On February 9th, Kraken agreed to pay $30 million in penalties to the U.S. Securities and Exchange Commission (SEC) for failing to register the offer and sale of their staking-as-a-service program. They were also permanently banned from offering a U.S. staking program.
The SEC’s enforcement action has given the industry some clarity about how not to design compliant staking offerings – but the question of what compliant offerings must do remains uncertain. Today, we unpack the key elements of the SEC’s complaint and action.
What is staking and staking-as-a-service (STaaS)?
Staking is the process by which proof-of-stake blockchain networks, like Ethereum, run. In it, market participants act as “validators” by locking their cryptocurrency in a smart contract on that token’s native blockchain.
These validators are then chosen at random to verify new sets (or “blocks”) of crypto transactions. When a validator is chosen to verify a block and does so successfully, they receive rewards denominated in the cryptocurrency they staked as compensation for securing the network.
Staking-as-a-service providers enable users to participate in staking without having to stake that blockchain’s minimum amount of cryptocurrency required or operate the multiple pieces of software needed to become a blockchain validator.
Staking service vary widely in their implementation. Some staking platforms are custodial, others are non-custodial, and still others are non-custodial and “liquid.” The non-custodial liquid staking protocol Lido finance, for example, issues one “Lido Staked Ether” ($stETH) for every Ether ($ETH) a user stakes on its platform, providing capital efficiency on that user's staked Ether liquidity. Lido Staked Ether tokens typically trade at a small discount to Ether.
Staking-as-a-service programs cater both to retail users, who can deposit token amounts below the blockchain’s technically required minimum, and to institutional users, who benefit from enterprise-grade custody and the outsourcing of engineering resources.
What were the SEC’s claims against Kraken?
The SEC claimed that Kraken’s staking-as-a-service program qualified as an investment contract and thus violated Sections 5(a) and 5(c) of the Securities Act of 1933. These sections require that issuers of securities register the offer or sale of securities with the SEC unless they qualify for an exemption.
Three of the SEC’s statements in particular stood out.
1. Kraken, not the protocol, determined the rewards users received from its staking program
“Investors in the Kraken Staking Program receive a reward determined by Defendants [Kraken], not the reward determined by the underlying blockchain protocol,” the SEC noted in the complaint. In other words, regardless of the staking rewards actually received by Kraken, Kraken determined the size of the reward to be dispersed to end-users.
Coinbase Chief Legal Officer Paul Grewal argued on Twitter that Coinbase’s staking business will not be affected by the SEC’s action because, unlike Kraken’s staking service, the rewards users of Coinbase Earn receive depend entirely on the underlying protocol and a commission rate Coinbase has publicly disclosed.
2. Kraken did not disclose whether users’ “staked” tokens were actually staked or put to some other use
The SEC also identified as missing material information on “how Defendants determine to stake investor tokens … or whether tokens are put to some other use.“
Defendants do not actually stake every investor token transferred to them. For many of these crypto assets, Defendants state that they hold back a subset of tokens as a “liquidity reserve.” However, Defendants do not disclose the extent of these “unstaked” tokens and how they are used. ... Nor do Defendants disclose the true source of the returns paid to investors to the extent rewards are paid with respect to “unstaked” tokens.
This suggests that Kraken could opt to lend rather than stake its customers’ tokens, for instance. Further, “Defendants are under no obligation to segregate the crypto assets that investors transfer to them in exchange for the advertised return (marketed as being from proof of stake activities).”
3. Kraken did not provide sufficient information about its “instant unstaking” offering
Per the complaint:
Defendants market the Kraken Staking Program’s advantage of “instant unbonding” and instant return of “staked” crypto assets. But … Defendants do not disclose the extent of their crypto-asset reserves and whether these reserves are sufficient to meet all redemption demands. If these reserves are insufficient, Kraken may be unable to honor a redemption request in a timely fashion, if at all. Investors could suffer market losses if the value of their crypto assets declines while waiting for redemption.
What is the impact of the Kraken staking action for other staking-as-a-service platforms?
Businesses that offer staking-as-a-service platforms may need to register with the SEC. In the SEC’s press release, Chair Gensler stated that “today’s 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.” Additionally, an SEC official told Coindesk that the agency “basically looks at the offering of a staking service as being similar to offering any other type of security.”
SEC Commissioner Hester Pierce said in her dissent that the ruling raises complicated questions, including “whether the staking program as a whole would be registered or whether each token’s staking program would be separately registered and what the accounting implications would be for Kraken.”
SEC’s Similar Actions Against Crypto Lending Platforms
Since 2021, the SEC and US state agencies have charged or settled charges against at least seven digital asset platforms for offering crypto lending services, including BlockFi, BitConnect, Celsius, Genesis, Gemini, Nexo and Voyager Digital.
In the SEC’s February 9th press release, Gensler stated: “Whether it’s through staking-as-a-service, lending, or other means, crypto intermediaries, when offering investment contracts in exchange for investors’ tokens, need to provide the proper disclosures and safeguards required by our securities laws.”
SEC’s crypto enforcement uptick in 2023
As our recent US crypto enforcement analysis shows, the SEC has been the most active regulator worldwide since 2014, levying fines totaling $2.6 billion against crypto companies. We expect SEC crypto enforcement activity to continue trending upwards in 2023, especially given the recent collapses of several major crypto businesses and the growth of various forms of crypto market abuse, including insider trading, wash trades, and rug pulls.