Coinbase Wants to Pay Interest on Crypto Coins, Sort Of

This June, as the news bristled with headlines about Facebook’s cryptocurrency-to-be and the price of bitcoin once again soared, the mood in the San Francisco offices of Coinbase was subdued. In 2017, the cryptocurrency exchange was close to the frenetic epicenter of the bitcoin boom. Millions of people used its app to dip their toes into cryptocurrency speculation. Then came the crash. By now, according to Coinbase COO Emilie Choi, the company has weathered a few similar cycles and drawn an important lesson from the highs and lows: Booms don’t last. “It’s a roller-coaster ride here,” she says. “There’s no two ways about it.”

Sure enough, bitcoin plummeted that same afternoon, as cryptocurrency prices are wont to do.

Coinbase has remained one of the biggest exchanges for buying and selling crypto—making it an $8 billion business, at last valuation. Despite increased wariness of overvalued unicorns after recent high-profile flameouts, CEO Brian Armstrong said last month that Coinbase has actually turned a profit three years running. But Coinbase’s fortunes, built around the fees users pay for trading, remain closely tied to rollicking price of bitcoin, and to a lesser extent the nearly two dozen other tokens it supports. Profitable, yes, but precarious.

So today Coinbase will begin offering a service, known as “staking,” that it hopes will convince users to stick around even when prices aren’t spiking. Under the new system, if you hold particular cryptocurrencies in your Coinbase account, you’ll receive set returns independent of market fluctuations. Coinbase is starting with a coin called Tezos. The returns—roughly 5 percent to start—come in the form of tokens that Coinbase receives for participating in the network that keeps the Tezos blockchain secure. Similar to how new bitcoin are distributed based on how much computing power is contributed to network, Tezos doles out new coins based on how many coins each participant has “staked.”

Basically, it’s interest. Just don’t call it that. Coinbase prefers the ersatz term “staking rewards.” That distinction is rooted in regulatory questions.

While staking has become a common choice for newer coins, it’s unclear where the process falls under investing rules. Because of those concerns, staking was made available to wealthy investors in March, but held back from ordinary Coinbase users until now. The company says it now feels confident that it has worked out an arrangement that falls within the SEC’s good graces. Coinbase is the first major exchange to open up staking to all US customers.

Rhetorical contortions aside, Coinbase bills staking as a step in the direction of looking more like a bank, with the diverse revenue sources they enjoy. That includes generating fees from serving as a custodian of assets and facilitating lending and consumer payments. “We’re just doing it in our own crypto way,” Choi says.

Beyond the risks of depending on bitcoin prices for revenue, the company faces growing competition. “They’re fighting a two-front battle,” says John Sedunov, a professor of finance at Villanova University. Coinbase has been seen as uniquely approachable in an industry known for shady actors. But others now compete for that mantle. Rival exchanges like Binance have grown in the US, and there are now a raft of startups that specialize in safe offline storage for your crypto coins. New offerings from the legacy world of finance, like Bakkt, which shares a common owner with the New York Stock Exchange, and Fidelity Digital Assets, are also entering the fray with existing financial relationships and trusted brands. “If I’m thinking about who I trust, do I trust JP Morgan to be the custodian of my cryptocurrency or a website that’s been operating for a few years?” Sedunov asks.

It’s no surprise, he says, to see big exchanges getting into edgier aspects of crypto that legacy businesses won’t yet touch. It’s a familiar playbook. During the so-called “crypto winter,” the long period of low prices after the 2017 bitcoin boom, a common way for exchanges to bolster bottom lines was to add more esoteric coins for trading. Tezos, listed on the exchange this August, is one of Coinbase’s newest additions.

Even in the context of the volatile cryptocurrency world, Tezos had a rough start. After raising $232 million by selling a token without a network in place, the project descended into chaos over a management dispute. The ship eventually righted itself, but regulatory questions have dogged it and other projects.

The SEC has made clear that people should assume tokens used to raise money are securities, says Joshua Klayman, an attorney who specializes in blockchain and digital assets at Linklaters. Some coins have gotten a pass based on a variety of reasons, but “there is no bright line,” she adds. “It really is a case-by-case basis.”

Last week, in an interview at San Francisco Blockchain Week, Hester Peirce, an SEC commissioner known for her cryptocurrency enthusiasm, noted her colleagues should be looking at the “structure of the product” instead of the underlying assets. Coinbase says it’s confident the Tezos token is in the SEC’s good graces. (The SEC did not respond to a request for comment.)

Staking adds a few other wrinkles. Bitcoin doesn’t use staking to keep its network secure; it has a system called proof-of-work, in which a network of computers, known as miners, race to solve cryptographic problems. In exchange for their services, the miners are rewarded with bitcoin and can also vote on proposed changes to the protocol. Staking puts both the incentives and the voting rights in the hands of token holders, not miners. To some, that has all the hallmarks of an investment relationship. “Initially [the SEC] said it would have serious concerns about this,” says Brian Brooks, Coinbase’s chief legal officer.

Brooks says the SEC became comfortable with the arrangement because of the unique structure of the Tezos staking process. Rather than having customers stake the tokens, Coinbase stakes coins itself using funds from its custody business. It then distributes the profits as “rewards” to customers based on how much Tezos they hold in the company’s accounts. Coinbase says the arrangement insulates customers from the potential risks of staking. Staked coins are harder to trade quickly during price swings, and more vulnerable to hacks than coins stored offline.

Still, nothing in the arrangement protects investors from the frequent whiplash of cryptocurrency prices. If Tezos were to crash, the customer’s funds would go with it. Max Branzburg, head of product for Coinbase’s consumer product, compares the idea to picking stocks, with all the attendant dangers. Of course, public companies are required to make extensive disclosures about their risks and financial health; Branzburg notes Coinbase has invested in making information available about specific coins. “The principle here was to make it as simple and easy for customers as possible,” he says.

That pitch is likely to irk independent-minded crypto enthusiasts, who already see companies like Coinbase as unnecessary middlemen who stand between users and their coins. A more practical tradeoff to convenience are fees. Tezos offers nearly 8 percent rewards to those who stake their coins directly. Coinbase plans to take a hefty percentage off the top, leaving users with a roughly 5 percent annual return that pays out every three days.

Coinbase says it will consider staking for other tokens, especially as other networks, including Ethereum, adopt similar security models. The company also has other ventures outside of trading, including an expanding crypto custody business for larger institutions to park their coins. It has also invested in efforts like Coinbase Commerce, which enables partner merchants to accept cryptocurrency. (The company also joined the Libra Association, the struggling Facebook-led group that hopes to enable global crypto payments.) Armstrong has also speculated on the possibility of offering crypto-based loans.

The fate of those products is unclear, given the hurdles of regulation and user adoption. Crypto loans have been called a bubble, and payments have gained little traction so far. Coinbase has stumbled in its attempts to get other ventures off the ground. Last spring, the company closed its Chicago office, the central hub of an effort to get into high-frequency crypto trading.

In the meantime, Choi says the company is focused on making sure the core product works and remains secure. During the big run-up in 2017, the onslaught of users forced portions of the trading system offline. This summer’s spike was a calmer affair; staffers seemed visibly relieved that no major gaskets had been blown—a reflection, Choi pointed to at the time, of the company’s investments when cryptocurrency prices were low. “It feels like the lessons have been learned.”