Coinbase CEO: Analyzing Some Regulatory Challenges Facing the Current Crypto Industry

Original Title: "Transcript: Brian Armstrong on the Challenges Facing Crypto"

Source: Bloomberg

Article Compiled by: Kxp, BlockBeats

Joe Weisenthal: Hello everyone, welcome to a new episode of the Odd Lots podcast, I’m Joe Weisenthal.

Tracy Alloway: I’m Tracy Alloway.

Joe: Tracy, a lot has been happening in crypto recently, with two major events standing out: one is the crypto winter. Although the crypto market has warmed up somewhat, prices have not yet returned to previous levels. The second is that regulatory scrutiny has been increasing recently.

Tracy: Indeed, this has undoubtedly created a double whammy for the crypto industry, and it’s hard to determine whether the drop in prices is directly related to the increase in regulatory activity.

Joe: Historically, regulators tend to ramp up their efforts after investors lose money due to scams. So, it’s not surprising to see increased regulatory activity during periods of declining investment.

Tracy: I agree, but it raises the question of whether regulators should be more proactive in preventing investors from losing money.

Joe: We have an expert on this topic joining us today, let’s welcome Brian Armstrong, the CEO and co-founder of Coinbase, one of the leading crypto trading platforms in the U.S. Brian, thank you for joining us for this episode of Odd Lots.

Brian Armstrong: Thank you for having me.

Joe: I want to ask you a question that we’ve asked other executives in the crypto space before, but I’m curious about your perspective. What is liquidity mining, and where does its yield come from?

Brian: The reputation of liquidity mining has been negatively impacted in the current environment due to the collapse of Terra Luna, BlockFi, and similar companies. It’s a concern worth noting, but I’m not qualified to speak on their behalf. However, other aspects of the crypto industry remain promising, and we can continue to explore many areas.

Tracy: We’ve discussed on the show before that crypto is the ultimate momentum asset, with prices fluctuating based on the inflow and outflow of funds, so the business of crypto trading platforms also has cyclical patterns. However, in your recent report, you mentioned wanting to be profitable throughout the cycle. Can you explain how you plan to achieve that?

Brian: In the past, trading fees made up a large portion of our revenue. As you pointed out, this revenue source is not stable due to the volatility of crypto prices. To create a more stable revenue source, we have been transitioning to subscription and service-based models. It turns out that even during bear markets, stablecoins like USDC can provide us with decent growth.

Additionally, we earn fees from custody services and merchant transactions using the Coinbase card. While these revenue sources are not entirely independent of the crypto market, they are less correlated compared to trading fees, which helps us build a more predictable business model.

Joe: I want to discuss regulatory issues. Yesterday, I saw a new initiative from Coinbase called the 435 Plan, urging people to contact their congressional representatives to express support for crypto policies. Similarly, Uber has used a similar approach, asking users of their app to contact local regulators to be able to drive for Uber. I want to phrase this as delicately as possible because I have many friends who are passionate about crypto, and I admire many of them. However, do we really want those who would contact congressional representatives to be the spokespersons for crypto regulation?

Brian: The average person involved in crypto, which includes about 50 million Americans or one in five households, constitutes an important lobbying group that will influence future elections. These people may not have the exact solutions for how to regulate the crypto industry, but they want their elected representatives to ensure that it is regulated while providing consumer protection and fostering innovation. Currently, 80% of Americans believe that the financial system is inefficient, expensive, and not accessible to everyone.

Today, the financial system still uses technology from 40 years ago, and the laws regulating it were even created before the internet emerged. Therefore, the financial system is in urgent need of modernization, and crypto is one of the technologies that can help achieve that. American voters recognize this and want their elected representatives to help establish regulations and laws around crypto.

Tracy: On the political front, Joe and I have hinted at this before, the collapses and scandals have led to increased regulatory activity in the industry. Can you share how your dealings with U.S. authorities have changed from 2020 to now?

Brian: Compared to 2020, I find that there are more officials in Washington now who have a better understanding of crypto. It’s no longer a niche topic; discussions around it have become more in-depth. There are mainly two camps: one is still haunted by the collapse of FTX and is hesitant to approach crypto; the other believes they have the opportunity to bring crypto under regulation and are working to draft legislation and gain bipartisan support. Personally, I support the latter camp.

Joe: So, I want to ask, given that one of the largest exchanges, FTX, collapsed without causing any major repercussions or consequences, why do you advocate for bringing crypto under regulation? It seems that placing crypto in a gray area has effectively avoided the "too big to fail" problem. Additionally, regulators have done well in preventing the tumultuous crypto industry from having any negative impact on the financial system. What’s your take on that?

Brian: I disagree with the notion that FTX's collapse didn't have adverse effects because many people lost money.

Joe: That’s true; many people lost significant amounts of money.

Brian: There are some bad actors in crypto, so the key issue remains consumer protection. I don’t believe there should be bailouts in crypto because nothing in crypto is too big to fail, which goes against the principles of crypto. Bitcoin was created to address the financial crisis of 2008, and the first Bitcoin block contains a message about the Chancellor preparing to bail out banks.

However, I do believe that centralized participants, such as exchanges and custodians, should be regulated to prevent fraud and corruption. But for the decentralized parts of crypto, like Bitcoin and Ethereum, they should not be constrained by any centralized authority, which is necessary for a more global and equitable financial system.

Tracy: In your view, what should consumer protection in crypto look like? Additionally, products like Dogecoin, which have no clear economic utility, are likely to cause losses for people. What are your thoughts on that?

Brian: I believe that centralized participants like custodians and exchanges should be responsible for regulation and consumer protection, and the regulatory focus doesn’t necessarily have to be on Dogecoin; it could be another decentralized coin. But I also believe that companies built around custody or trading need to adopt some best practices from traditional financial services. These include having audited financials, separating customer funds from company funds, implementing anti-money laundering/KYC programs to prevent fraudulent transactions, and providing appropriate disclosures. However, these practices should be aimed at centralized participants, not the decentralized parts.

Joe: Interestingly, you distinguish between centralized participants and decentralized DeFi. However, you seem to have integrated both parts recently by launching a layer-2 rollup to scale Ethereum. As a regulated entity, you are obligated to comply with FINCEN and anti-money laundering laws. Can you clarify whether implementing a rollup layer-2 with a centralized sequencer, where transactions are batched and sent to the Ethereum main chain, creates any tensions? As a regulated entity, how do you address this issue? If someone wants to or attempts to launder money through layer-2, are you facilitating that by batching those transactions onto the Ethereum main chain?

Brian: Earlier, I mentioned that we should regulate centralized participants like Coinbase, especially regarding our main revenue sources like custodians and exchanges. But you’re right; Coinbase is embracing decentralization through our various products and legal entities, including a layer-2 solution called Base.

We built Base because we want to provide more scalability and better usability for layer-2 solutions. We hope to bring Ethereum transaction costs down to a penny or less and help scale it to a billion or more users.

I think what you’re asking is how we differentiate between the centralized and decentralized parts. Today, Base still has some centralized components, but over time, it will become increasingly decentralized. So, we still need to monitor transactions, especially in the early stages. However, as Base becomes more decentralized, I believe centralized actors may need to bear the most responsibility to avoid money laundering issues and establish transaction monitoring programs, etc.

Tracy: Speaking of accountability, there are currently a few thousand coins and tokens on Coinbase, right?

Brian: No, there are about 250.

Tracy: I haven’t gone through every page, but there are indeed many pages. While you’ve never listed securities, given the current regulatory environment, it’s quite possible that one day the SEC will declare a coin to be a security. For example, not long ago, there was an enforcement action against Kim Kardashian for promoting an illegal crypto security. Given the current situation, how can you confidently assert that there are no securities on Coinbase?

Brian: I believe that having a clear set of rules that everyone must follow would benefit our industry. We have petitioned the SEC for this and outlined how current securities laws do not adequately cover this niche of crypto. At the same time, we have established our internal processes for reviewing assets, which include a 72-point legal analysis and considerations of compliance and cybersecurity risks.

We have evaluated about 1,000 assets, rejecting 800 of them due to securities, compliance, or cybersecurity issues, while listing about 200-250 assets. If the SEC determines that an asset is a security, we would be happy to update our processes. However, if the SEC declares all assets to be securities, we will comply with the court's decision because we all must follow the law.

Joe: Can you provide an example, not necessarily related to a specific coin, of token characteristics that you believe make it unsuitable for listing due to its similarity to a security?

Brian: There are many factors to consider, just like the Howey test has many components, so I won’t delve into a deep legal analysis here.

Tracy: We’ve never done a show related to the Howey test, so this episode might cover that.

Brian: Yes. So there are multiple aspects, right? I think, you know, if people are buying it primarily with the expectation of profit and there’s a common enterprise…

Joe: Have you noticed a pattern in crypto projects, particularly in the actions taken by teams, that suggests certain tokens do not meet Coinbase's standards? Have you observed practices in the industry where teams may have crossed the boundaries of what you consider a common enterprise, making it unsafe to list them on the platform?

Brian: I will provide an example of a security, but there are also other examples in cybersecurity and other areas. Securities laws apply when funds are invested in a common enterprise with the expectation of profits from the efforts of others, which applies to seeking funding for a company or project (like an apartment building) legally. This is a necessary aspect of business and should continue to exist.

Our broker-dealer license is currently dormant, but we plan to activate it and are working with the SEC to achieve that. Crypto technology has the potential to provide benefits and improve the financial system, including settlement times, etc.

We take consumer protection seriously and will avoid some bad patterns, like those tokenomics that appear very rough and insiders selling. Additionally, we may reject assets for other reasons, such as cybersecurity risks. For example, we assess potential vulnerabilities in smart contracts and the issuer's ability to safeguard investor funds.

If an issuer loses their keys, it could inadvertently or maliciously sweep away everyone’s funds, which does not meet our security standards.

Tracy: In some ways, is crypto self-destructing by resisting securities regulations? Does this imply that perhaps there are no reasonable profit expectations here?

Brian: I mean, we want the existence of crypto securities. We’re not saying that these things are not securities or that everything is a security; that’s inaccurate. Just the expectation of profit alone does not make something a security; it must pass every part of the Howey test. For example, buying a Picasso painting or gold does not make them securities. We believe that Bitcoin, Ethereum, and the assets we trade on our platform are crypto commodities, which people sometimes trade to increase their value, similar to buying gold; other times, they are used for other purposes.

Joe: Before we discuss regulatory issues, can I ask your opinion on Bitcoin? Although the crypto industry has evolved into new phases in many ways, some people on Twitter still believe you don’t like Bitcoin. Nevertheless, you launched Ethereum’s layer-2, and I’m curious if you will also launch a Coinbase Lightning node in the future?

Brian: We want to do more with the Lightning node.

Joe: But that hasn’t happened yet, and there are still some unresolved issues, such as funding for Bitcoin core developers, who aren’t getting enough funding to sustain themselves, which is frustrating for them. What’s your take on Bitcoin?

Brian: I like Bitcoin, but I really don’t understand why some people think otherwise.

Tracy: We’ve all been battered by Bitcoin maximalists.

Brian: I’m not sure how severe the situation is. While I’ve seen similar statements on Twitter, I’m not sure about their impact. Given that I’ve spent a significant portion of my life working on Bitcoin and its development, it seems unbelievable. In fact, I even quit my job after reading the Bitcoin white paper to start this company.

While the crypto industry has evolved in many ways since then, I remain a staunch supporter of Bitcoin, and I believe it is the gold standard in the crypto economy. I expect that to remain unchanged, and its popularity will continue to grow, especially if Lightning continues to gain traction and if Bitcoin evolves into a settlement layer. I run a trading platform and custodian and strive to be fair, listing and providing every coin that meets our standards and necessary legal requirements. My neutral stance may lead some to believe I oppose certain coins, but that’s not the case.

Tracy: Returning to the SEC, it seems to be emphasizing enforcement work right now. Therefore, the SEC may issue many new announcements tomorrow. In your view, what is the SEC's ultimate goal regarding crypto? Is the SEC aiming to completely eliminate crypto, or is the agency working to help the industry continue to develop in a different way?

Brian: My approach is not to speculate on the SEC's motives, although we have established positive relationships with several staff members and commissioners. While it’s hard to determine, there may be differing opinions within the organization on this matter. If some people within the SEC simply want crypto to disappear, I wouldn’t be surprised.

However, I believe that this is not the view of the majority, as it does not align with the best interests of American citizens or consumer protection. One in five American households uses this technology, and if we don’t establish regulatory measures, consumers will turn to unregulated offshore options. I believe the prevailing attitude is that this technology will continue to exist, and we must bring it into a regulatory framework. Ideally, this would be achieved through the issuance of clear guidelines and an industry-participatory regulatory rule-making process. However, so far, that hasn’t been the case. If necessary, an enforcement-based approach can be taken to resolve some issues through case law. This approach may take more time, but it can be acceptable.

Tracy: What do you think is the reason for the incoherence or ambiguity in the actions of regulators? Is it due to a lack of resources, or simply a lack of understanding of the industry by regulators?

Brian: Maybe you can clarify what you mean by incoherence?

Tracy: I think, first of all, their responses are relatively slow and somewhat unclear.

Joe: You go in and ask them questions, and they don’t give you answers, is that right?

Brian: Frankly, I’ve spent a lot of time in Washington trying to figure things out. Maybe I was a bit naive to think that regulators would simply provide rules for running a business, and we would follow those rules. However, things seem to be more complicated than that. There are different factions within the authority, each with different goals. So, those who successfully pass legislation would call it a miracle because it requires agreement from the House, Senate, and the President, along with some momentum. I believe the collapse of FTX may lead to further clarity in legislation next year.

Joe: Let me ask you another regulatory question, although it’s not related to the SEC. It seems that some banks are canceling banking services for crypto companies, but I don’t think this poses a threat to Coinbase. Do you see this as a regulatory advantage for Coinbase, as smaller trading platforms may find it difficult to secure banking partners in this environment?

Brian: I don’t see it as an advantage; we have no issues with our banking partners. However, after the FTX incident, bank regulators raised serious questions about the liquidity risks associated with crypto deposits, which is understandable. Specifically, they are questioning the feasibility of issuing loans against these deposits and whether the risks of doing so are too great. We believe that the banking industry will not be told that they cannot handle any crypto business. No one has mentioned this to me, and doing so without congressional input would likely exceed their authority. Nevertheless, it is reasonable for regulators to question liquidity issues.

Joe: Have you engaged in any lobbying or other attempts with Washington authorities to ensure that crypto is not treated discriminatorily within the banking system?

Brian: In our conversations with congressional representatives and senators, we have emphasized the need for crypto to be treated fairly and equitably compared to traditional financial services. We are not advocating for preferential treatment but rather for a level playing field that does not excessively penalize the crypto industry, but rather achieves a balance.

Tracy: We’ve discussed this topic before, but I’m eager to hear your thoughts on the events surrounding FTX. The events of that week in November were shocking to many, and reactions varied from person to person. However, I’m curious about how it affected you, considering everything happened so quickly—within a week to ten days from Twitter exchanges to bankruptcy filings.

Brian: That week was quite tumultuous. While I was in Japan meeting with our team and regulatory officials, someone told me that FTX might collapse within the next 48 hours, and Sam might face imprisonment. After that, I reached out to Sam and CZ and began assessing the situation we were facing. We wrote to our trading partners, including FTX and any other parties that might have potential secondary impacts, and verified our compliance methods that we had built over the past decade. While the industry may suffer from negative impacts, given our long-standing commitment to these values, Coinbase can benefit from increased trust and compliance awareness.

Joe: I want to understand the current price situation of crypto during this market downturn. Although there has been a slight recovery, it seems primarily due to the upward movement of the NASDAQ index. It appears that many of these coins are highly correlated with other risk assets. In the past, investors had two reasons to invest in crypto: it was classified as a new uncorrelated asset class, particularly for Bitcoin, which could serve as a hedge against inflation.

Despite recent record-breaking inflation, Bitcoin's value has not significantly increased over the past few years. In fact, it has remained relatively stable. At this point, most cryptos seem closely related to the NASDAQ, QQQ, and similar indices.

Tracy: Now we have a new narrative approach.

Joe: Given the previous claims made by some in the industry that have proven ineffective in persuading investors to invest, what new arguments can be made about this industry? I’m not specifically referring to you, as I don’t know your involvement, but it’s clear that many in the industry have not been successful in trying to present a compelling investment case.

Brian: Certainly. I find it interesting that crypto has become as volatile as the stock market. During my time at Coinbase, people often questioned whether anyone would use it due to its volatility. However, now its volatility has reached levels similar to the stock market, which I see as a small victory and a step in the right direction.

Joe: Well, we don’t use Tesla stock to buy coffee, but anyway.

Brian: Clearly, stablecoins can now be used for commerce, which is a positive aspect. However, let’s talk about your question regarding inflation hedging. Initially, there was a widespread belief that crypto, particularly Bitcoin, would serve as the new gold standard in the crypto economy. This idea was embraced by many, including Bitcoin maximalists, who believed that during uncertain times, people would buy Bitcoin because it has scarcity like real estate.

However, the reality has been different, with crypto experiencing a rapid decline in a high-inflation environment. People believe that the world has changed, and they are ready to consider crypto as an inflation hedge. Unfortunately, this assumption has proven to be premature. Currently, crypto remains a small part of the global economy and is more often viewed as a growth asset rather than a true "gold" asset. Therefore, for crypto to play a substantial role in a broader macro environment, the crypto economy needs to grow tenfold or twentyfold from its current state.

Tracy: Regarding stablecoins, I remember a few years ago when Sam Bankman-Fried was on the show, we inquired about the potential impact of a sudden collapse of Tether. In hindsight, asking about the impact of the FTX collapse might be more relevant. However, can you talk about your views on the role of Tether in the crypto ecosystem?

Brian: I don’t want to criticize anyone in the ecosystem, and I’m not sure about their standing. Tether has had many uses on our platform in the past, and I know they have been investigated by various parties and have reached consensus and satisfaction with various methods. Currently, we are focused on USDC, which we work with Circle on, and it is well-supported, one-to-one backed, and audited. While I lack information about Tether, I have no negative comments or grievances against them.

Joe: I also want to ask you, even without the FTX incident, there have always been questions about the validity of crypto, with many viewing it as purely speculative with no practical applications outside certain niches. While many have made substantial profits from crypto, most of these digital currencies have no other use besides economic gain, and there is currently no decentralized platform similar to Facebook. Given the level of power held by people like Musk and Zuckerberg, the absence of such a platform is concerning. When do you predict we will see a crypto with practical utility rather than being limited to speculative investment?

Brian: I don’t fully agree with the assertion that crypto is entirely speculative. While that may have been a reasonable statement five years ago, there won’t be a clear turning point. Instead, the transition will be gradual. We have been monitoring the activities of active customers on Coinbase to determine the proportion of those engaging in activities beyond crypto trading. As of now, that number has exceeded 50%.

Joe: What are some examples? Is purchasing NFTs considered an activity outside of trading?

Brian: Besides what has already been mentioned, there are many other use cases for crypto. However, I will provide a framework to explain its evolution over time. While people engage in commerce, lending, earning, and staking, crypto has three main use cases. First, it serves as a new form of currency and asset class. While early activity was speculative, we must recognize the significance of having a global, decentralized, and scarce new form of currency.

This is a luxury that most people in the world do not have. Second, crypto also represents a new type of financial service, such as DeFi, which allows for lending, borrowing, payments, staking, and more. Third, it is a new application platform beyond financial services, including decentralized identity with ENS, which allows for the creation of decentralized social networks, public profile pages, badges, and certifications. With this technology, access to buildings, concert tickets, and other items can be managed through proof of attendance. This development opens new business models for industries like music, YouTube, and Spotify.

Tracy: I think the question is why it hasn’t happened yet? You know, it’s been over a decade since the white paper was published. So, if this is a revolutionary technology that is far better than the way we’ve always done things, why hasn’t it been adopted more quickly?

Brian: One reason blockchain technology has developed slowly is the lack of scalability, which needs to be addressed. Additionally, improving the usability of the technology is crucial, as the average person may not understand technical terms like "private keys" and may be reluctant to install extensions. For blockchain to achieve widespread adoption, it must be better popularized among ordinary internet users. Analogous to the development of the internet, while the foundational parts of the internet can be traced back to the 1960s, it wasn’t until the 1980s that early versions of Telnet and similar technologies emerged. Although the internet has achieved widespread adoption today, it also took years of foundational work and technological advancements, such as broadband, to become scalable.

Joe: Of course, crypto technology is similar. I mean, in some cases, people have been working on hash cash and all of that for decades. So, Bitcoin also went through a long process before its birth.

Brian: To be honest, the current regulatory environment is not conducive to progress. In the U.S., there’s a sense of unease that starting a business in this space will result in significant legal bills and subpoenas. This mindset is unhelpful, but we can’t place all the blame on that. The technology must become more scalable and user-friendly; although it is progressing, the time required is longer than expected.

Joe: I want to ask a question related to Coinbase, inspired by our previous guest Jim Chanos, who has been critical of Coinbase. He questioned why Coinbase hasn’t been profitable during some of the most incredible crypto bull markets and pointed out the significant gap between the commissions from institutional traders on Coinbase Pro and those on regular Coinbase. While switching between the two is easy, people may not realize how cheap it is to trade on the professional version. What measures will you take to narrow that gap, and how do you view the claim that retail investors are treated unfairly compared to more professional traders?

Brian: Our profitability declined in 2022; however, in 2021, our company was highly profitable, with $4 billion in EBITDA and a 600% revenue growth. While we experienced a downturn in 2022 due to market conditions, we have implemented cost-cutting measures to ensure profitability in any market environment. Your question seems to relate to fee compression, which has several aspects.

One is that pricing varies based on customers’ choices between professional or simple interfaces and their trading volumes. Our customers are willing to pay for convenience and trust. Our fees are comparable to other companies in the market, although some claim to have zero fees, they may be accepting order flow or other less obvious fees. We also launched Coinbase One, a subscription service that offers customers reduced trading fees and other benefits, especially for our premium users.

Joe: Brian Armstrong, thank you very much for joining us on the Odd Lots podcast. We’ve wanted to have you on for a long time, and I’m glad we finally made it happen.

Brian: I’m also glad to have the opportunity to talk with you today.

Tracy: Yes, I’m glad we were finally able to do this. I want to thank Brian for being willing to answer our questions during the crypto winter.

Joe: The current regulatory situation is quite complex, and many entities in the industry face challenges in complying with various regulations. There are concerns about the SEC's ambiguity regarding securities rules. Additionally, some entities are cautious about launching until they determine they are operating within the bounds of the law. However, this caution has led some entities to remain in pre-launch stages for three years, while others have already made billions. It’s worth noting that several people in the industry share this view.

Tracy: Yes, you can be penalized for participating, while sometimes not asking questions and just launching can lead to better outcomes.

Joe: The industry tends to focus on tokens like the Kim Kardashian token, which may not have significant impacts. However, I do empathize with entrepreneurs in this regard.

Tracy: While I think it’s crucial to discuss the clarity of regulations, it’s also important to explore why regulators don’t go further in clarifying regulations. If regulators start enforcing or establishing new rules, they may inadvertently grant legitimacy to crypto. If regulators want to avoid legitimizing crypto, they should clarify their stance.

Joe: While many have indeed experienced financial losses, there’s a viewpoint that the collapse of FTX did not have widespread macroeconomic impacts, which should be seen as a positive outcome. This is particularly important compared to the significant impacts caused by the collapse of shadow banking in 2008. Therefore, when deciding whether to include FTX in that context, it may be worth considering certain parameters. However, the specific parameters remain unknown.

Tracy: While people lost money, at least the financial system didn’t collapse as a result, which is the best outcome we can hope for today.

Joe: That’s not terrifying.

Tracy: Okay, let’s pause here for now.