An interesting moment for the crypto industry
This week, the US SEC made an interesting move by fining the crypto exchange Kraken for offering “staking-as-a-service.”
But what is staking, and why is this an important development in the crypto industry?
What is staking?
It’s important to highlight that the fine relates not to typical “lending” (as was prolific in the DeFi world and led to the failures of Celcius, Voyager, and other crypto-lenders), but rather “staking” which is pledging coins as part of the blockchain’s “proof-of-stake” validation model.
Ethereum famously migrated from proof-of-work (spending loads on electricity) to proof-of-stake last fall. Now, if you have ether, you can “stake” that ether in return for the opportunity to validate new transactions. If you commit fraud and validate fake trades, you lose your stake. But if you act honorably, you earn a yield on your staked ether.
The key question here is whether staking passes the test of being a “security” in the eyes of the US SEC.
Passing the test
There is a landmark supreme court case from 1946 that determines that, to be a security, a contract must pass the following 4 criteria (the Howey Test):
An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others.
This “smell-test” makes sense in the world of traditional securities like equity or even debt. When we raise equity investment for Origin, we are offering securities, just as our issuers are doing when they raise debt funding for themselves. Investors are being offered the chance to “invest money in [our] common enterprise with the expectation of profit to be derived from [our] efforts.”
So what about staking your ether to help run the Ethereum blockchain?
The key point is that the SEC seems to be taking issue with centralised exchanges offering “staking-as-a-service” to their small-balance crypto customers.
The key difference
To become a validator, one needs a minimum of 32 ether (approximately $48k). If you have less than that in a Coinbase or Kraken account, these centralised platforms were offering an “aggregation” service that allowed you to stake your smaller balance of tokens and earn the staking yield.
The SEC has taken issue with this aggregation function and said that Kraken needed to follow the normal disclosures required as part of a securities offering.
“Not your keys, not your coins”
It's an interesting case. Die-hard crypto-proponents are worried about the US being too heavy-handed about regulating the industry. That being said, it’s not surprising to see an outcome like this (against a centralised exchange) a few months after the fallout from FTX.
This CNBC interview with SEC chair Gary Gensler highlights the point as he cites the famous industry phrase, “not your keys, not your coins.” He’s saying that if you hold your own crypto on your own hardware wallet, you can do whatever you want with it (including stake it).
But when your coins are held at a centralised exchange like Kraken/Coinbase/FTX, you are actually depositing your coins into their account, and they can do whatever they want with it. If they entice you into depositing your coins with them with the promise of yield, this (according to the SEC) is a securities offering, and they need to have proper disclosures.
Interesting and important
So, staking on Ethereum isn’t a security. But Kraken/Coinbase offering “staking-as-a-service” for less sophisticated investors is a security.
This is an interesting and important distinction. It’s a boon for those who believe in the future of decentralised exchanges, but you can understand the frustration of entities like Coinbase/Kraken who say they are simply acting as a “pass-through” administrator.
It’s almost like depositing cash into a bank, and expecting the bank to lend it out and give you a savings interest rate. While a savings account isn’t technically a security, it is heavily regulated and comes with deposit protection schemes and the like.
Greater and greater scrutiny
This is an interesting moment for the crypto industry. Clearly the US isn’t afraid to regulate the industry more heavily if it smells like it needs regulation. Most other countries are taking the opposite approach in the hopes of trying to tap into the growth of crypto and create a destination for platforms and investors.
Which strategy is better remains to be seen. The US economy is doing quite well, so it has much less need for a hot (and risky) new tech-sector to supercharge growth, unlike the UK, the Bahamas, and others who are seeking to cash in on the growth of crypto.
Fundamentally, centralised exchanges are coming under greater and greater scrutiny. For those ideological purists who believe the promise of the blockchain was always decentralisation and democratisation of power, this is a very good thing.
