications from Base are very positive. Since launch, Base has generated roughly 12 million cumulative transactions and has been averaging about a half million transactions each day for most of August.

Looking at DeFi numbers, Base is already the 5th largest L2 on Ethereum with nearly $240 million in total value locked. There are currently over 70 protocols on the network and top protocol dominance for BaseSwap is 29.9%. In my view, these are healthy numbers.

Revenue For Coinbase

The market getting another option for scaling Ethereum is wonderful. But for the benefit of COIN investors, it’s difficult to argue this effort matters all that much if it doesn’t result in incremental revenue for shareholders. Fortunately, since the entire point of an ETH scaling network is for assets to live on-chain, we can follow activity in real time to assess how much Coinbase might be earning from Base usage.

Cumulatively, Base has generated about $3.5 million in fees in the short time since launch. If we annualize that figure, Base is on pace for a little under $42 million in revenue from L2 activity. This would not make Base one of Coinbase’s larger sources of revenue, but the annualized figure is also assuming activity and margin levels stay flat. Which in my view is unlikely.

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Source: Token Terminal, *as of 8/20/23

It’s admittedly very early but Coinbase’s margin on those fees has been terrific so far. Combining data from both July and August, Coinbase has collected nearly $3.5 million in Base fees with a little over $1.1 million in on-chain expenses. This makes Base not only more profitable than the other leading ETH scaling chains, but it’s currently one of the most profitable chains in all of crypto after Ethereum and Tron (TRX-USD). While this is clearly not enough revenue to get the company to profitability at current network activity levels, it is a good start for a network that is only a few weeks old.

Risks

The obvious risk is that network activity on Base potentially cannibalizes the company’s CEX trading volume. Longer term, I think that may be a valid concern. However, I’m less convinced of that in the shorter to medium term given Ethereum accounts for 21% of Coinbase’s transaction revenue. For me, the bigger risk to Base as a revenue-generating product are the company’s long term plans to decentralize the network and the commitment to OP Collective Public Goods.

While Base has started by being incubated inside of Coinbase, the team is deeply committed to progressing towards full decentralization over the years ahead.

As a network, Base has a single, private sequencer in Coinbase. This means Coinbase doesn’t have to split Base network fees with any other entity though it is choosing to do so anyway. The company’s Head of Protocols Jesse Pollak has indicated through various media appearances that a portion of Coinbase’s sequencer fees will go to the OP Collective to fund further development of ecosystem initiatives. Ultimately, the timeline on when Base will be more decentralized isn’t all that clear from where I sit. But if/when that decentralization truly begins, there will have to be an incentive structure for the additional sequencers and that means Coinbase will almost certainly be splitting fees.

Summary

I think Base is a very interesting move for Coinbase. The trend in trading volumes over the last three years has shown increasing share for DEXes. This is not a good thing for centralized exchanges and it makes sense that Coinbase would want more of an on-chain presence because of this. COIN now offers the market an on-ramp, a wallet application, and an OP network.

There’s a potentially strong synergy for Coinbase users who may buy ETH and other tokens through Coinbase and send the coins to the Base network for on-chain activities. In this way, COIN gets paid twice by the same user – first on the original purchase and then on the network fee to send the ETH to Base. And that’s before any on-chain swap fees that may happen later by that same user.

But it’s still way too early to tell if Base will remain a top 5 ETH scaler or if the company’s eventual end of its “Onchain Summer” campaign will result in diminished interest in Base. Given the amount of TVL in Base’s DeFi protocols, I don’t expect activity to simply disappear in September. But I’d wait for a clear monetization plan from the company before buying COIN due to any perceived early success with Base.