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A margin of almost half a cent on every dollar traded is gigantic by Wall Street standards. For example, Goldman Sachs’s Global Markets segment, a huge trader in the lucrative domain of corporate bonds, posted an operating margin of 38% in 2020, way below Coinbase's Q1 bonanza. And that was in a fantastic year for Goldman, when the business more than doubled its 2019 margins.

The potential problem: Trading revenues track the crazy swings in Bitcoin

In the registration statement, Coinbase states that trading volumes rise and retreat following three factors: First, the number of customers who trade, represented by the metric called monthly transacting users, or MTUs. Second, the level of volatility. Third, the trend in prices of cryptocurrencies led by Bitcoin, the token accounting for over 40% of its trades.

Here's what makes Coinbase's future so unpredictable: The ranks of users rise and fall with the price of Bitcoin, which strongly influences what rival coins sell for. As Bitcoin's price careens from peak to peak, it plumbs valleys in between, raising volatility. That helps Coinbase collect bigger "spreads" (the difference between the "offers" at which it purchases as a market maker versus the "bids" at which it sells), although those spreads are a much smaller moneymaker than its transactions fees.

As of today, Coinbase is highly dependent on the price of Bitcoin

Hence, the forces that drive trading volumes, and profits, are primarily driven by the price of Bitcoin. How closely related are Coinbase's revenues and the fluctuations in the signature cryptocurrency? When Bitcoin explodes by x percent, Coinbase does even better, as much as 1.5x—because it both gets higher fees due to the higher price, and at the same time attracts a flood of new users and benefits from a more feverish fever chart.

In Q2 of 2019, Bitcoin's average price more than doubled to $8,250, while Coinbase's revenues tripled to $211 million. A fading Bitcoin cuts the other way: When it retreated in Q4 of 2019, Coinbase took an outsize hit of almost 40%. The Q4 2020 to first quarter 2021 proved true to form. Bitcoin rose on average by 120% to around $45,000, and Coinbase revenue more than tripled to $1.8 billion.

Coinbase: More institutional trading means smoother results

Coinbase has done an extraordinary job luring hedge funds, banks, and corporations to both trade on its exchange and park their coins in its well-protected vaults. Just over half of the $233 billion it holds for customers belong to institutions. Its SEC filing also reveals that in Q4 of last year, those money managers and other large clients contributed $57 billion, or two-thirds of its $81 billion in trades.

In the filing, Coinbase makes a call that's crucial to its future: that more institutional trading will lessen its reliance on the rising price of Bitcoin. "Retail trading volume is more influenced by the Bitcoin price and Crypto Asset Volatility than institutional Trading Volume. As institutional trading increases, we expect the correlation between the Bitcoin price and Crypto Asset Volatility and Trading Volume to decrease." This helps explain why Armstrong says that Coinbase may retreat to breakeven for a while. Bitcoin's spikes and descents are completely unpredictable, and a sharp fall could send Coinbase back to 2020 numbers, or even below.

Is Coinbase really worth $100 billion?

Answer: When you look at the Q1 result, you'd have to say it could indeed be worth that princely number. The challenge is twofold. First, investors will want a high return since this is the epitome of a chancy stock. So to give its shareholders good, risk-adjusted gains, let's say that it would have to deliver 8% annual increases in share price. In that scenario, Coinbase would more than double its expected opening day valuation to $216 billion by 2018. Even at a premium multiple of 30 times earnings, its profits bogey would be $7.2 billion. That's not impossible. After all, it made $4.4 billion on an annualized basis in Q1 of this year.

But that happened under extraordinary circumstances, in which the price of Bitcoin more than doubled, volatility jumped, and fans came rushing to buy. It is likely that Coinbase will be less dependent on Bitcoin's price over time. But its profits will remain tightly tied to the market cap of all cryptocurrencies. The reason: Its trading revenues flow from the around 0.5% fees it charges on the dollar value of its trades. When coins double in price, Bitcoin gets twice as much revenue, all other things being equal.

Coinbase says it's offering discounts to big customers, but those discounts so far appear small by Wall Street standards. The 0.5% is also a big, big number. Coinbase is able to get those premium fees because it's the biggest player out there; it harbors a sterling reputation; and competition is limited. But fat fees are a magnet for rivals. Investors should consider that first, crypto prices may not keep rising from these already unheard-of levels well into the future, and second, that an intense fight for fees will likely crimp the kind of extraordinary profitability Coinbase displayed in Q1.

Armstrong was right on to caution the path ahead will be rocky and may not ascend for a long time. Investors need to decide whether with Bitcoin at a mountaintop, it will ascend at all.