Cryptocurrency Analyst
Summary: Coinbase launched a blockchain named Base at the start of August, following the firm's announcement to launch the native blockchain in February of this year. In the span of just one and a half months, Base has become the most popular Layer 2 blockchain on Ethereum, even processing more transactions than Ethereum on most days. This is a win-win for both Coinbase and Ethereum.
The largest US-based crypto exchange, Coinbase, announced its plan to launch a native blockchain named Base in February of this year. Coinbase released Base as a beta six months later in July before eventually launching it to the public on August 9. Although Base was launched just one and a half months ago, it has already accomplished a crucial milestone that very few blockchains ever accomplish: achieving a network effect.
A network effect means that a blockchain has attracted enough users and applications for the network to have value for everyone involved. This is a two-way street: the blockchain needs a large enough user base to be valuable, but users will only adopt the blockchain if there are enough useful applications on it. And of course, developers do not want to build applications for a network with no users, creating a chicken-and-egg problem.
Base has managed to avoid this paradox by attracting both users and applications in large numbers. Over the past month, Base has often exceeded the number of transactions on Ethereum and other popular Layer 2 blockchains, reaching nearly 2 million transactions on some days. Now, let us take a closer look at Base and its technological foundation as a Layer 2 solution for Ethereum.
With Base, Coinbase did not select to establish an entirely new blockchain. Instead, Base builds upon Ethereum as a so-called Layer 2. This means that Base bundles a bunch of transactions from its own chain to execute them in a batch off-chain before posting the transaction data as a single transaction on Ethereum. The final transaction on Ethereum is computationally heavier, and thus, more expensive, than a regular layer 1 transaction, but since it is technically hundreds of transactions from Base, it reduces each transaction fee by between 5 to 20 times relative to a similar transaction on Ethereum. Base is built around the OP Stack, powering another large Layer 2 on Ethereum named OP Mainnet, formerly known as Optimism.
The application of Ethereum as a settlement layer for Base promises greater security and decentralization than Base completely on its own, as it inherits some of the security and decentralization from Ethereum, perhaps the most decentralized and secure cryptocurrency. Besides, Base taps into Ethereum’s strong network effect by facilitating safe and easy interoperability such as bridging of assets to and from Ethereum’s native layer and other Layer 2s within the ecosystem. This is not only an advantage to users, but also developers, as the identical technical architectures of Ethereum and Base allow them to effectively copy-paste applications from Ethereum onto Base without great modifications.
The value, however, is not a one-way street merely flowing from Ethereum to Base, because Ethereum profits from the transaction fees of Base, altogether having paid about $2.4mn in transaction fees to settle its transactions on Ethereum so far during its short existence. These fees are mainly burnt and, hence, removed from the Ethereum supply, while the remaining part is paid to validators, so Base as a Layer 2 on Ethereum is a win-win.
Any transaction on Base is largely immutable as soon as it has been broadcasted to Ethereum in a bundled transaction, however, to bundle these transactions from Base to form a single transaction on Ethereum, there needs to be a so-called sequencer in place. In the case of Base, its sequencer is merely in the hands of one entity namely Coinbase. This is not something out of the ordinary, as the sequencers of other Layer 2s are presently also exclusively in the hands of the respective developer. This allows Coinbase and other Layer 2s to largely censor, front-run, and move about transactions before they are bundled.
The Layer 2s, including Coinbase, are not interested in engaging in such activities, as it would severely damage their reputation and integrity. However, the main proposition of any blockchain is its decentralized nature, so trust should be in decentralized code rather than centralized entities. Because of this, not only Coinbase but largely every single Layer 2 have stated their intention to decentralize their sequencers over the coming years, but as of now, like any other Layer 2s, Coinbase has retained substantial control over Base and its sequencer.
Until Coinbase thoroughly decentralizes the sequencer of Base, it acts as the main revenue source of Base for Coinbase. The compact compression of transactions allows for a discrepancy between what users pay in transaction fees on Base relative to the settlement cost of Base of its large transactions on Ethereum. So, in essence, 100 users on Base may pay $0.1 per transaction for a total of $10, but it alone costs Base $5.0 in transaction fees on Ethereum, so Coinbase nets a profit of $5.0 without considering the computational cost of the sequencer. So far, Base has generated a total of about $7mn in fees, of which $2.5mn has been paid in fees to Ethereum, leaving Coinbase with a profit of about $4.5mn since Base launched in early August. It is too early to say how Coinbase’s plan to decentralize Base materializes, but Coinbase must wave goodbye to at least a portion of that profit whenever Base is decentralized.
This is already the case to some degree. Coinbase has guaranteed a revenue-sharing pact with Optimism; the original developer of the OP Stack, which acts as Base’s technological foundation. The revenue-sharing pact says that Coinbase must contribute 2.5% of Base’s revenue or 15% of the network’s net profits, whichever is greater, to the decentralized autonomous organization (DAO) of Optimism.
For now, there is perhaps at least one additional substantial revenue source of Base for Coinbase. Together with Circle, Coinbase launched the stablecoin USDC in 2018; now the second-largest stablecoin measured in issued dollars. Circle is now the sole issuer of USDC; however, the firm shares a part of its interest income from the USD with Coinbase. In Q2 2023, this amounted to a revenue of $151mn for Coinbase, some 22% of the firm’s total revenue in that quarter.
It is possible that Coinbase has made an even greater agreement with Circle for USDC issued on Base, so Coinbase receives more of the interest than normal for every dollar issued on Base. At present, there is already about $274mn worth of USDC on Base, both bridged and natively. Provided that Coinbase has a valuable agreement in place and that this number continues to increase, then the interest income on USDC on Base could easily exceed the revenue of the sequencer in the near future.
The advantages of Base are not merely monetary. For Coinbase, Base is largely also a tool to cement its brand and stress that it is the one and only go-to place for crypto needs. It appears that Coinbase has already achieved this, considering the press coverage of Base, alongside the substantial activity carried out on the very same. Bond. Long Bond(s)
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