What Is Crypto Staking and Why Is the SEC Cracking Down?

(Bloomberg) — In the latest of a string of actions brought by the US Securities and Exchange Commission, the crypto exchange Kraken agreed to pay $30 million to settle allegations that it broke the agency’s rules by offering a service that allowed investors to earn rewards by “staking” their coins. The SEC is pushing to bring crypto operators within the US under the same regulatory framework that governs the sale of all sorts of securities — to treat the tokens much like stocks and bonds. What’s different from other crackdown efforts is that staking is a central feature of many blockchains such as Ethereum and key to potentially switching other cryptocurrencies away from a system that requires vast amounts of electricity.

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1. What is staking?

It’s depositing Ether or other cryptocurrencies for use in what’s known as a “proof-of-stake” system that helps run a blockchain network by ordering transactions in a way that creates a secure public record. Ethereum in September switched to staking to replace the “proof-of-work” system pioneered by Bitcoin, which continues to use it. Ethereum’s switch was said to cut the network’s energy usage by about 99%, an important step for an industry that has come under fire for the amount of electricity it uses.

2. What are the ‘proof of’ systems for?

Cryptocurrencies wouldn’t work without blockchain, a relatively new technology that performs the old-fashioned function of maintaining a ledger of time-ordered transactions. What’s different from pen-and-paper records is that the ledger is shared on computers all around the world. Blockchain has to take on another task not needed in a world of physical money — making sure that no one is able to spend a cryptocurrency token more than once by manipulating the digital ledger. Blockchains operate without a central guardian, such as a bank, in charge of the ledger: Both proof-of-work and proof-of-stake systems rely on group action to order and safeguard a blockchain’s sequential record.

3. How are the two different?

In both systems, transactions are grouped into “blocks” that were published to a public “chain.” In proof of work, that happens when the system compresses the data in the block into a puzzle that can only be solved through trial-and-error computations that can potentially need to be run millions of time. This work is done by miners who compete to be the first to come up with a solution and are rewarded with new cryptocurrency if other miners agree it works. Proof of stake works by giving a group of people a set of carrot-and-stick incentives to collaborate on the task. An example: People who put up, or stake, 32 Ether (1 Ether traded at around $1,519 on Feb. 10) can become “validators,” while those with less Ether can become validators on Ethereum jointly. Validators are chosen to order blocks of transactions on the Ethereum blockchain.

4. What’s the incentive for staking?

If a block is accepted by a committee whose members are called attestors, validators are awarded new Ether. But someone who tried to game the system could lose the coins that were staked. Typically people who stake their coins are rewarded by earning yields of about 4% for staking-as-a-service users on Ethereum.

5. What’s the SEC’s issue with staking?

Kraken and other centralized providers had been offering “staking as a service,” which lets users stake their coins without buying or maintaining the computers needed for staking. The agency’s action against Kraken makes clear that it considers this to be akin to crypto lending, in which providers would pay crypto depositors high rates of interest for lending out their coins. It’s a practice regulators cracked down on last year, when a slew of lenders like Celsius Network, BlockFi and others collapsed. The SEC considers both crypto lending and staking-as-a-service programs to be securities, a designation that imposes a wide range of regulatory requirements that crypto used to think it was immune from. Kraken agreed to immediately cease offering or selling securities through crypto asset staking services in the US; it didn’t admit or deny allegations in the SEC complaint.

6. What does it mean for something to be a security?

In its most simple form, whether something is or isn’t a security under US rules is basically a question of how much it looks like shares issued by a company raising money. To make that determination, the SEC applies a legal test that comes from a 1946 Supreme Court decision. Under that framework, an asset can be under SEC purview when it involves a. investors kicking in money b. into a common enterprise with c. the intention of profiting from d. the efforts of the organization’s leadership. In staking-as-a-service, users deposit their coins with the expectation of earning a yield on them, while the service provider takes care of the technical side of things.

7. Why does being labeled a security matter?

For starters, such designations may make running a staking-as-a-service program more expensive and complex. Under US rules, the label carries strict investor-protection and disclosure requirements. This burden would put smaller providers at a disadvantage compared to deeper-pocketed competitors. What’s more, exchanges that try to continue offering the service would face continuous scrutiny by regulators, which could lead to fines, penalties and, in a worst case, prosecutions if criminal authorities ever got involved. It could also mean losing future funding from investors who may be skittish of those increased compliance burdens and regulatory scrutiny. Supporters of more regulation believe securities designations would result in more information and transparency for investors — and would ultimately bring more users into the services.

8. What might a crackdown on crypto staking mean?

The crackdown only applies to staking-as-a-service providers focused on US consumers. Blockchains are typically secured by validators from around the world, so they will continue to function, assuming overseas regulators take a more lenient view of their services. This would further the split between heavy regulation in the US and the Wild West in some other parts of the world. There are questions about whether the tightening of regulations surrounding staking will impact so-called decentralized staking providers, which claim to be immune to them because they are not operated by a particular company or based in a particular place; in theory, such providers are just collections of software that execute transactions automatically. But many of these decentralized finance (DeFi) services are actually run by a core group of people whom regulators could potentially still hold responsible for noncompliance.