Well hello again, and Happy Valentine’s Day! Sorry for the long hiatus, but glad to be back with this piece from Nathan, who is too modest to call himself Mr. Crypto…but if the shoe fits…. Not saying I always understand what he says, but it’s nice to have him as an incredible resource for this important and growing aspect of our financial services world. – Alan
Over the years, this blog has not shied away from calling out FINRA or the SEC for regulating via enforcement actions rather than providing formal guidance. Well, the SEC did it again last Thursday with a complaint filed against Kraken, a cryptocurrency exchange that offered staking-as-a-service. Under the terms of the settlement that was announced on the same day, the company agreed to pay a $30 million fine for failing to register its staking program as a security.
So, what is staking and why does the SEC have a problem with staking-as-a-service?
Staking is a process in which a cryptocurrency holder locks up (remember this part!), or “stakes,” its cryptocurrency tokens with a blockchain network to validate transactions and secure the network. In exchange for providing/locking up the tokens, the holder is rewarded with newly minted tokens and/or a percentage of transaction fees. Staking is one of several consensus mechanisms used to validate transactions and secure blockchain networks, and it is the main alternative to the proof-of-work consensus mechanism used by networks like Bitcoin.
Staking-as-a-service is a business model where a company pools funds from multiple stakers and uses them to participate in the validation of transactions on a blockchain network. The service is marketed as a way for individuals to participate in blockchain networks and earn rewards without having to operate their own node or perform the technical tasks (or meet the financial minimums) required for staking. One reason for the creation of staking-as-a-service is that some protocols require a substantial amount of capital to participate in the validation process. Ethereum, for example, requires each validator to have a minimum of 32 ETH (approximately $50,000). This keeps smaller retail investors from participating in the validation process and earning yield from their Ethereum holdings. Enter a company like Kraken. By providing staking-as-a-service, smaller retail investors could pool their tokens together, satisfying the threshold for participation.
The SEC complaint took issue with Kraken for two principal reasons. First, the SEC concluded that Kraken’s approach to staking-as-a-service operated as an unregistered security. The interpretation of whether staking-as-a-service constitutes a security will often depend on the specifics of each staking service. Here, Kraken’s service may have fallen under the SEC’s definition of a security under Howey because Kraken smoothed out the returns promising a set rate of return rather than simply facilitating retail users participation as a validator. If Kraken had simply passed through the reward provided by the protocol for validating transactions, it may not have drawn the same regulatory ire.
Second, the SEC focused on a lack of disclosure; a common refrain from the regulators regardless of whether they are focused on crypto, traditional securities or alternative investments. SEC Chairman Gary Gensler said Thursday following the settlement announcement, “Today’s action should make clear to the marketplace that staking-as-a-service providers must register and provide full, fair, and truthful disclosure and investor protection.” Given that securities laws in the U.S. are largely disclosure-focused, it’s no surprise that disclosure was a focus.
But what about the requirement to register? Has the SEC outlined or described a way for crypto firms to properly register their tokens, products or services? No, and this has been a source of frustration for the industry, which has been clamoring for clear regulations for years. Yet, despite repeated calls for guidelines, the SEC has remained stubbornly opaque, choosing instead to enforce its views through enforcement actions again and again.
Following the settlement another SEC Commissioner, Hester Peirce, colloquially known as “Crypto Mom” for her vocal support for the nascent industry, dissented from the Kraken Complaint. In that dissent, she highlighted the fact that there is no specific means to register this kind of service nor is there any guidance as to what disclosures are necessary to comply with the SEC’s interpretation of existing rules. She also said:
Most concerning, though, is that our solution to a registration violation is to shut down entirely a program that has served people well. The program will no longer be available in the United States, and Kraken is enjoined from ever offering a staking service in the United States, registered or not. A paternalistic and lazy regulator settles on a solution like the one in this settlement: do not initiate a public process to develop a workable registration process that provides valuable information to investors, just shut it down.
On Friday, Gensler made the rounds on various cable business networks to discuss the Kraken settlement and made registration seems as simple as filing the right paperwork. CEO of Kraken, Jesse Powell, did not hold back his frustration with this seemingly disingenuous framing. Echoing Commission Peirce’s dissent, he tweeted:
To recap, the SEC fined Kraken for failing to properly register (without outlining the method for registration) and it criticized Kraken’s lack of disclosures (again without providing guidance on what those disclosures required). Was there anything else the SEC did?
Remember I told you to remember how staking requires the tokens to be locked up? Under the current Ethereum staking program, once the tokens are locked in, they cannot be withdrawn until some undetermined future time when Ethereum goes through another network upgrade. Presently, that upgrade is not expected to occur for another year or two. So, say you’re a user who deposited your Ethereum tokens with Kraken’s staking-as-a-service to earn yield. The SEC just ordered that program be shut down. Kraken can’t pay yield under the program. Kraken also can’t get the tokens back from the Ethereum protocol to return to the user. How are those users made whole? Will they still earn yield for their locked coins? How will they get paid? The SEC hasn’t addressed that but I’m sure they’ve got “investor protection” at the front of mind. Right?
 SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Although the Supreme Court has outlined other test/standards for determining what constitutes a security (see e.g. Reves v. Ernst & Young, 494 U.S. 56 (1990)), the main test for crypto-projects remains the Howey test.
 See, e.g., Sec. & Exch. Comm’n v. LBRY, Inc., 21-cv-260-PB, (D.N.H. Nov. 7, 2022).