Where Will the SEC Staking Hammer Land Next?

Last week, Coinbase CEO Brian Armstrong sent the crypto staking verse into a speculative frenzy — with one tweet thread positing “rumors” that the SEC wanted to “get rid of” crypto staking for US retail traders.

The frenzy spread with a video of SEC Chair Gary Gensler breaking down crypto staking and, of course, the SEC complaint against Kraken’s staking service.

The news onslaught sowed rumors and fears about a pending all-out staking ban. Though there’s no ban on the books, it’s still not clear if the SEC has any other service or validator, or protocol in its sights.

What happened

The tweet: On Wednesday, Feb. 8, Armstrong ignited the rumor mill with a tweet stating he heard, “The SEC would like to get rid of crypto staking in the U.S. for retail customers.”

1/ We’re hearing rumors that the SEC would like to get rid of crypto staking in the U.S. for retail customers. I hope that’s not the case as I believe it would be a terrible path for the U.S. if that was allowed to happen.

— Brian Armstrong (@brian_armstrong) February 8, 2023

The complaint: The next day, Feb. 9, the SEC charged Kraken, a crypto exchange, “with failing to register the offer and sale of their crypto-asset staking-as-a-service program.”

The complaint, crucially, did not explicitly label staking a security. Instead, it outlined the details of Kraken’s staking as a service program — and based its charges on the summary of its conduct.

Lacking specificity, the regulator’s claims makes it difficult to pin down what precisely about Kraken’s program constituted an illegal offering of an unregistered security.

It’s like when an orchard farmer starts to harvest her apples. Just because the first apple is a big, low-hanging, ripe macintosh doesn’t mean she isn’t also planning to pick the green granny smith a few trees over.

Ambiguity aside, the defining characteristics that the SEC listed in their summary of Kraken’s alleged conduct contains a number of clues as to what’s next.

How the SEC characterized Kraken’s Staking As a Service:

• Kraken aggregated client funds
• Their efforts added a competitive advantage
• They advertised regular returns
• Kraken determined the returns — instead of the protocol
• Investors lost possession and control over staked cryptoassets
• Clients took on risks associated with Kraken’s platform, such as slashing penalties
• Kraken retained the right to not pay out investor returns (as stated in their old terms of service)
• Kraken did not provide a security registration statement or exemption

The video: The SEC dropped a staking explainer video with Gensler moments after their enforcement hit the wires. Instead of directly addressing the SEC’s charges against Kraken, Gensler provided his agency’s understanding of protocol staking — and outlined conditions covering when a staking/client relationship falls under federal securities law:

• The service provider takes control of client funds
• They “possibly pool the funds”
• They promise a return

There’s still plenty of room for interpretation. But the conditions provide a simpler framework when it comes to trying to anticipate SEC enforcement actions that may be coming down the pipeline.

Coinbase — responding to spreading concerns about the fate of the exchange’s own staking program, Coinbase Earn — claimed their version was different. Why? Because customers retained ownership of their funds — and because the protocol, not Coinbase, made determinations as to rewards.

Coinbase’s terms of service outlines ownership of funds via the exchange’s user agreement, which says that “customers retain a title to Supported Digital Assets shall at all times.”

That’s not the same thing as exclusive ownership, though. Coinbase still handles the custody aspect on behalf of customers.

In this case, Coinbase may be the green apple from the analogy. Just because the exchange’s staking service doesn’t aggregate funds — nor does it calculate returns in Kraken’s exact fashion — doesn’t mean it’s safe from the SEC’s line of sight.

The big questions​

What do YOU mean by “control”?

This much is now clear: SEC predicates much of its staking enforcement on who controls client funds.

Does Coinbase, for example, take control when they take custody of customer assets? The answer is important: If they do, it could imply that a client relies on that effort.

And that notion is an essential requirement for the Howey test.

When it comes to crypto staking, the level of control a client has over their funds varies. The recent SEC charges against Kraken put the service provider at the far end of the spectrum – meaning total control.

Some services and protocols promise clients that they will retain custody over their funds – but different staking risks can arguably reduce client control.

On select proof of stake mechanisms, for instance, the protocol can slash the validators stake if they fail to follow the correct and prescribed procedure.

And some protocols require validators to lock up funds for a predetermined period. Taking these risks into account, clients still transfer a degree of control — even if they own the private keys to their stake.

These risks fall along a spectrum between the risk of not earning a profit and the risk of losing the principal value.

Staking risks of the protocols listed in SEC complaint:

• Ethereum

Risks of not yielding a profit: Yes

ETH staking yields are made up of MEV, tips and block rewards and can vary based on individual validator size and performance and network demand. So, while staking rewards hover between 4 and 10%, there is no guarantee stakers will always turn a profit.

Risks of losing principal value: Yes

Ethereum enforces validator slashing penalties for failing to follow network procedures.

If an individual chooses to stake through a third party’s validator, they run the risk of losing their principal stake if the validator falls short. Etherem also requires validators to lock up funds.

Meaning that if the value of the staked ETH becomes less than it was worth prior to the commitment, stakers will lose value — if their rewards do not cover the loss.

• Cardano

Risks of not yielding a profit: Yes

Cardano staking yields are made up of a fixed release of block rewards and transaction fees. They depend on the size of a given staked pool and its performance, as well as network demand.

While yields average around 4% — like Ethereum — there is no guarantee stakers will yield a profit.

Risks of losing principal value: No

Cardano does not enforce slashing penalties or lock-ups. Delegates to a pool can remove their staked assets anytime. The only risk to the principal value is if the delegator loses the private keys and seed phrase to their staking wallet.

• Polkadot

Risks of not yielding a profit: Yes

Polkadot staking yields are made up of inflationary block rewards and are dependent on a stake pool’s size and performance.

Staking yields average around 13%, and the network’s inflation clocks in between 7 and 10%. Like Ethereum and Cardano, there is no promise that stakers will come out in the green. There is a potential that validators can perform poorly — and that supply dilution can surpass staking yield, resulting in a loss.

Risks of losing principal value: Yes

Like Ethereum, Polkadot enforces slashing and a 28 day bonding period. Both expose stakers to the risk of losing principal value.

• Cosmos

Risks of not yielding a profit: Yes

Cosmos staking yields are made up of transaction fees and new ATOM emissions (newly created ATOM) and are dependent on validator size and performance. Yields average between 8-15% and are not guaranteed.

Risks of losing principal value: Yes

Cosmos also enforces slashing penalties and a 21 day bonding period. Stakers face the risk of losing their principal stake if the value drops during the bonding period or if funds are slashed.

Liquid staking protocols like Lido make it possible to stake ETH without having to deal with lockups.

They provide a derivative, stETH, in return for staking ETH via their protocol. Once staked ETH becomes eligible for withdrawals, users can redeem stETH for ETH.

Not to say using those protocols is a risk-free endeavor.

Because all staked ETH is locked until withdrawals are enabled by Ethereum’s pending Shanghai upgrade, users can only redeem stETH through exchanges. The value of the derivative often fluctuates, exposing stETH holders to potential downsides.

Read more: ETH Liquid Staking Derivatives Primer

Who’s next?

The SEC’s future enforcement of staking will likely depend on two things:

IF regulators believe individual stakers rely too much on others in these staking arrangements,

AND

IF they determine that the initial staking investment is in a common enterprise.

Kraken and Coinbase are easy targets because they represent a clear common enterprise.

Individual validators can also fit the bill, if they actively solicit their services. But they may not fit that first prong if the SEC thinks their efforts lack a reasonable impact on the underlying value of the staked asset in question.

It’s much harder to argue that private validators invest their stake into a common enterprise — since their consensus mechanisms are managed across decentralized networks. The setup also makes it unreasonable to assume that the pools’ staking success relies on the efforts of others.

Liquid stalking protocols fit somewhere in the middle of private validators and staking as a service. They are more decentralized than a single validator service, but less decentralized than the entire network.

There are still slashing risks to the underlying stake of the protocol — along with smart contract risks for individual stakers — making investors (at least) somewhat reliant on the managerial efforts of others.

I like S-T-A-K-E. What does that mean for me?

Retail investors are generally not targeted for merely buying and selling unregistered securities.

There have only been a few cases along those lines. But each instance included the purported intention to defraud other investors. There are actually a number of cases in which some retail investors can file a complaint if they suffered a loss from buying an unregistered security.

So, even though the SEC may be targeting your ability to stake through a staking as a service platform, they aren’t necessarily targeting you.

Their strategy is to educate retail investors on the inherent risks of trading unregistered securities — and make it more difficult to access them through online exchanges.

All in all, the SEC’s efforts make it more difficult to access protocol staking and staking services by forcing everything offshore.

But the SEC — like any other single regulator — does not have the power to eliminate proof of stake options outright.

Final thoughts

The SEC’s rub — as Gensler put it — with staking as a service platforms is that they “don’t provide the proper disclosures.”

Investors deserve to know if these platforms are “lending, borrowing, or trading with [customer funds].

Are they commingling them with other businesses? Where do the rewards come from? Are you getting your fair share? Are the underlying crypto protocols genuinely creating value on your investment — or are they just new tokens that dilute the value of the ones you already have?”

All of which happen to be the exact same concerns that crypto participants have with centralized financial entities, including banks.

Even so, a savings account is not considered a security. And — even though saving accounts are under tight regulatory control — customer funds are commingled and diluted at a massive scale.

Protocol staking offers a transparent alternative for users to claim a fair share of the monetary system — without the need for disclosures.

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