This article originally appeared in FIN, the best fintech newsletter; subscribe here.
One of the most powerful innovations in cryptocurrency is the idea of ”staking”. From a consumer standpoint, the idea is similar to an old-fashioned savings account: you own some ether (or other crypto) and you agree to lock it up for a certain amount of time on the blockchain network. Usually this is done through the exchange, for example Coinbase, where you bought the crypto. In return, you get an interest rate that will vary according to the circumstances, but will usually be much higher than any bank will pay to hide your money. To date, it has been a very popular way for investors to earn passive income from a crypto investment without having to sell. It is also part of the blockchain validation process where crypto networks maintain security.
The potential downside should be glaringly obvious in the wake of the FTX meltdown. It’s far from clear that even the purest crypto exchanges have investors’ best interests in mind when doing whatever they do with these digital assets. And unsurprisingly, while traditional US banks are heavily regulated, there is an astonishing lack of clarity and oversight when it comes to crypto efforts.
That gap became central on Thursday, when the Securities and Exchange Commission (SEC) accused Kraken, one of the world’s largest crypto exchanges, of failing to register its betting service as a security. Kraken will close the stake and pay a $30 million penalty.
This was no small operation. The SEC says:
By April 2022, US investors had invested over $2.7 billion in crypto assets in the Kraken Staking program. Kraken has earned approximately $147 million in net revenue from the program since its inception, and a significant portion of this net revenue – more than $45 million – is attributable to crypto assets raised from US investors. By June 2022, more than 135,000 unique US-based usernames had transferred crypto assets to participate in the Kraken Staking Program.
The problem, according to the SEC, is that Kraken provides investors with almost no information about what is being done with their crypto or what risks they are exposed to. The agency also notes that while Kraken advertised returns as high as 21% to those who gave up crypto for stakes, the company actually reserved the right to pay less than the advertised price, or indeed nothing at all (the complaint does not provide an example that Kraken has refused payment to any investor).
It’s tempting to think of Kraken as some kind of renegade in the crypto industry. After all, this isn’t Kraken’s first brush with regulators. In September 2021, the Commodity Futures Trading Commission fined Kraken $1.25 million for “unlawfully offering margined retail transactions in digital assets, including Bitcoin.” The CFTC argued that these transactions could legally only take place within a designated contract market, which Kraken is not.
A few years earlier, Kraken openly thumbed its nose at regulators in New York state. When the state began requiring crypto exchanges to apply for a “BitLicense” in order to do business in the state, Kraken decided to pull out of New York. (Some others took similar action, although today most of the major exchanges, including Coinbase and Gemini, have BitLicenses.) The company then refused to cooperate with a government investigation; Kraken CEO and co-founder Jesse Powell compared the New York state attorney general to “that abusive, controlling ex you broke up with 3 years ago, but they keep coming after you.” (Powell stepped down as CEO in September 2022.) In November, the company paid more than $360,000 to the U.S. Treasury Department to settle allegations that the company had violated sanctions against Iran.
However, the reality is that when it comes to crypto stakes, Kraken looks just like any other major crypto exchange. Coinbase, for example, offers a service called Earn, with an almost identical offering to the one Kraken has just had to shut down. For that reason, Coinbase’s stock began to fall as soon as the SEC’s Kraken decision became public, as this five-day chart shows:
On February 10, Coinbase published a detailed blog post, arguing that crypto-staking is not a security, either under the Securities Act or under the famous Howey test that regulators and courts use to determine whether something is a security or not. At least one of the company’s arguments seems particularly shaky. Coinbase claims that “staking services do not meet Howey’s ‘reasonable expectation of profit’ element.” Not only does the SEC complaint allege the opposite, but it’s clear that’s how the services are being marketed to investors, by Kraken, Coinbase and everyone else. The SEC lately hasn’t been shy about going after Coinbase, and it seems clear that Coinbase’s betting business is in the exact same legal bucket as Kraken’s. It is hard to imagine Coinbase or other exchanges voluntarily shutting down this important aspect of their business. But it’s equally difficult to understand why a company would rather pay a large fine and potentially be forced to shut down its bet business than just go ahead and register it.
