On Thursday evening, SEC Chair Gary Gensler said crypto exchange Kraken failed to register a crypto staking feature with the commission. What exactly is crypto staking? Why did the SEC ban it?
There were already rumors of a possible crypto staking ban prior to the announcement of Kraken’s US$30 million settlement with the SEC, with Coinbase chief executive Brian Armstrong calling crypto staking regulations a “terrible path” for retail traders.
The news on Thursday had an impact on the crypto market, with bitcoin tumbling more than 4 percent to a low of US$21,850 and Ethereum dropping 4.5 percent to around US$1,572, according to CoinDesk data.
What is Crypto Staking?
Crypto staking is a way for crypto investors to earn passive income from their tokens.
Staking allows users to earn cryptocurrency as a reward for using their existing crypto holdings to verify the accuracy of transactions on the underlying blockchain network.
Participants in a blockchain network pledge their coins to help validate new blocks of transactions. New cryptocurrencies are minted every time a new block is added to the blockchain, and these cryptocurrencies are distributed as staking prizes to those who pledge their coins.
The more coins pledged, the more likely they are to be used as validators, and the higher the reward. In the case of Kraken, investors can earn returns of up to 21 percent, according to a statement from the SEC. Staking is not always an option for investors, and is only available if the cryptocurrency uses a proof-of-stake model instead of a proof-of-work model.
In the proof-of-stake model, participants stake crypto behind new blocks added to the blockchain, whereas in the proof-of-work model, participants use computing power and electricity to solve complex math to generate new blocks. Therefore, the proof-of-stake model is more energy efficient than the proof-of-work model.
Why is SEC Cracking Down on Crypto Staking Features?
The SEC’s decision to crack down on crypto staking stems from its concern that the risks are not fully disclosed to investors rather than from an aversion to new technologies. “Companies like Kraken may offer investment contracts and investment schemes but must have full, fair and honest disclosure. It puts investors in a better position,” said Gary Gensler in an interview with CNBC on Friday.
In the eyes of the SEC, crypto entities like Kraken do not comply.
Gensler is concerned with the risks staking poses to investors, and claims that Kraken did not clearly disclose technology risks to its investors by filing with the SEC.
“Investors need that disclosure. What do you do with tokens? Are you trading against tokens? Are you borrowing against tokens? Are you using it for your own purposes?” Gensler said. Industry experts have been vocal about the proposed regulatory changes. “We need to ensure that new technologies are encouraged to grow in the US, and are not held back by a lack of clear rules,” Coinbase’s Armstrong said in a Twitter thread earlier this week.
“It is a matter of national security that this capability is built in the US.” Armstrong added that regulation with law enforcement didn’t work out, and that’s what prompted FTX, a bankrupt crypto exchange once headed by Sam Bankman-Fried, to operate offshore in the Bahamas.
In response to the SEC’s move, Kraken divested all US client assets registered in its on-chain staking program, although betting services are still offered to all non-US clients through a separate Kraken subsidiary.
What Impact will it have on Industry and Traders?
One aspect of staking may have taken a hit with the SEC’s latest move, but that won’t stop investors from staking crypto in other ways, one expert says.
“It is important to clarify that this crackdown is for services using pooled staking… and not direct staking,” said Konstantin Boyko-Romanovsky, CEO and founder of Allnodes, a cryptocurrency hosting and staking platform.
Pooled staking, also sometimes called staking-as-a-service, has intermediaries who use the investor’s assets as a product, as Kraken does. These benefits are determined by how the assets are managed. In the case of direct staking, user rewards are determined by the blockchain, and users have control over their assets. Pooled bets provide smaller rewards than if tokens were directly staked on the blockchain, but live bets have a higher barrier to entry.
“This SEC decision may affect any cryptocurrency exchange using pooled staking but will not affect validators or services that allow users to stake the protocol directly,” Boyko-Romanovsky said in an email to MarketWatch. According to Boyko-Romanovsky, retail investors may turn to the street of direct staking as a result of the SEC’s move.
Boyko-Romanovsky also added that by direct staking, users’ funds remain in their digital wallets even if the platform fails. Some industry insiders worry that investors will go overseas to gamble. “In the absence of regulatory clarity, the main concern is that innovation is shifting overseas and overseas,” David Wells, CEO of Enclave Markets, a crypto trading platform, told MarketWatch.
“Apart from the US being one step behind its international counterparts, there is an ever-present risk that investors will still be involved with these products, despite the loss of the important consumer protections provided in the US.” With uncertainty surrounding regulation, it’s hard to predict exactly what’s next for the industry.
“There is currently uncertainty about how these new technologies will be regulated, which is making it difficult for the industry to align how best to build critical infrastructure for a more inclusive financial system without fear of heavy penalties,” Wells said.
