Beware The Kraken: SEC Forces Kraken To End Crypto Staking

February 14, 2023
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The crypto exchange has agreed to pay $30m and end its crypto staking programme to settle an investigation by the US Securities and Exchange Commission (SEC).

  • Kraken staking programme is a security, SEC says
  • Rival Coinbase defends staking amid share fall

Crypto exchange Kraken has agreed to pay $30m and end its crypto staking programme to settle an investigation by the US Securities and Exchange Commission (SEC).

In a case that some fear could have a wider impact on crypto staking activities in general, the SEC alleges that Kraken’s staking programme is a security and the company failed to register it with the agency.

Staking is a process in which investors lock up their crypto tokens with a blockchain validator with the goal of being rewarded with new tokens when their staked crypto tokens become part of the process of validating data for the blockchain.

As it requires significant commitments from token holders and they may not receive a reward even if they stake, crypto businesses started to offer staking-as-a-service which pools the tokens and shares the returns with holders.

From 2019, Kraken began offering a staking programme with a 21 percent reward. By June 2022, around 135,000 US token holders transferred their crypto worth $2.7bn in the Kraken staking programme.

The SEC now claims that Kraken’s staking programme is an unregistered security which was marketed and sold as an investment opportunity to earn a high return.

As Kraken did not register these sales with the SEC, the company was not obliged to disclose material information such as its fees, financial condition, profits and detailed risks of the investment.

The regulator also criticised Kraken for transferring the staked tokens into a pool and designated some for staking and others as a liquidity reserve.

When users transfer their tokens to Kraken, the SEC said they lost control of those tokens and took on risks associated with those platforms with very little protection.

“Investors have had no insight into [Kraken’s] financial condition and whether [Kraken] has the means of paying the marketed returns - and indeed, per the Kraken Terms of Service, [Kraken] retains the right not to pay any investor return,” the complaint says.

SEC chair Gary Gensler said the 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”.

The move was nonetheless criticised by SEC commissioner Hester Peirce, who disagreed with the agency’s decision.

Peirce, who serves as one of the two Republican commissioners at the SEC and often speaks out against the SEC’s approach to crypto, said the agency should have put out guidance on staking rather than regulating by enforcement.

“Instead of taking the path of thinking through staking programs and issuing guidance, we again chose to speak through an enforcement action,” Peirce claimed.

This is “a not efficient or fair way of regulating”, the commissioner said, adding that staking services are not uniform, “so one-off enforcement actions and cookie-cutter analysis does not cut it”.

Kraken was the first crypto exchange to get a banking licence in the US. The company said at the time that its Wyoming-state licence will enable it to offer a wide range of banking services and get access to the federal payments system, a goal that no crypto firm has achieved to date.

According to CoinMarketCap, it is the third largest crypto exchange by trade volume after Binance and Coinbase.

Kraken did not admit wrongdoing and the company clarified in a blog post that the SEC action concerns only US users' ability to participate in staking.

New precedent set

Although the case is already noteworthy because of the significance of the parties involved, it also provides insights into the SEC’s approach to yet another segment of the crypto space.

“It looks like another precedent type of case that is further clarifying the regulatory framework around crypto,” Jim Preissler, chief strategy officer at SOMA.finance, told VIXIO.

The SEC has previously hit many key categories such as unregistered securities issuance, promotion activities, earn and yield products, and now staking, Preissler pointed out while noting that the SEC’s move did not come as a total surprise.

“It's not like the SEC didn’t fully telegraph this move across all these categories with official pronouncements and public statements. Most just refused to engage with regulators … and now this is the consequence."

“Working with other people’s money is a highly regulated industry and it should be. Providers of all products — crypto or otherwise — need to work within the system," Gene Grant, CEO of LevelField, added.

Grant stressed that all firms that offer financial products and services in the US must do so in accordance with the existing, complex mixtures of rules and regulations.

“The cryptocurrency proponents must view their activities within the context of existing financial services and structure the offerings to work within the system.”

“The technology developments that allow cryptocurrency to exist, and the benefits that cryptocurrency presents to users, do not lift the asset class above the requirements to comply with the existing laws and regulations,” according to Grant.

Kraken case impact spills over to other staking programmes

The crackdown on Kraken’s staking programme had an impact on rival crypto platform Coinbase whose shares fell 16 percent since the announcement was made public.

Although the SEC case suggests staking programmes are security, Brian Armstrong, CEO of rival crypto exchange Coinbase, went on to Twitter to say an SEC crackdown on staking “would be a terrible path for the US”.

“Staking is not a security”, according to Armstrong, who has a vested interest in this issue as Coinbase also offers staking programmes.

“Staking is a really important innovation in crypto.”

“Staking brings many positive improvements to the space, including scalability, increased security, and reduced carbon footprints,” Armstrong said.

He shared Peirce’s views that “regulation by enforcement doesn’t work”.

“It encourages companies to operate offshore, which is what happened with FTX.”

Coinbase chief legal officer Paul Grewal was also trying to tame the fall of the exchange’s share price, emphasising that its staking services “are fundamentally different“ from that of Kraken.

Grewal argues that one of the key differences is that Coinbase customers have a right to their rewards.

“We can’t just decide not to pay any rewards at all.”

Additionally, in Coinbase’s staking programme, customers’ staked assets always remain theirs and are accounted for transparently in regular public audits.

“Our finances are a matter of public record. We provide deep insights into those finances every quarter.”

“Rules making clear these distinctions would provide real clarity to the industry and our customers,” Grewal stressed.

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