What investors need to know about crypto “staking”

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Not six months ago, ether led to a recovery in cryptocurrency prices ahead of a major technological upgrade that would make something called “staking” available to crypto investors.

Most people have barely wrapped their heads around the concept, but now the price of ether is falling amid growing fears that the Securities and Exchange Commission may crack down on it.

On Thursday, Kraken, one of the largest crypto exchanges in the world, ended its staking program in a $30 million settlement with the SEC, which said the company failed to register the offering and sale of its crypto staking-as-a-service program. .

The night before, Coinbase CEO Brian Armstrong warned his Twitter followers that the securities regulator might want to more generally end efforts for US retail customers.

“This should take notice of everyone in this marketplace,” SEC Chairman Gary Gensler told CNBC’s “Squawk Box” Friday morning. “Whether you call it lending, earning, giving, whether you offer an annual percentage return – it doesn’t matter. If someone takes [customer] tokens and transfer to their platform, the platform controls it.”

Staking has been seen as a catalyst for mainstream crypto adoption and a major revenue opportunity for exchanges like Coinbase. A breakdown of staking and staking services could have detrimental consequences not only for these exchanges, but also Ethereum and other proof-of-stake blockchain networks. To understand why, it helps to have a basic understanding of the activity in question.

Here’s what you need to know:

What is staking?

Staking is a way for investors to earn passive returns on their cryptocurrency holdings by locking tokens on the network for a period of time. For example, if you decide to stake your ether holdings, you will do so on the Ethereum network. The bottom line is that it allows investors to put their crypto to work if they don’t plan to sell it anytime soon.

How does staking work?

Staking is sometimes referred to as the crypto version of a high-interest savings account, but there is a major flaw in that comparison: crypto networks are decentralized, and banking institutions are not.

Earning interest through stake is not the same as earning interest from a high annual percentage offered by a centralized platform like those that got into trouble last year, like BlockFi and Celsius, or Gemini last month. These offerings were actually more akin to a savings account: people would deposit crypto with centralized entities that lent these funds and promised rewards to depositors in interest (up to 20% in some cases). Rewards vary by network, but generally speaking, the more you bet, the more you earn.

When you stake crypto, however, you contribute to the proof-of-stake system that keeps decentralized networks like Ethereum running and secure; you become a “validator” on the blockchain, meaning you verify and process the transactions as they come through, if chosen by the algorithm. The selection is semi-random – the more crypto you stake, the more likely you will be selected as a validator.

The locking of your funds acts as a kind of security that can be destroyed if you, as a validator, act dishonestly or insincerely.

This only applies to proof-of-stake networks such as Ethereum, Solana, Polkadot and Cardano. A proof-of-work network like Bitcoin uses a different process to verify transactions.

Staking as a service

In most cases, investors don’t want to bet themselves – the process of validating network transactions is just inconvenient at both the retail and institutional levels.

This is where crypto service providers like Coinbase, and formerly Kraken, come in. Investors can give their crypto to the staking service and the service does the staking on behalf of the investors. When using a staking service, the lock period is determined by the networks (like Ethereum or Solana), and not the third party (like Coinbase or Kraken).

That’s also where it gets a little murky with the SEC. On Thursday, the securities regulator charged Kraken with failing to register the offering and sale of crypto-asset staking-as-a-service program.

Although the SEC has not issued formal guidance on what cryptoassets it considers securities, it usually sees a red flag if someone makes an investment with a reasonable expectation of profit that will come from the work or efforts of others.

Coinbase has about 15% of the market share of Ethereum assets, according to Oppenheimer. The industry’s current retail participation rate is 13.7% and rising.

Proof-of-stake vs. proof-of-work

Staking only works for proof-of-stake networks such as Ethereum, Solana, Polkadot and Cardano. A proof-of-work network, like Bitcoin, uses a different process to verify transactions.

The two are simply the protocols used to secure cryptocurrency networks.

Proof-of-work requires specialized computing equipment, such as advanced graphics cards, to validate transactions by solving highly complex math problems. Validators receive rewards for each transaction they verify. This process requires a ton of energy to complete.

Ethereum’s major migration to proof-of-stake from proof-of-work improved energy efficiency by nearly 100%.

Risks involved

The source of return on investment is different from traditional markets. It’s not people on the other side who promise returns, but rather the protocol that pays investors to run the computational network.

Despite how far crypto has come, it’s still a young industry fraught with technological risk, and potential bugs in the code are huge. If the system does not work as expected, it is possible that investors may lose some of their coins.

Volatility is and has always been a somewhat attractive feature of crypto, but it also comes with risk. One of the biggest risks investors face when betting is simply a drop in price. Sometimes a big downturn can cause smaller projects to raise their prices to make a potential opportunity more attractive.