Why Coinbase’s USDC Interest Rate Offer is Confusing and Perhaps Illegal (Pt. 2)

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Below is the second installment of our series called, ‘Why Coinbase’s USDC Interest Rate Offer is Confusing and Perhaps Illegal’, where we dive into the details surrounding the offer by Coinbase and dissect some issues/poorly explained facets of the poorly reported on stablecoin.

Here’s Where the Problem Lies With Coinbase’s USDC Interest Offer

As we saw in the excerpt from the end of their press release, Coinbase claims that they don’t even touch the USDC deposited on their exchange by customers.

So why on earth are they offering 1.25% APY on all USDC deposits by U.S. Coinbase customers? As a for-profit institution, there must be some financial/business incentive for them doing so. While we may believe Coinbase is a noble entity (and perhaps they are), the concept of simply giving funds away in a capitalist, competitive environment like the one they’re in is simply implausible.

Based on what we know currently and what logic tells us, the first reasonable assumption to make is that Coinbase is offering APY because they want to use this deposited USDC to invest/loan/etc.

However, they stated explicitly that they have “no right to use any USDC you hold on Coinbase.”

So let’s break down what we know and see if we can’t narrow down some potential reasons for why Coinbase would do this.

First, let’s start out by outlining the obvious intended effects of this offering, which are:

  1. Increased the demand for USDC, in general
  2. More USDC out of circulation (from people parking their funds)
  3. Substantially increased amounts of USDC parked at Coinbase

Why is This Offer Only Available for USDC and not USD?

The above heading represents another good question worth asking here.

According to the Coinbase press release, customers still have the option to purchase and use USD (actual fiat) on Coinbase. What makes Coinbase unique from many other exchanges in the crypto space that claim to offer both stablecoins and actual fiat currency trading pairs/options is that Coinbase has distinct markets that differentiate between the two.

They do not simply credit a user’s account with a stablecoin that can be used interchangeably with USD and vice versa. There is a defined difference (at least from what users can see on their account balance on Coinbase).

So why not make the same offer for regular USD?

Perhaps they haven’t done this yet due to regulatory concerns, but its hard to imagine that there are any regulatory issues restricting their ability to implement this same program for USD (APY on deposits) that they have for USDC in a way that would not also pose similar issues for USDC.

No FDIC Insurance is Enigmatic

Another interesting (major)tidbit from the press release is that:

“Your USDC wallet is not insured by the Federal Deposit Insurance Corporation (FDIC) or the Securities Investor Protection Corporation (SIPC).”

One must ultimately ask, ‘Why?’, since Coinbase has publicly stated before that they have FDIC protection for customer assets.

Read the excerpt below from Coinbase’s legal disclaimer:

“To the extent U.S. customer funds are held as cash, they are maintained in pooled custodial accounts at one or more banks insured by the FDIC. Our custodial accounts have been established in a manner to make available pass-through FDIC insurance up to the per-depositor coverage limit then in place (currently $250,000 per individual). FDIC pass-through insurance protects funds held on behalf of a Coinbase customer against the risk of loss should any FDIC-insured bank(s) where we maintain custodial accounts fail. FDIC insurance coverage is contingent upon Coinbase maintaining accurate records and on determinations of the FDIC as receiver at the time of a receivership of a bank holding a custodial account.”

In this same legal disclaimer, Coinbase is careful to note that they cannot provide these same protections for users holding Bitcoin/Ethereum/other digital assets (which makes sense, since this isn’t fiat).

However, USDC is different.

As Coinbase stated in their press release, “USD Coin maintains its stable price because you can always redeem one USD Coin for one US dollar.”

If that’s the case, then that means that Coinbase has dollars stored somewhere (or can at least obtain the requisite amount of fiat dollars necessary) to exchange with customers that are seeking to exchange their USDC for actual USD (presumably via a ‘cash out’ to their bank account).

That USD should be coming from a traditional bank account, as Coinbase explicitly states in their legal terms that their cash is, “Maintained in pooled custodial accounts at one or more banks insured by the FDIC.”

Therefore, at least some of these USDC funds should be covered by FDIC. This can be stated because Coinbase goes on to state in their legal terms that,

“Our custodial accounts have been established in a manner to make available pass-through FDIC insurance up to the per-depositor coverage limit…”

For those wondering what these ‘custodial accounts’ are comprised of, this is also explained in the legal terms by Coinbase, where they state:

“Cash balances, such as U.S. Dollars, British Pounds, Euros, customers store with Coinbase are held as balance in your Coinbase or Coinbase Pro account(s). For U.S. customers, Coinbase combines your balance with the balances of other customers and holds these funds in custodial accounts at U.S. banks and/or invests these funds in liquid U.S. Treasuries in accordance with state money transmitter laws. For non-U.S. customers, funds are held as cash in dedicated custodial accounts. All custodial pooled amounts are held separate from Coinbase funds, and Coinbase will neither use these funds for its operating expenses or any other corporate purposes.”

So, we must assume that either:

A) Coinbase is not being entirely honest about the nature of USDC (i.e., not being forthright about how this digital asset is handled)

B) Operating in a way that could put them in regulatory trouble over time

Doing the Math

There is one way where this all makes sense.

Despite the fact that Coinbase states that they do not touch USDC at all (in any facet), we do know that they are the primary ones responsible for selling it (as its creator), alongside Circle.

Assuming that USDC is only being minted when it is being directly purchased from Coinbase or Circle, it is possible that Coinbase is simply establishing a reserve with the USD they receive from those purchases, then using that USD to participate in speculative lending/trading/purchasing/etc.

By doing this, Coinbase can say, ‘Hey, we’re not touching any of your USDC! That belongs to you, the customer’, whilst also being able to use said funds for speculative lending/trading/investing like other financial institutions.

However, doing so would undermine, or at least provide reason to question if these funds are actually being backed 1:1 by an equivalent amount in assets. This is especially questionable when considering that Coinbase is:

  • Not subject to the same reserve requirements (or oversight) as traditional financial institutions
  • Not an actual bank, so they more than likely would not receive the same ‘bailout’ considerations that legacy financial institutions (Goldman, JP Morgan, Morgan Stanley, etc.) received in times of financial trouble (ex: ‘08/’09 financial crisis). Thus, if there is any mismanagement of said funds on the part of Coinbase, then the results could be catastrophic
  • Coinbase is not actually insured in any meaningful way beyond what is provided by the FDIC (which all U.S. citizens are entitled to by virtue of having a bank account). While this may seem sufficient, Coinbase would benefit from having separate insurance for their business, in general, in the event of some catastrophic event (major hack, exploit in some digital asset they have in their reserves, technological error, ‘black swan’, etc. ).

As it pertains to Coinbase’s lack of insurance, this makes them a unique risk, on several levels.

Below are excerpts from the ‘insurancejournal’, which outline the various types of insurance that traditional financial institutions typically purchase to provide some layer of protection for their operations:

USDC Does Not Have to Be Obtained Via Circle/Coinbase

USDC is widely available on various markets and there are no restrictions on which secondary parties can sell or buy USDC unless Circle deems a given entity to be a ‘threat’ (in which case, Circle has stated they will ‘freeze’ certain wallets; which is a function of the USDC token contract).

However, Circle has stated that this liberty will only be taken in instances where they have gained concrete intel suggesting that there is a threat posed by a specific entity transacting with USDC (hacker/scammer/phishing/terrorism/etc.).

Thus, if one does not fall in one of those categories, or if Circle is not ‘aware’ of this fact (or simply decides not to act), then presumably, users are free to interact with one another and transfer USDC back and forth at their leisure.

Nowhere was this fact made more patently obvious than on Bitmax’s exchange, where the USDT/USDC markets were generating billions of dollars worth of volume per day earlier this year, according to CoinMarketCap data captured in March 2019 (showing reported volume from BitMax via API) :

Between USDC/USDT + PAX/USDT, the BitMax stablecoin markets were generating nearly $3 billion in phony volume back on April 10th, 2019 ; this accounted for 97%+ of all of BitMax’s volume

Thus, even if Coinbase were keeping the USD on hand that they received in exchange for more USDC, there isn’t necessarily a reason for there to be any greater demand of USDC directly from Coinbase, which nullifies the theory that the APY offer could be used as a means of giving themselves more leeway to lend out the assets/funds that allegedly ‘back’ USDC 1:1.

However, that last sentence written above may underlie why Coinbase launched this program. Perhaps the fact that USDC is so freely available on various exchanges has resulted in very few customers actually seeking out Coinbase or Circle, specifically, to obtain USDC. Thus, this APY offer was created by Coinbase to address this fact.

Conclusion (Intermittent)

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Stay tuned for Part Three!