A lucrative corner of crypto that’s fast becoming the lifeblood of the way many networks operate got a shock to the system this week.
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Published Feb 11, 2023 • 5 minute read
(Bloomberg) — A lucrative corner of crypto that’s fast becoming the lifeblood of the way many networks operate got a shock to the system this week.
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The US Securities and Exchange Commission on Thursday signaled a crackdown on platforms offering rewards to their customers via a process called staking, as it reached a settlement with trading platform Kraken for $30 million and won agreement from the exchange to shut down those offerings domestically. It’s possible other providers such as larger rival exchange Coinbase Global Inc. may feel the heat and follow suit in discontinuing their own staking services, experts said — or move them offshore.
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Staking allows users to lock up their coins on blockchains and help order the transactions that keep the protocols running, earning yields in return at an average of 7.7%, according to an estimate by data provider Staking Rewards based on 176 tracked assets.
The “proof-of-stake” method for running a network became a popular choice for developers in recent years, because it uses much less energy than so-called proof-of-work chains like Bitcoin and potentially allows more people to share in the rewards. Networks including Ethereum, Solana, Tezos, Cosmos and Polygon all rely on some version of staking to operate their chains, with Staking Rewards putting the global value of all staked assets at $91.8 billion as of Friday.
Large exchanges like Kraken, Coinbase and Binance are at the heart of the staking-as-a-service industry, taking on the significant upfront cost and technical know-how for customers in return for a fee. Coinbase, one of the biggest providers of staking-as-a-service at $3.3 billion in value locked, was previously forecast to be in line for around $450 million in related revenue this year.
The enforcement action against Kraken “may cause all retail-focused and US-based staking-as-a-service businesses to shut down their operations,” Christine Kim, research associate at Galaxy Digital, wrote in a note Friday, adding that Kraken and Coinbase account for nearly 20% of all staking on Ethereum combined. “If the recent enforcement action by the SEC is, as it appears, targeted against all staking-as-a-service businesses in the US, this will have wide-reaching impacts” on proof-of-stake blockchains, she said.
While Ethereum is the most well-known proof-of-stake network, it’s the smaller blockchains like Solana that may be hit the hardest by a sudden exit of big centralized exchanges from the US market. Staking is what makes these networks run smoothly, facilitating millions of transactions and also helping to improve security.
The price of SOL, Solana’s native token, fell as much as 9.15% on Thursday following the SEC’s announcement.
There are other staking providers — less centralized services that claim to avoid concentrating oversight under a specific group, person or exchange — but their interfaces aren’t user-friendly enough for many everyday investors.
- Read: US Staking Crackdown Seen as ‘Gift’ for Decentralized Services
“If US crypto exchanges are not able to do custodial staking, we might see much more trend towards decentralization and self-custody,” added Lex Sokolin, chief crypto economist at Consensys. “However, that will also make it more difficult for very small accounts to participate in the security of networks, which is something we want.”
Such platforms would need to rapidly improve their onboarding processes in order to keep up without a Coinbase or Kraken around, said Conor Ryder, an analyst at blockchain analytics firm Kaiko.
There is a question of whether the SEC will target other exchanges like Coinbase that offer staking to customers. Eagle-eyed analysts, lawyers and policy experts pored over SEC Chair Gary Gensler’s Thursday announcements, and largely came to the conclusion that it’s more a matter of how Kraken marketed its staking than the practice itself that is at issue.
Specifically, the SEC alleged that Kraken’s terms of service transferred complete control of all staked tokens to the exchange and allowed it to “determine these returns, not the underlying blockchain protocols” at its sole discretion. It also didn’t allow customers to have any insight into its overall financial health, which would help them make informed decisions about how likely it was that Kraken would pay the market-beating returns it advertised.
As a publicly traded company, Coinbase provides such financial disclosures on a quarterly basis, Paul Grewal, its chief legal officer, said in a series of tweets on Thursday. “We don’t play games,” he said. “Our customers have a right to their rewards. We can’t just decide not to pay any rewards at all.”
Galaxy Digital’s Alex Thorn, however, doesn’t see it the same way. “While Coinbase’s CLO refers to some of the specifics of Kraken’s program and argues that it’s those specifics that made Kraken’s product a security and not Coinbase’s, it appears both from the complaint and the press release that the SEC isn’t making such a distinction,” Thorn said.
Access to revenue from staking services is vital for exchanges such as Coinbase at the moment, stuck in a bear-market environment where low volumes and increased competition have served to crimp the trading fees earned from general crypto buying and selling. Platforms like Binance have sought to mop up what’s left of consumer demand by reducing such fees to zero, placing the burden on other revenue streams to fill the gap.
“An SEC settlement with Kraken, shuttering its staking operation, puts this entire growth pillar at risk for Coinbase,” said Bloomberg Intelligence analysts Paul Gulberg and Jamie Douglas Coutts in a note Friday. Coinbase shares fell 14% on Thursday, and Gulberg and Douglas Coutts forecast a 35% downside to its predicted staking revenue this year.
The unintended result of Gensler’s crackdown could see some validators move offshore in order to continue servicing non-US customers, a transition that would likely cause increased risk of consumer harm if investors are tempted to access non-regulated products, according to Ryder.
“This is only going to hurt US businesses that are involved in crypto, this isn’t going to do much to protect the average investor,” he said, adding that he doesn’t believe staking rewards meet the requirements needed to be categorized as securities. “At the end of the day, I don’t think the SEC has much jurisdiction here, and it’ll just be something that will harm US customers and see the innovation move to Europe and Asia.”
—With assistance from Olga Kharif.