Cryptocrackdown: Lido Finance a beneficiary? (LDO-USD)

US regulators appear to be at the beginning of a significant crackdown on cryptocurrencies and the banks that service the wider industry. The latest development in what has been called “Operation Chokepoint 2.0” by some has been the halting of further minting of The Binance token (BNB-USD) dollar-pegged stablecoin Binance USD (BUSD-USD) by Paxos Trust Company. In my view it is significant implications from that, and the latest development has been a Wells Notice issued to Paxos by the SEC amid allegations that BUSD is an unregistered security. This is important context given what happened last week.

Claims against the Kraken

Just days before Paxos halted BUSD mining and disclosed the Wells alert, Kraken paid a $30 million fine and stopped offering staking-as-a-service products for its clients after the SEC accused the company of selling unregistered securities. The Kraken is one of them largest exchanges by trading volume and has been an important crypto-on-ramp for US customers. However, it is important to distinguish that the SEC’s charge was not a result of Kraken selling certain cryptocurrencies. Rather, the SEC believes that Kraken’s yield products are unregistered securities. In the SEC’s press release:

The Securities and Exchange Commission today charged Payward Ventures, Inc. and Payward Trading Ltd., both known as Kraken, with failing to register the offering and sale of their crypto-asset staking-as-a-service program.

One part of this bet as a service model that the SEC appears to be questioning is Kraken’s ETH staking pool on Ethereum (ETH-USD). Like similar centralized and decentralized products, Kraken is essentially an ETH staking intermediary for customers who lack the minimum ETH for direct staking. This product has made Kraken the third largest player on Ethereum behind only Lido Finance (LDO-USD) and Coinbase (COIN):

Click to enlarge

Source: Dune Analytics/hildobby, as of 14.02.23

Since Coinbase is also a major contributor to ETH investment through pooled customer funds, it is natural that Coinbase could also be sued by the SEC for similar unregistered securities violations. That said, Coinbase has been proactive in the public discourse in recent days, laying out what it says are the differences between what Kraken offered customers and what Coinbase offers. Furthermore, Coinbase CEO Brian Armstrong said on Twitter that the company plans to fight a similar charge from the SEC in court:

Coinbase’s staking services are not securities. We will be happy to defend this in court if necessary.

How that plays out is very much up in the air, but if Coinbase is indeed charged with unregistered securities sales by the SEC for the same reason as Kraken, it opens up the possibility that any market demand for staking intermediaries could continue on the chain. . A possible winner in that regard could be Lido Finance.

Lido to the rescue?

Lido Finance is a floating stake protocol that I have covered for Seeking Alpha in the past. One of the main responses to the Kraken news is the idea that Lido Finance, RocketPool (RPL-USD) and other similar floating stake protocols should benefit from centralized exchanges losing the ability to offer any kind of stake as a service product. However, I’m not quite so convinced. To be clear, I think it makes sense to go through a staking pool if the user can’t bet directly on the chain, either due to high minimum requirements or due to technical competency issues. But I’m not sure the SEC will distinguish between a corporation and a DAO.

If Kraken’s effort as a service product is an unregistered security in the eyes of the SEC, I think we can reasonably assume that the agency will take the same view of Lido Finance’s or Rocket Pool’s product offerings. Right or wrong, I’m not entirely sure the agency would view decentralized betting services much differently than the yield accounts offered by centralized exchanges. Especially with regard to floating stake protocols, ETH derivative coins also characterize that the SEC could potentially also consider unregistered securities.

This can get more complicated

Something I think the US based crypto user should think deeply about is that these protocols are laid out right in the terms of use that geoblocking is a possibility. This is from Lido’s:

we reserve the right to limit or restrict access to the interface for any person or entity, or within any geographic area or legal jurisdiction, at any time and in our sole discretion. We will not be liable to you for any loss or damage you may suffer as a result of or in connection with the interface being unavailable to you at any time or for any reason.

From the user’s point of view, if one is unable to directly interact with the contract without the front-end application, it may be too risky to venture through these protocols since jurisdiction is a non-zero percent risk at best and a major headwind in worst case.

From the LDO investor’s point of view, geoblocking US consumers from Lido’s front-end interface will almost certainly slow the growth of what has otherwise been a hugely popular DeFi protocol, but is unlikely to stop it entirely. As I mentioned, DeFi participants who are more technically savvy can interact with the contract without the front-end interface. And it’s also possible that foreign developers could build a non-affiliated interface and simply choose not to comply with US regulators. But none of this would be good. For what it’s worth, Lido Finance’s head of business development also seems concerned, recently telling Bloomberg:

The biggest risk I personally see as a US-based person is if they come down and say you can no longer interact with or contribute to these kinds of protocols. So as a contributor to DAO, does that mean I can’t work on Lido anymore? Do I have to go and do something else?

Summary

What I don’t want this article to portray is FUD. I am still very long term bullish crypto, Ethereum and liquid staking protocols on Ethereum. What I’m much less sure about is whether US consumers will be allowed to interact with many of these DeFi protocols. I don’t think there is any doubt at this point that there is a broad crypto crash that appears to be just starting. If I were a DeFi user in a more crypto-friendly jurisdiction, I wouldn’t be nearly as concerned as a US-based DeFi user.

Crypto will develop with or without the US. Whether or not the SEC considers Lido Finance, the staking service Lido offers, LDO, or the floating staking tokens that Lido creates to be securities may not ultimately matter 5 to 10 years from now. However, if the SEC takes that position, I think it will slow the growth of the protocol and, by extension, reduce the demand for LDO. To be clear, I’m not saying sell everything. But I am of the opinion that LDO holders (and RPL holders) should probably be careful. Especially after such nice price runs in the last couple of weeks.