A one-off or opening salvo in an attack on crypto?

In a year of crypto upheaval, the United States Securities and Exchange Commission’s settlement with crypto exchange Kraken, announced on February 9, set off yet another tremor. Agency chief Gary Gensler took to the mainstream media last week to explain the agency’s action, which appeared to be an attack on crypto staking — part of the validation mechanism used by a number of blockchain platforms, including Ethereum, the world’s second-largest network.

The immediate problem, in the agency’s view, was that Kraken had sold unregistered investment products. In fact, it advertised huge returns on betting crypto — up to 21%, Gensler told CNBC.com.

“The problem was that they didn’t disclose to the investing public the risk that the investing public was getting into,” Gensler said. Moreover, the SEC’s action, which required Kraken to pay $30 million and shut down its betting operation, could have been easily avoided, he seemed to suggest:

“Kraken knew how to register, others know how to register. It’s just a form on our website. They can come in, talk to our skilled people on the disclosure assessment team. And if they want to offer bet, we are neutral. Come in and register, because investors need that disclosure.”

However, not everyone in the crypto industry was completely satisfied with this answer. “I find the SEC’s ‘all crypto projects need to do is come in and register’ line incredibly insulting,” tweeted Morrison Cohen LLP Attorney Jason Gottlieb. “There is simply no path to registration for many crypto products.”

“The registration of securities in the stake program is not as simple as submitting a form on the SEC’s website,” Michael Selig, an attorney at Willkie Farr & Gallagher LLP, told Cointelegraph. “Public offerings of securities are highly regulated and expensive to carry out.”

Others see the agency’s decision to charge Kraken as the first salvo in a general assault on crypto by US regulators. “If approved by a court, the settlement marks a potential turning point for cryptocurrency regulation and the SEC’s broader efforts to bring the industry under its jurisdiction,” CNN reported. “The move could lead to a broader crackdown,” speculated The New York Times, including possibly banning American investors from betting.

But perhaps the industry overreacted. That is, staking as practiced by Ethereum and other blockchains as a way to reward network validators may not be on the SEC’s radar screen at all. The agency may be primarily motivated by consumer protection, and in this case it wanted to make an example of Kraken, especially in light of FTX’s collapse in November and the bankruptcy of various crypto lending firms.

“Yes, I’m sure they do [the SEC] wanted to create an example of Kraken, especially because it promoted the possibility of achieving returns of up to 21%, Carol Goforth, university professor and Clayton N. Little Professor of Law at the University of Arkansas, told Cointelegraph.

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“Kraken set the ROI for stake amounts, not the underlying blockchain protocols. […] Frankly, the way Kraken operated the program looks like an investment contract under Howey,” she said. The SEC uses the Howey test to determine whether a transaction qualifies as an investment contract, which then requires SEC registration.

Bill Hughes, senior advisor and director of global regulatory affairs at ConsenSys, told Cointelegraph, “It’s a one-time action intended not only to resolve Kraken’s offering, but, more importantly, to send signals around the world about what features of staking-as – a service the SEC believes is problematic.” If another betting service doesn’t heed those signals, they too can expect the SEC to take action, Hughes said, adding:

“I think the SEC hopes the market gets the message and adjusts accordingly — since they’d probably prefer to move on to other issues.”

“The American Kraken case is primarily about sanctioning it [Kraken’s] overt and non-transparent behavior towards its retail customers, and not just to offer an effort-as-a-service per se“, Markus Hammer, a lawyer and principal at the Switzerland-based Hammer Execution consultancy, told Cointelegraph.

Is Ethereum in danger?

The market did not necessarily see this as a one-off action by the agency. Ether (ETH) fell around 6.5% on the day of the settlement announcement, the biggest one-day decline since mid-December. As widely reported, last year Ethereum moved from a proof-of-work to a proof-of-stake (PoS) consensus mechanism. This technical makeover was called “the Merge” and was hailed by many for radically reducing the network’s enormous energy use and carbon footprint. But at least some feared that Ethereum was now in the eyes of US regulators because of the new staking protocols.

However, equating Kraken with Ethereum could be a mistake. As Matthew Hougan, chief investment officer at Bitwise Asset Management, told Cointelegraph:

“The SEC’s enforcement action against Kraken is not an enforcement action against Ethereum for using a proof-of-stake consensus mechanism. It was an enforcement action against Kraken for offering a staking service. Those are different things.”

Also, Ethereum could continue to operate securely as a PoS network even if the SEC were to ban all staking services in the United States, Hougan said, though he doesn’t expect that to happen. “Activity will simply migrate offshore or be carried out directly by individuals,” he said. More than enough ETH can still be staked to ensure network integrity. “The main result would be that American investors would lose both the opportunity and the risk of betting. However, the world would go on.”

“The action is not against betting platforms, but against betting service providers who organize and operate pools,” Goforth said. “If the promoter controls the pools and rates of return” — as with Kraken — “this action suggests that the SEC will treat the program as involving the distribution of investment contracts.”

By comparison, she said, “if the blockchain protocol allows others to set up pools,” as with Ethereum, “that’s not necessarily within the rationale of this order.”

Hughes agreed. There is nothing in the SEC’s complaint to suggest that striking itself is problematic. “The SEC’s action directly focuses on Kraken’s custody program, which promised a specific return, pooled funds and did not disclose risks or fees. It says nothing about ETH stake or any other chain’s consensus mechanism,” he said.

Ethereum also hosts many use cases that have nothing to do with investing (e.g. elections). Just because the network has moved to a proof-of-stake consensus mechanism does not in itself mean that its original coin, Ether, should now automatically be classified as a security. One needs to look at “the nature of the underlying multi-use blockchain and the respective ecosystem,” Hammer said. Moreover, these must be considered blockchain by blockchain, he added.

An opening salvo?

All this may be well and true, but could this really be an opening as part of a wider post-FTX attack on cryptocurrencies and blockchain technology – and not just “investment solutions” offered by a few centralized service providers?

“The SEC tends to act in an incremental fashion, bringing new enforcement actions that build on previous enforcement actions,” Selig told Cointelegraph. “The crypto industry is reasonably concerned that the SEC is focused on custody programs today, but will aim to venture more broadly in the future.”

Hughes tends toward the more limited view, mainly “because that’s what this complaint is on its face. Whether the SEC gets more aggressive and goes after the core blockchain functionality remains to be seen.”

Blockdaemon CEO and founder Konstantin Richter seemed to agree. “With the complaint, it doesn’t appear that staking itself is the problem,” Richter told Cointelegraph. “This indicates that institutional investors who have the ability to bet can proceed without using a centralized custodian exchange.”

Hougan, for his part, is not so sure that there won’t be a crash, he tells Cointelegraph:

“Crypto is facing a coordinated regulatory crackdown in the US. You see that crackdown in the SEC’s recent statements and actions, and in recent efforts by the FDIC, OCC and Federal Reserve to limit the crypto industry’s access to the traditional banking system.”

These actions are concerning but not surprising, Hougan continued. The many failures of the past year such as FTX, Celsius, Genesis, BlockFi, Voyager and Terra have “pointed to some significant risks in the crypto ecosystem and the need – in certain cases – for better regulation.”

“This is far from the first salvo in an American attack on crypto,” Goforth said. “The SEC has been relatively hostile to cryptoassets for years; this appears to be a continuation of this approach […] as it continues to spend resources on case-by-case enforcement rather than providing a genuinely useful roadmap for compliance, for example by devising exemptions based on tailored disclosures.”

‘First inning of a nine-inning game’

Gensler may have been disingenuous when he invited exchanges like Kraken to simply fill out a form on the SEC’s website. SEC registration is an involved undertaking. “It’s an incredibly difficult process, often costing a million dollars or more — in legal, accounting and investment advisor fees — the first time an issuer seeks to register a conventional security,” Goforth noted. It can also take a long time to be approved.

However, it does not necessarily follow that Gensler will go after Ethereum and other PoS platforms. The agency chief, it may be recalled, once taught a course on blockchain technology at the Massachusetts Institute of Technology, and he knows a great deal about decentralized networks and their purpose. He probably understands that the technology offers all kinds of use cases without investment, even PoS platforms with validators that have “skin in the game” as they work to ensure network integrity.

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In fact, the Kraken settlement may have only confirmed that “the SEC is still not clear on when consumer protection regulations apply to the crypto world,” Hammer opined. Prior to the merger, both the SEC and the Commodity Futures Trading Commission viewed Ether as a commodity rather than a value.

Overall, the jury may still be out on whether the SEC is engaged here in a limited regulatory action or instead is making the opening volley in a broader war against cryptocurrencies and blockchain technology. Most favor the former interpretation, but as Hougan concluded:

“Whether the current regulatory rift is going to stifle crypto or ultimately unleash its full potential – I think it’s too early to say. The right kind of regulatory progress could be incredibly positive for crypto, but overly restrictive or punitive regulation would be crippling.” […] We’re in the first inning of a nine-inning game.”