Coinbase: the SEC could ban crypto staking

Yesterday, controversy arose over a tweet by Coinbase co-founder and CEO Brian Armstrong regarding crypto staking.

In fact, Armstrong reports that he has heard rumors about the possibility that the SEC may ask to ban crypto staking for retail users.

1/ We’re hearing rumors that the SEC would like to get rid of crypto staking in the U.S. for retail customers. I hope that’s not the case as I believe it would be a terrible path for the U.S. if that was allowed to happen.

— Brian Armstrong (@brian_armstrong) February 8, 2023

Coinbase, the problem with crypto staking

The issue behind this possible decision by the SEC, as reported by Armstrong from Coinbase, concerns security.

3/ Staking is not a security. Here’s a good primer: https://t.co/G2YLL3IPyo

— Brian Armstrong (@brian_armstrong) February 8, 2023

The SEC, or Securities and Exchange Commission, is the US government agency that is responsible for overseeing the financial markets for securities. And securities in the US are regulated by the Securities Act of 1933, which is the law enacted by the US Congress on 27 May 1933 after the stock market crash of 1929.

Thus if crypto staking is considered a security then the SEC has not only the right but also the duty to intervene to make sure that everything is done in full compliance with the laws.

The US laws regarding securities state that those who sell investment contracts can only do so after the SEC has approved a prospectus.

However, there is no such prospectus for crypto staking, and in any case it would be very difficult to get it approved by the SEC, so if crypto staking were considered an investment contract it would in fact be illegal to offer it as a service.

Investment contracts generally have two distinguishing features: they promise financial returns, and most importantly, they require the customer to simply invest money. That is, customers who sign an investment contract because they hope to earn a financial return are not asked to do anything other than hand over money to the issuer of the contract.

The problem for crypto staking is: should it be considered an investment contract?

What is crypto staking

Staking crypto involves locking tokens on a validator node to participate in the process of validating new blocks that contain transactions to be recorded on the blockchain. In return, one receives a portion of the fees paid by the senders of those transactions, or sometimes even a small reward from the creation of new tokens.

theoretically, those who set up their own validator node, and deposit their tokens there, do not sign any contract with anyone.

In other words, there is no one asking them for money promising them a return. Therefore, it is really very difficult to imagine that such a transaction could be equated with signing an investment contract.

However, the vast majority of people staking cryptocurrencies do not do so on their own node, but send their tokens to a node manager in exchange for the promise of getting a return.

For example, right now the APR of ETH staking is 5.3% per year, so on average those who have ETH staked on Ethereum’s new blockchain receive a reward in ETH every 12 months equal to 5.3% of the ETH staked.

This type of investment is only possible for those blockchains based on Proof-of-Stake (PoS), whereas it is not possible on, for example, Bitcoin and all those blockchains based on Proof-of-Work (PoW).

Ethereum switched from PoW to PoS in September last year.

So there are two ways to do crypto staking: either by yourself, on your own validator node, or by handing over your tokens to a validator node manager who in return returns a portion of the proceeds.

Why staking could be a security

The problem therefore lies precisely in this second method.

Indeed, by sending one’s tokens to a validating node manager in exchange for a portion of the proceeds, both of the features peculiar to investment contracts occur.

The node manager promises a financial return to the investor, and the investor simply gives his tokens.

So the issue raised by the CEO of Coinbase specifically concerns all those many services, often offered by exchanges themselves, that offer returns in exchange for staking investment.

Apparently the SEC is reportedly intent on intervening to try to block the provision of these services to retail investors, i.e., private citizens who are not financial professionals, and perhaps even to force those who offer this service to professional investors to register their investment contracts with the agency.

The problems that crypto staking could cause Coinbase

Should the SEC succeed in getting such a rule passed, the multitude of crypto exchanges and platforms that offer the staking service to their users would have to stop providing it, particularly to users in the United States. There is also a risk that other similar agencies around the world would do the same in other countries.

However, it should not affect those who are staking on their own with their own validator node, but it is not at all easy to get a validator node working properly. Moreover, for example, 32 ETH are required to activate a node on Ethereum, which has a current countervalue of over $52,000.

For this reason, the operation of PoS-based blockchains should not be affected by such a decision, for indeed the number of validator nodes paradoxically might even increase.

It would instead be prohibited in the US to be able to participate in staking without owning a node.

Coinbase would be the first exchange to have to stop providing staking service to its customers.

Lido’s boom

However, there is a sort of exception to this reasoning.

Some services that offer staking are decentralized, that is, not provided by a financial intermediary that has legal obligations.

It is not yet clear whether any new legislation against retail crypto staking will apply to decentralized services as well, but even if it did, it would be very difficult to enforce, not least because these are services that are used anonymously and not geolocated.

The largest provider of these decentralized staking services is Lido, which to date is already the largest holder of staked ETH: 4.2 million, compared to Coinbase’s 2 million which is in second place, and Kraken’s 1.1 which is in third.

Hence it is hardly surprising that today Lido DAO’s governance token, LDO, is gaining 3% while the rest of the crypto market is languishing or even suffering a bit. For example, Ethereum is losing 2% today.

Incidentally during its two and a half years of existence, LDO’s price has always fluctuated between $0.5 and $5, with rare and brief exceptions above and below these thresholds. Therefore, this could benefit greatly should the SEC succeed in passing a ban on offering crypto staking to retail customers.

In light of this data, it is also not surprising that Coinbase itself is trying to fight against such a decision, whereas Lido does not seem to care.

This matter, if nothing else, once again demonstrates how much more resilient decentralized services can be when they work well and allow for P2P logic to bypass financial intermediaries.