Key Points

• In June 2023, the SEC published a complaint against Coinbase, a centralized cryptocurrency exchange that controls 76% of the market, alleging it violated both the Exchange Act as well as the Securities Act.
• In this piece, Fideres argues that, separately from any alleged violation of US securities laws, Coinbase exploited its unlawful gains to foreclose competitors in the crypto exchange market. We argue that this conduct may amount to an infringement of competition laws.
• As a result, Coinbase has been able to charge significantly higher fees to consumers who traded in cryptocurrencies than it would have absent the allegedly illegal conduct to “build a moat around its castle”.
• Coinbase’s fees may have been inflated as much as 73% as a result of this conduct.

Introduction

In the 1995 Berkshire Hathaway (BH) annual meeting of shareholders, Warren Buffett explained his approach to investment using the “moat and the castle” metaphor:

“The most important thing […] we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, […] protecting a terrific economic castle with an honest lord in charge of the castle.”

He claimed that all prosperous castles are subject to attacks from rival firms, and that understanding what keeps the castle standing is central to the work of holding companies like BH. While Buffett defines the “honest lord” as “low agency costs”, another interpretation for honesty is compliance with the law.

Achieving high barriers to entry can be a strategic goal for businesses seeking to establish a competitive advantage. One effective avenue to achieve that is to invest in innovation. A firm can come up with a brand-new product and take first-mover advantage in the market, or benefit from monopoly profits given by a new patent. Alternatively, big financial investment in research and development (R&D) can lead to higher efficiency and/or quality, creating a larger and deeper moat.

This is the system that competition aims to promote, leading to innovation and lower prices to consumers. In a competitive market, both new entrants and incumbents have an incentive to improve. New entrants have an incentive to come up with a competing product and gain market share. Dominant players, on the other hand, need to protect their market and keep up with consumers demands.

The SEC’s Investigation Into Coinbase

In June 2023, the SEC filed a complaint against Coinbase for violating the Exchange Act 1934,¹ alleging that Coinbase acted as an exchange, broker, and clearing agency without registering as any of those functions.² Moreover, Coinbase violated the Securities Act of 1933³ by making available for trade at least 12 assets sold as securities without registering its offers and sales.⁴ These included tokens such as SOL, ADA, and DASH.

When performing the roles of exchanges, brokers, and clearing agencies, entities must satisfy specific requirements under the Exchange Act. The SEC found that Coinbase violated one of these requirements, by not segregating customers’ crypto deposits from other customer’s as well as the firm’s assets. The conduct may therefore have enabled trades that – if regulated properly –would not have been possible. Securities exchanges are also required to go through clearing agencies as intermediaries. Coinbase is alleged to have bypassed this rule and acted as both the exchange and the clearing agency for all trade occurring on the platform.⁵

By allowing users to earn financial returns – amounting to up to approximately 10% – Coinbase lured users into transferring their crypto assets to its exchange. As such, the SEC alleged that Coinbase’s Staking program consisted of a de-facto investment program for the five stackable cryptocurrencies offered by the platform, thus categorising them as securities.⁶ However, Coinbase did not register under the provisions of the Securities Act, and the SEC found that it profited from the program while offering unique features not available to those investors that were staking independently.⁷

The Conduct

While foreclosure through unlawful asset dealing is not the most traditional antitrust theory of harm, conduct that is illegal under other laws can have anticompetitive effects. Burning down your rival’s facilities is the most basic anticompetitive strategy to raise rivals’ costs.⁸ Similarly, Coinbase’s violations of US securities’ laws can also be analysed for its anticompetitive effects.

Coinbase is reported to have a market share of between 62% and 76% of centralized cryptocurrency exchanges in the US, indicating that it now has a monopoly in the market.

Source:  US Crypto Exchanges’ Market Share | CoinGecko

Foreclosure via the Illegal Acquisition of Network Effects

Competition between platforms like Coinbase is driven primarily by users’ expected benefit from adopting the platform, which in turns depends on direct and indirect network effects, the size of the installed user base, and expectations about future adoption rates.⁹ In the case of cryptocurrency exchanges, attracting more buyers increases the value of the platform for sellers, and vice-versa, while more traders (buyers and sellers) increase the value of the platform for cryptocurrencies choosing to list their coins on the platform.

In the graphs below, the average number of monthly users active on Coinbase increased from 900,000 in 2019 to 9 million in 2021. At the same time, the increase in the number of users in 2020 saw a parallel increase in the number of available assets on the platform, which more than doubled from 2019 to 2020.

Source:  US Active Coinbase Users, 2019-2023 (millions and % change) | Insider Intelligence, Coinbase Usage and Trading Statistics (2023) (backlinko.com) Document (sec.gov)

Network effects can be acquired by competing to offer a better, more innovative product or a cheaper price. In that case, consumer preferences strengthen exponentially as adoption increases, leading the best platform to become even more valuable than its rivals.¹⁰ This creates barriers to entry and market power for the platform in question, which may become visible in the form of inflated fees.

However, network effects can also be achieved through illegal conduct that forecloses rivals instead of competing with them. For example, predatory pricing,¹¹  or, as in the case of Coinbase, the illegal provision of services on the platform. Each of these can build network effects and tip or monopolize a market, instead of competing for it. Once built, these network effects can then provide self-sustaining barriers to entry and expansion from rivals.

While monopoly prices built on competitively acquired network effects are perfectly legal (in the US), monopoly prices built on illegally acquired network effects are anticompetitive and could not be matched (or constrained) by an equally effective law-abiding competitor.

Coinbase Staking Program

As well as its illegal offering of exchange, brokerage, and clearing services, the SEC also alleged that in the examined period (2019-2022), Coinbase offered a Staking Program in most of the US for five tokens.¹² Coinbase’s Staking Program attracted traders, increase momentum, and strengthened the network effects and hence the size of the moat. Between Q1 and Q2 2021, the adoption of the Staking Program increased more than 300%, reaching 1.7 million customers,¹³ and the end of 2021, the total value of crypto assets committed by investors amounted to approx. $28.7 billion.

In 2022, the number of users “investing” in the staking program reached over 4 million. Kraken, one of Coinbase’s competitors in the US, used to also offer a staking program until February 2023, when the program was discontinued in its US operations, following a SEC complaint regarding the unregistered staking program operating with “crypto securities”.¹⁴

The choice by Kraken to close the program because of the complaint, and not to instead register it and provide disclosure and investor protection, helps illustrate that no equally efficient law abiding competitor could adopt the same practices in order to build their own network effects.

Impact Of The Conduct

In the US market, centralised cryptocurrency exchanges like Coinbase charge fees per transaction that vary by the transaction value. They also distinguish between maker and taker fees (i.e. fee paid by buyer or seller depending on matching offer availability).¹⁵ Thanks to the market power it reached through its anticompetitive conduct, Coinbase has been able to set significantly higher fees compared to its competitors. As shown below, when compared to Kraken fees, Coinbase’s fees are much higher for low value transactions, are broadly comparable for middle value transactions, and are again higher for the high value transactions.

Figures: Maker and Taker fees by transaction value¹⁶

We estimate an overcharge on maker fees and taker fees as high as 73% and 30% for small volume transactions, respectively.

Conclusion

Fraud in the cryptocurrency market comes with no surprise. Exchanges like FTX¹⁷ and Binance¹⁸ have been investigated by the SEC over the past couple of years, with the former ultimately filing for bankruptcy. This commentary suggests that violations of SEC regulations by Coinbase should also be examined from an antitrust perspective. Network effects ought to be established via fair competition, low prices, enhanced efficiency, and innovation. Castles relying on fraudulently obtained moats ought to be torn down by the townsfolk – since they breed lazy, incompetent and exploitative rulers.

¹ Securities Exchange Act of 1934, 48 Stat. 881, 15 U. S. C.

² “Coinbase violated section 5, 15 (a) and 17A(B) of the Exchange Act [15 U.S.C. §§ 78e, 78o(a), and 78q-1(b)(1)], and for purposes of Coinbase’s violations of the Exchange Act, CGI was a control person of Coinbase under Exchange Act Section 20(a) [15 U.S.C. § 78t(a). It has also violated Sections 5(a) and 5(c) of the Securities Act [15 U.S.C. §§ 77e(a) and 77e(c)].” SEC vs. Coinbase, Inc and Coinbase Global, Inc Coinbase, Inc. and Coinbase Global, Inc. (sec.gov)

³ Securities Act of 1933, 48 Stat. 74, 15 U. S. C.

⁴ These 12 securities are, by trading symbol: SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH, and NEXO. Coinbase, Inc. and Coinbase Global, Inc. (sec.gov), page 33.

⁵ Ibid.

⁶ Coinbase Earn

⁷ Coinbase, Inc. and Coinbase Global, Inc. (sec.gov)

⁸ See Baker, Jonathan B. “Exclusion as a core competition concern.” Antitrust LJ 78 (2012): 527, page 13.

⁹ Developing network effects for digital platforms in two-sided markets – The NfX construction guide – ScienceDirect

¹⁰ (PDF) Endogenous Timing and Intensity of Inertia in a Bandwagon Equilibrium (researchgate.net)

¹¹ See Fletcher (2007): https://papers.ssrn.com/sol3/papers.cfm?abstract_id=987875

¹² Coinbase, Inc. and Coinbase Global, Inc. (sec.gov)

¹³ 0001679788-21-000026 (d18rn0p25nwr6d.cloudfront.net), page 43.

¹⁴ SEC.gov | Kraken to Discontinue Unregistered Offer and Sale of Crypto Asset Staking-As-A-Service Program and Pay $30 Million to Settle SEC Charges and On-chain staking eligibility and availability | Kraken

¹⁵ Coinbase Fees: A Full Breakdown and How To Minimize Costs | GOBankingRates

¹⁶ Source: Coinbase Pro | Digital Asset Exchange ; Fee Structures | Explore our trading fees | Kraken

¹⁷ https://www.nytimes.com/2022/11/11/business/ftx-bankruptcy.html

¹⁸ https://www.reuters.com/legal/binance-heads-court-seeking-dismissal-sec-fraud-lawsuit-2024-01-19