In the latest of a series of actions brought by the US Securities and Exchange Commission, crypto exchange Kraken agreed to pay $30 million to settle allegations that it violated the agency’s rules by offering a service that allowed investors to earn rewards by to “bet” their coins. The SEC is pushing to bring crypto operators within the United States under the same regulatory framework that governs the sale of all kinds of securities — to treat tokens much like stocks and bonds. What’s different from other mining efforts is that staking is a central feature of many blockchains like Ethereum and the key to potentially switching other cryptocurrencies away from a system that requires massive amounts of electricity.
What is Crypto Staking and Why is the SEC Cracking Down?
It is staking Ether or other cryptocurrencies for use in what is known as a “proof-of-stake” system that helps run a blockchain network by ordering transactions in a way that creates a secure public record. Ethereum switched in September to efforts to replace the “proof-of-work” system developed by Bitcoin, which continues to use it. Ethereum’s switch was said to cut the network’s energy use by about 99%, an important step for an industry that has come under fire for the amount of electricity it uses.
2. What are the “proof of” systems for?
Cryptocurrencies would not work without blockchain, a relatively new technology that performs the old-fashioned function of maintaining a ledger of time-ordered transactions. What differs from pen-and-paper records is that the ledger is shared on computers around the world. Blockchain must take on another task that is not necessary in the world of physical money – making sure that no one is able to use a cryptocurrency token more than once by manipulating the digital ledger. Blockchains operate without a central guardian, such as a bank, in charge of the ledger: Both proof-of-work and proof-of-stake systems rely on group action to order and secure a blockchain’s sequential record.
3. How are the two different?
In both systems, transactions are grouped into “blocks” that are published to a public “chain”. Proof of work happens when the system compresses the data in the block into a puzzle that can only be solved through trial-and-error calculations that could potentially need to be run millions of times. This work is done by miners who compete to be the first to come up with a solution and are rewarded with new cryptocurrency if other miners agree that it works. Proof of Stake works by giving a group of people a set of carrot-and-stick incentives to cooperate on the task. An example: People who put up, or stake, 32 Ether (1 Ether traded at around $1519 on February 10th) can become “validators”, while those with less Ether can become validators on the Ethereum community. Validators are elected to order blocks of transactions on the Ethereum blockchain.
4. What is the incentive for effort?
If a block is accepted by a committee whose members are called attestors, validators are awarded new Ether. But someone who tried to game the system could lose the coins that were bet. Typically, people who stake their coins are rewarded by earning a return of around 4% for users who use Stake as a Service on Ethereum.
5. What is the SEC’s problem with staking?
Kraken and other centralized providers had offered “staking as a service,” which allows users to stake their coins without buying or maintaining the computers needed for staking. The agency’s action against Kraken makes it clear that it considers this to be akin to crypto lending, where providers would pay crypto depositors high interest rates to lend their coins. It’s a practice regulators cracked down on last year, when a number of lenders such as Celsius Network, BlockFi and others collapsed. The SEC considers both cryptolending and staking-as-a-service programs to be securities, a designation that imposes a wide range of regulatory requirements that crypto used to think it was immune to. Kraken agreed to immediately cease offering or selling securities through cryptoasset betting services in the United States; it did not admit or deny allegations in the SEC complaint.
6. What does it mean that something is a security?
In its simplest form, whether or not something is a security under US rules is basically a question of how much it looks like stock issued by a company raising money. To make that determination, the SEC uses a legal test that comes from a 1946 Supreme Court decision. Under this framework, an asset can be subject to SEC purposes when it involves a. investors who kick in money b. into a joint venture with c. the intention of profiting from d. the effort of the organization’s management. In staking-as-a-service, users stake their coins with the expectation of making money from them, while the service provider takes care of the technical side of things.
7. Why is it a matter of security to be stamped?
First, such designations can make running a staking-as-a-service program more expensive and complicated. Under US regulations, the brand has strict investor protection and disclosure requirements. This burden will put smaller providers at a disadvantage compared to competitors with deeper pockets. In addition, exchanges that try to continue to offer the service will face ongoing scrutiny by regulators, which could lead to fines, penalties and, in the worst case scenario, prosecution if criminal authorities were ever involved. It could also mean losing future funding from investors who may be scared off by these increased compliance burdens and regulatory scrutiny. Proponents of more regulation believe securities designations will result in more information and transparency for investors – and ultimately will bring more users into the services.
8. What could a crypto stake breakdown mean?
The requirement only applies to staking-as-a-service providers with a focus on US consumers. Blockchains are usually secured by validators from around the world, so they will continue to function, assuming foreign regulators take a more lenient view of their services. This will further the divide between heavy regulation in the US and the wild west in some other parts of the world. There are questions about whether the tightening of the regulations around staking will affect so-called decentralized staking providers, who claim to be immune from them because they are not run by a particular company or based in a particular place; in theory, such providers are just collections of software that perform transactions automatically. But many of these decentralized financial services (DeFi) are actually run by a core group of people who regulators could potentially still hold accountable for non-compliance.
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