The SEC’s crackdown on Ethereum stakes has a silver lining

While this year’s price performance for the two largest cryptocurrencies has been impressive, with bitcoin (BTC) up over 46% year-to-date and ether (ETH) up over 37% YTD, the US Securities and Exchange Commission (SEC) has aggressively pursued increased regulation of cryptocurrencies and has sued major cryptocurrency exchanges and custodians.

This aggressive action by US regulators has left many crypto investors worried about the future of the industry. But while worrying, it could actually help the industry by increasing decentralization and providing much-needed clarity.

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When Ethereum completed a successful network upgrade in 2022, moving from a proof-of-work (PoW) blockchain to a proof-of-stake (PoS) network, this created an opportunity for individuals to earn blockchain rewards by running a network validation node and contributes to network security. Under the new PoS mechanism, the Ethereum network is secured by validators instead of miners, and those running a validator can earn rewards paid to them directly by the network, for their help in securing and running the network.

Running a validator on Ethereum requires more technical knowledge than many cryptocurrency investors have, which has led companies to offer “staking-as-a-service” products to retail traders and investors. Kraken, along with others, offered its customers the ability to stake Ethereum collectively, in a mixed staking pool, to generate staking rewards.

While many investors appreciated these services, the SEC did not. Its public complaint states: “Kraken has offered and sold its crypto-asset ‘staking services’ to the general public, where Kraken collects certain crypto-assets transferred by investors and stakes them on behalf of those investors. Staking is a process by which investors unlock – or “stake ” – their crypto tokens with a blockchain validator with the goal of being rewarded with new tokens when their stake crypto tokens become part of the process to validate data for the blockchain. When investors give tokens to staking-as-a-service providers, they lose control over these tokens and take on the risks associated with these platforms, with very little protection.”

The SEC argued that this service, offered by Kraken and others, violates modern securities rules and “staking-as-a-service” products are unregulated securities offerings. Although we have seen many crypto lending products fail (Gemini Earn, Voyager Digital and Celsius Network), crypto betting is quite different from lending, which has led many to push back against the SEC’s requirements.

Staking is actually easier to understand than crypto lending. In particular, outsourced and pooled effort is a process where investors pool their tokens and a centralized entity inserts the pooled tokens into a validator to secure the network. When the pooled assets earn a reward from the network, the controller distributes the earnings to the participants in the pool.

Although crypto lending is seen as a risky endeavor, the effort does not involve lending pooled capital to hedge funds or traders. No leverage is involved and it does not require underwriting or risk management practices seen in asset lending.

Although crypto staking is less complex and risky than crypto lending, the SEC still took issue with the process, effectively shutting down all US-based “staking-as-a-service” product offerings.

So how does this change the Ethereum landscape?

Because Ethereum is now a proof-of-stake blockchain, staking assets in validators is critical for network security and proper functioning.

Because exchanges are not allowed to offer staking services to their customers, none of the Ethereum currently held on exchanges will be able to contribute to network security. To be staked on the network, Ethereum must be withdrawn from exchanges and staked via another method.

While the SEC’s actions have hurt the future of centralized betting services, which many would argue benefits retail investors in the long run, their decisions will ultimately push cryptocurrency to become more decentralized and distributed.

Companies such as Lido and Rocket Pool offer “decentralized” betting services through their platforms. There is also the ability to run an individual node, directly on the Ethereum network – although this requires considerable technical knowledge and, if done incorrectly, can result in the loss of tokens.

The SEC does not have the ability to prevent users from staking ETH tokens themselves or from using a decentralized staking service. Many cryptocurrency advocates believe that these regulations only strengthen the future of cryptocurrencies, by forcing them to follow the principles of decentralization and anonymity from which they came.

While recent regulations limit the number of centralized companies that can contribute to network security, it forces many individuals to pursue more decentralized options. One of the risks with centralized emergency services is that a large institution, or a group of two or three, can gain majority power over the network if their service becomes large enough. This will put the network at risk of centralized control and manipulation. The SEC preventing firms from pooled staking would force individuals to run their own node, which would increase decentralization and network security.

While SEC regulations may temporarily halt crypto-innovation in the financial sector, it is likely to strengthen the use of decentralized finance and increase network decentralization and diversification. True to the very roots cryptocurrency was founded on, SEC regulations appear to force crypto to be truly independent of modern financial systems.