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One of the most powerful innovations in the realm of cryptocurrency is the idea of “staking.” From a consumer standpoint, the idea is similar to an old-fashioned savings account: you own some ether (or other crypto) and you agree to lock it up for a certain amount of time on the blockchain network. Typically, this is done through the exchange, such as Coinbase (COIN), where you bought the crypto. In return, you are paid an interest rate that will vary according to circumstances but is generally going to be much higher than any bank will pay for stashing your cash. To date it’s been a very popular way for investors to make passive income on a crypto investment without having to sell. It’s also part of the blockchain validation process by which crypto networks maintain their security.
The potential downside should be screamingly obvious in the wake of the FTX meltdown. It’s far from clear that even the cleanest crypto exchanges have investors’ best interest in mind when they do whatever they do with these digital assets. And unsurprisingly, while traditional US banks are highly regulated, there is a stunning lack of clarity and oversight in the realm of crypto staking.
That gap took center stage on Thursday, when the Securities and Exchange Commission (SEC) charged Kraken, one of the world’s largest crypto exchanges, with failing to register is staking service as a security. Kraken will shut down staking, and pay $30 million in penalties.
This was no tiny operation. The SEC says:
By April 2022, U.S. investors had over $2.7 billion worth of crypto assets invested in the Kraken Staking Program. Kraken has earned approximately $147 million in net revenue from the Program since its commencement, and a substantial portion of this net revenue—more than $45 million—is attributable to crypto assets obtained from U.S. investors. By June 2022, more than 135,000 unique U.S.-based usernames had transferred crypto assets to participate in the Kraken Staking Program.
The problem, according to the SEC, is that Kraken gives investors next to no information about what is being done with their crypto or what risks they are being exposed to. The agency also notes that while Kraken advertised returns as high as 21% to those who gave up their crypto for staking, the company actually reserved the right to pay less than the advertised rate, or indeed nothing at all (the complaint does not offer an example of Kraken having denied payment to any investor).
It’s tempting to think of Kraken as a kind of renegade outlier in the crypto industry. After all, this is not Kraken’s first brush with regulators. In September 2021, the Commodity Futures Trading Commission fined Kraken $1.25 million for “illegally offering margined retail commodity transactions in digital assets, including Bitcoin.” The CFTC maintained that these transactions could legally only take place inside a designated contracts market, which Kraken isn’t.
A few years earlier, Kraken flagrantly thumbed its nose at regulators in New York State. When the state began requiring crypto exchanges to apply for a “BitLicense” in order to do business in the state, Kraken decided to simply pull out of New York. (A few others took similar action, although today most of the major exchanges, including Coinbase and Gemini, have BitLicenses.) The company then declined to cooperate with a state investigation; Kraken CEO and cofounder Jesse Powell compared the New York attorney general to “that abusive, controlling ex you broke up with 3 years ago but they keep stalking you.” (Powell stepped down as CEO in September 2022.) In November, the company paid more than $360,000 to the US Treasury Department, to settle allegations that the company had violated sanctions against Iran.
The reality, however, is that when it comes to crypto staking, Kraken looks just like every other major crypto exchange. Coinbase, for example, offers a service called Earn, with nearly identical offering to what Kraken has just had to shut down. For that reason, Coinbase’s stock began tumbling as soon as the SEC’s Kraken decision became public, as this five-day chart shows:
On February 10, Coinbase published a detailed blog post, arguing that crypto staking is not a security, neither under the Securities Act nor under the famous Howey test that regulators and courts use to determine whether something is a security or not. At least one of the company’s arguments seems especially shaky. Coinbase claims that “staking services fail to meet Howey’s ‘reasonable expectation of profits’ element.” Not only does the SEC complaint claim the opposite, but it’s clear that this is how the services are marketed to investors, by Kraken, Coinbase and everybody else. The SEC in the past hasn’t been shy about going after Coinbase, and it seems plain that Coinbase’s staking business is in the exact same legal bucket as Kraken’s. It’s hard to imagine Coinbase or other exchanges voluntarily shutting down this major aspect of their business. But it’s equally hard to understand why a company would rather pay a huge fine and potentially be forced to shut down its staking business instead of just going ahead and registering it.
