What is crypto staking and why did the SEC go after Kraken for it?

1. What is staking?

It deposits ether or other cryptocurrencies for use in a so-called “proof-of-stake” system, which helps run a blockchain network by arranging transactions to create a secure public record. Ethereum switched to staking in September to replace the “proof-of-work” system developed by Bitcoin, which it continues to use. The Ethereum switch is expected to reduce network energy use by about 99%, a major step for an industry that has come under fire for its power consumption.

2. What are the “Proof of” systems for?

Cryptocurrencies wouldn’t work without blockchain, a relatively new technology that performs the old-fashioned function of keeping a ledger of time-ordered transactions. It differs from pen and paper records in that the ledger is shared on computers around the world. Blockchain must perform one more task that isn’t needed in a world of physical money – ensuring that no one can spend a cryptocurrency token more than once by manipulating the digital ledger. Blockchains function without a central custodian, like a bank responsible for the ledger: both proof-of-work and proof-of-stake systems rely on group actions to order and protect a blockchain’s sequential record.

3. How are the two different?

In both systems, transactions are grouped into “blocks” that have been published on a public “chain”. In proof-of-work, this happens when the system compresses the data in the block into a puzzle that can only be solved through trial-and-error calculations that may need to be performed millions of times. This work is done by miners who compete to be the first to find a solution and are rewarded with new cryptocurrency if other miners agree it works. Proof of Stake works by giving a group of people a set of carrot-and-stick incentives to work together on the task. For example, people who post or stake 32 ethers (1 ether traded at around $1,519 on Feb 10) can become “validators,” while those with fewer ethers can collectively become validators on Ethereum. Validators are chosen to order blocks of transactions on the Ethereum blockchain.

4. What is the incentive for staking?

When a block is accepted by a committee whose members are called attestors, the validators receive new ether. But someone who tried to play the system could lose the coins wagered. Typically, people who stake their coins are rewarded with a return of around 4% for staking-as-a-service users on Ethereum.

5. What is the SEC’s problem with staking?

Kraken and other centralized providers offered staking as a service, allowing users to stake their coins without having to purchase or maintain the computers required for staking. The agency’s crackdown on Kraken makes it clear that it views this as a form of crypto lending, where vendors would pay crypto depositors high interest rates to loan their coins. It’s a practice regulators cracked down on last year when a number of lenders like Celsius Network, BlockFi, and others collapsed. The SEC considers both crypto lending and staking-as-a-service programs to be securities, a designation that imposes a variety of regulatory requirements that crypto used to believe it was immune to. Kraken Agreed to Immediately Stop Offering or Selling Securities on Crypto Asset Staking Services in the US; Allegations in the SEC complaint were neither admitted nor denied.

6. What does it mean when something is a security?

At its simplest, it’s basically a question of whether or not something is a security under US rules, how much it looks like stock issued by a company raising money. To make this determination, the SEC uses a legal test derived from a 1946 Supreme Court decision. Under this framework, an asset may fall under the jurisdiction of the SEC if it: a. Investors who put money in b. into a joint venture with c. the intention to benefit from it d. the efforts of the organizational leadership. With staking-as-a-service, users deposit their coins with the expectation of earning a return while the service provider takes care of the technical side of things.

7. Why is security marking important?

First of all, such designations can make running a staking-as-a-service program more expensive and complex. Under US regulations, the label is subject to strict investor protection and disclosure requirements. This burden would put smaller providers at a disadvantage compared to financially strong competitors. Additionally, exchanges attempting to continue offering the service would face constant scrutiny from regulators, which could result in fines, penalties, and in the worst case scenario, prosecution if the criminal authorities ever got involved. It could also mean losing future funding from investors who may be skeptical in the face of these heightened compliance burdens and regulatory scrutiny. Proponents of more regulation believe that labeling securities would lead to more information and transparency for investors – and ultimately bring more users to the services.

8. What Could a Crackdown on Crypto Staking Mean?

The crackdown only applies to staking-as-a-service providers that focus on US consumers. Blockchains are typically secured by validators from around the world, so they will continue to work provided foreign regulators are more lenient on their services. This would further fuel the split between heavy regulation in the US and the Wild West in some other parts of the world. The question is whether the tightening of staking regulations will affect so-called decentralized staking providers who claim to be immune because they are not operated by a specific company or based in a specific location; In theory, such providers are just collections of software that execute transactions automatically. But many of these decentralized finance (DeFi) services are actually run by a core group of people who could still potentially hold regulators accountable for non-compliance.

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