Blogs from February, 2023

SEC v Kraken's Staking Service Program

R Tamara de Silva

Today the Securities and Exchange Commission (SEC) charged Payward Ventures and Payward Trading, part of Kraken, with failing to register the offer and sale of securities through their crypto asset staking program. Both companies, without admitting or denying the allegations, have consented to a final judgment that would permanently enjoin them from offering staking services to their customers. They have agreed to pay $30 million to settle the charges and to immediately stop offering asset staking services and programs, which the SEC deems to be the unregistered offer and sale of securities.

Through this enforcement action, the SEC is declaring that staking-as-a-service program providers must register their programs as securities offerings with the SEC and provide full, fair, and truthful disclosure and investor protection. This case has ramifications for all other centralized crypto platforms that offer staking for payment or rewards programs-like Coinbase. It may force retail investors who want to be paid for staking their crypto assets to go to offshore centralized cryptocurrency exchanges. But it may also be the beginning of when the SEC addresses some of the inherent weaknesses of centralized crypto exchanges.

Proof of Stake (PoS)

Proof of Stake (PoS) and Proof of Work (PoW) are two different methods used to secure some blockchains and validate transactions on a cryptocurrency network.

Proof of Work is a method used by some cryptocurrencies, such as Bitcoin, to validate transactions and add new blocks to the blockchain. In PoW, individuals or organizations, known as miners, use specialized computer equipment to perform complex calculations in order to validate transactions and add new blocks to the blockchain. The miner that successfully completes the calculation first is rewarded with cryptocurrency. This process consumes a significant amount of energy and computing power, making it both expensive and environmentally harmful.

Staking, on the other hand, is a method used by some cryptocurrencies, such as Ethereum, to validate transactions and add new blocks to the blockchain. In staking, individuals or organizations hold, or "stake," a certain amount of cryptocurrency as collateral in exchange for the right to validate transactions and earn rewards. The likelihood of being selected to validate transactions and earn rewards is proportional to the amount of cryptocurrency that an individual or organization has staked. This process consumes significantly less energy and computing power compared to PoW.

In a proof-of-stake (PoS) cryptocurrency network, staking is the process of holding or "staking" a certain amount of cryptocurrency as collateral in exchange for the right to validate transactions and earn rewards.

Simply put, staking is like putting your digital money in a special "lockbox" for a certain amount of time to help make the network work better. In exchange for staking your digital money, you can earn rewards. Think of it like leaving your money in a savings account and earning interest. The more digital money you stake, the more rewards you can earn. But unlike with a savings account with a U.S. bank, your savings deposits are not insured by the Federal Deposit Insurance Corporation (FDIC).

Cryptocurrency exchanges can make money by allowing their customers to stake their crypto assets on the exchange. This is because staking often requires a certain minimum amount of cryptocurrency to be held for a certain period of time. By holding the staked assets on the exchange, the exchange can earn a portion of the rewards generated by the staking process.

For example, suppose an exchange allows its customers to stake their Ethereum (ETH) on the exchange. The exchange would hold the staked ETH and earn a portion of the rewards generated by the staking process. The exchange would then share a portion of these rewards with its customers, often in the form of reduced trading fees or other incentives.

According to the SEC complaint, since Kraken started its Kraken Staking Program in December 2019, it staked over $2.7 billion worth of crypto assets and earned $147 million in revenue or which $45.2 million was attributable to U.S. investors.  Complaint at 68

Risks for customers

In terms of risks, the staking of assets on a centralized cryptocurrency exchange include:

Security Risks: Centralized cryptocurrency exchanges are vulnerable to hacking and other security breaches. If a hacker is able to access an exchange's staking system, they may be able to steal or manipulate the staked assets. This could result in significant financial losses for customers.

Counterparty Risk: When customers stake their assets on a centralized cryptocurrency exchange, they are relying on the exchange to secure their assets and manage the staking process. If the exchange fails to do so, customers may suffer losses. For example, if the exchange goes bankrupt or experiences a technical failure, customers may lose their staked assets.

Lack of Control: When customers stake their assets on a centralized cryptocurrency exchange, they give up control over their assets. The exchange is responsible for managing the staking process and distributing rewards. If the exchange fails to do so, customers may not receive the full benefits of staking or may receive rewards that are lower than expected.

Lack of Transparency: Centralized cryptocurrency exchanges may not provide full transparency into their staking operations. This can make it difficult for customers to assess the stability and security of the exchange, as well as the expected returns from staking.

Regulatory Risks: Staking on centralized cryptocurrency exchanges may also be subject to regulatory risk. The events of today are a case in point...

Regulatory takeaways

What is particularly interesting in the SEC complaint are the references to the lack of disclosures, (disclosures all other regulated centralized exchanges in the U.S. already make) of Kraken’s Staking Program related to two of critical topics, the commingling of customer funds and transparency,

Defendants’ public disclosures have contained selective or no information about Defendants’ financial history, audited financial statements, management discussion and analysis of financial condition…Nor do Defendants disclose what they do with “unstaked” tokens, the extent to which Defendants are staking investor tokens, whether Defendants are lending, borrowing, trading, or otherwise alienating investor tokens into some enterprise other than staking protocols, whether and to what extent Defendants are commingling “unstaked” tokens with other assets, Complaint At 85.

Until centralized crypto exchanges and platforms address transparency of financial condition and the segregation and commingling of customer assets, they will remain behind all other centralized and regulated U.S. exchanges in customer protection.

R Tamara de Silva