This week shares of cryptocurrency exchange Coinbase will list on the Nasdaq stock exchange. The listing is being interpreted as confirmation of Bitcoin's seriousness and maturity. More telling, in my view, is the extent to which Coinbase’s practices reproduce the very same banking practices that crypto’s own narrative rejects.

Bitcoin is thought of as a peer-to-peer means of payment: a deficit agent can extinguish their debt to a surplus agent by direct transfer of Bitcoin. The transaction is recorded on the blockchain without requiring the participation of any other entity. Such “on-chain” payments could be recorded using T accounts like this:

The payor sends Bitcoin to the payee, and the change in ownership of the Bitcoin is recorded in the distributed ledger.

But Coinbase has made clear, and Izabella Kaminska reported, that the company makes use of “off-chain” transfers when its 56 million customers pay each other. If one Coinbase user sends Bitcoin to another Coinbase user, it is not recorded on the blockchain. That means that payments between Coinbase customers are settled on Coinbase’s books, which avoids an expensive and slow blockchain transaction for Coinbase.

What does not yet seem widely recognized is that this means that Coinbase is issuing deposits denominated in Bitcoin, while holding its own Bitcoin as a reserve asset. Here is what an off-chain Bitcoin-denominated payment between Coinbase customers looks like in T accounts:

All that happens is that Coinbase reassigns its deposit liabilities from one customer to another. No Bitcoin changes hands. Nothing is recorded on the blockchain. Such a transfer is fast, requiring only a ledger entry on Coinbase’s systems, and the company does not charge for this service.

Coinbase’s Bitcoin depositors probably think they own Bitcoin. But these off-chain transactions show otherwise. In fact, what its customers own is a claim on the company for a payment on demand of an amount of Bitcoin. It is Coinbase that owns Bitcoin, which it holds in custody for its users.

The difference between owning Bitcoin and owning a Bitcoin-denominated claim on Coinbase is the possibility that Coinbase might not actually deliver Bitcoin when demanded. Most days, this possibility will not materialize.

But that does not mean the problem is trivial. Imagine Coinbase were to fail. Even assuming all of its depositors’ Bitcoin holdings are safely in third-party custody, re-assigning those custodial Bitcoin holdings would require on-chain transactions to return depositors’ funds.

Of course, not all of Coinbase customers’ transactions are off-chain. When a Coinbase customer wants to send Bitcoin to someone who is not a Coinbase customer, the company completes the transaction on their behalf. In these T accounts, the reduction in Bitcoin-denominated deposits is off-chain, on Coinbase's books, while the transfer of Bitcoin is on-chain:

The slow speed of the blockchain means that Coinbase’s assets, i.e. Bitcoin held in custody, trade much more slowly than its liabilities to its customers, which can be settled instantly off-chain as long as Coinbase continues to operate.

This is a significant liquidity mismatch. If a substantial fraction of Coinbase depositors sought to exit their positions simultaneously, Coinbase would be stuck between demands for instantaneous redemption of its liabilities and a 4.6 transaction-per-second speed limit on its assets. If this became a backlog, customers might find themselves waiting a long time for transactions to clear. In the meantime, prices might be changing rapidly.

And so

Coinbase’s custodial model is essentially that of a deposit-taking bank. Like other banks, its portfolio carries a substantial liquidity risk—it funds an illiquid investment in Bitcoin with liquid deposit liabilities.

An entity with a liquidity mismatch counts on at least one of three protections: outside liquidity, depositor forbearance, or a flexible central bank. There is, by design, no central bank for Bitcoin. So Coinbase is counting on the beneficence of its customers and other Bitcoin buyers.

I can't wait to find out how this story ends.

Correction

Reader Satoshi points out that exchanges can batch on-chain transactions. The post was revised to remove an estimate that assumed one on-chain transaction per customer.

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Previously on Soon Parted

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• CBDCs

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