Ethereum May Face Contagion from SEC Crackdown on Crypto Exchanges’ Staking Services

Ethereum (ETH), the world’s second largest cryptocurrency by market cap, may be particularly exposed to the SEC’s “staking-as-a-service” crackdown. Unlike many proof-of-stake (PoS) cryptocurrencies, Ethereum requires a sizeable deposit of 32 ETH (currently worth more than $52,000) to become a validator and earn rewards. This high barrier to entry blocks out many retail investors from “solo staking” on Ethereum, which means they’ll usually need to find a third party solution to pool their assets with other ETH investors and reap the rewards of staking. Oftentimes, that third party is the cryptocurrency exchange where they bought their ETH in the first place.

Just three exchanges are responsible for more than a quarter of all the ETH held in the network’s deposit contract, and each of them are now at the center of scrutiny from the SEC, which has already charged and fined one of them for offering unregistered securities in the form of an investment contract. If exchanges are no longer able to offer staking services in the US, it would present a significant hit to their revenues, which could also flow downstream to the digital assets that rely on those services the most.

Related Assets: Ethereum (ETH-USD), Coinbase Global, Inc. (COIN)

Last week, MRP covered the initiation of a regulatory crackdown on cryptocurrency exchanges by the Securities and Exchange Commission (SEC). More specifically, the commission is targeting the practice of “staking-as-a-service” within the US, which purportedly enables users to take part in the consensus mechanism of proof-of-stake (PoS) cryptocurrencies while simultaneously keeping their assets on exchange. The staking validation process results in a reward for whichever user is chosen by the protocol to be the validator for a specific number of transactions, which then become a “block” that will be added to the chain of other blocks which came before it – hence, blockchain. To stake, however, one will typically have to deposit capital (in the form of a coin or token) into a program known as a smart contract that will distribute the rewards.

For a cryptocurrency like Ethereum (ETH), that reward can be anywhere from 3.92% to 4.26%, depending on whether you are running a validator yourself or participating in staking-as-a-service. However, the SEC claims that, while exchanges are offering rewards for staking, there is no way for users to know exactly how their “staked” assets are being rehypothecated and where the return on their assets is being generated. Maybe crypto exchanges are indeed staking the assets of users who opt into staking-as-a-service programs and simply returning all or part of the rewards to users who’ve pooled their assets on their platform, but due to the precedent set by the SEC’s recent Kraken suit, that likely constitutes an investment contract. If that is the case, certain disclosures and registrations with the commission will be required if they are to resume.

If you follow the guide to staking on Ethereum.org, the service exchanges are offering is more aptly classified as pooled staking by a centralized entity or enterprise, but the SEC has decided to term this process “staking-as-a-service”, so for the purposes of explaining the regulators’ concerns, we will use that terminology. In our previous treatment on staking-as-a-service, we noted that Ethereum may be particularly exposed to the oncoming regulatory pressure. That’s largely due to the fact that many ETH owners cannot stake their tokens on their own and require a third party service to assist them with the process. To “solo stake” and run a validator of your own on Ethereum, one must be able to deposit 32 ETH ($52,640) into Ethereum’s staking contract, a very high upfront cost that many retail investors will not be willing or able to invest. However, even a small exchange will almost certainly…