Regulation: SEC Intensifies Crypto Enforcement With Exchange Settlement

Miners: Crypto mining firms Hut 8 and US Bitcoin plan merger

Stablecoins: Tether records surprise profit as stablecoin giant aims to put reserve controversy behind it

Institutions: ‘Deposit Tokens’ Could Trade On DeFi Like Stablecoins: JPMorgan

Russia: Russia's massive new crypto mining facility will open by summer, but legal regime remains in limbo

After several weeks of strength, digital assets prices declined across the board, dragging the market capitalization of all cryptocurrencies down to a four week low, close to the $1 trillion mark. That coincided with Bitcoin’s (BTC) price in USD terms slumping by -7.2% from a weekly high beyond $23,500 to roughly $21,800 as of Friday morning. The largest part of that downturn was due to an unprecedented enforcement action by the US Securities and Exchange Commission (SEC) to halt “staking” services being offered by popular cryptocurrency exchange Kraken.

Kraken settled SEC charges regarding the unregistered offer and sale of securities for a sum of $30 million and an agreement to discontinue their “staking” services in the US. As MRP has previously highlighted in our Intelligence Briefings, staking is the consensus mechanism of proof-of-stake cryptocurrencies (PoS), used to validate transactions as miners would on a proof-of-work (PoW) blockchain like Bitcoin. Instead of utilizing hardware and intensive amounts of electricity to engage in hashing as one would do to mine Bitcoin, staking requires owners of a certain cryptocurrency to lock up all or a portion of their assets within a specific protocol to become a “validator”. Typically, a larger amount of assets locked up by a user will result in that user receiving a larger share of the network’s transactions to validate. Validation is necessary to prevent network participants from using the same coin(s) or token(s) in multiple transactions at the same time, known as “double spending”.

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 validated previously – hence, blockchain. The incentive for users to take part in the validation process is that, for each transaction they validate, they will be compensated with a certain amount of tokens disbursed by the network and/or transaction fees paid by other users who are sending the transactions. Each PoS cryptocurrency’s validation and staking systems will have its own nuances, but this description is meant to provide a general overview of what staking actually is. PoS blockchains accounted for 23% of the total market value of digital assets at the end of 2022, according to a report from Staked and Kraken, cited by Bloomberg. The report estimated the value of staked assets on these PoS blockchains at $42 billion.

Now, let’s talk about what staking is not. In this particular example, it is not providing your assets to a centralized third-party, who will then take custody of those assets and rehypothecate them as they please, which is essentially what the SEC is now cracking down on. This “staking-as-a-service” approach that Kraken and other exchanges have been engaging in is what the SEC appears to be going after, not the process of staking itself. Gary Gensler, the Chairman of the SEC, broke this down in a short video released alongside the commission’s official statement on the Kraken suit, noting “Basically, if you transfer your tokens to a staking-as-a-service provider, they take control… For example, what do they actually do with your tokens? Are they really staking them? Are they lending, borrowing, or trading with them? Are they co-mingling them with their other businesses?… there’s an expression in crypto: ‘not your keys, not your crypto’.”

MRP has oft cited that exact expression in regard to recent crypto exchange and “lending platform” bankruptcies that have left traders and depositors at the back of the line to make a claim on the funds they thought were theirs. The reality is that users of most exchanges are subordinated to unsecured creditors and their assets belong to the exchange once transferred. Only users who have the “keys” to their cryptocurrency, the digital signature that allows them to be transacted, are truly in custody of their assets. Perhaps exchanges are being totally above board with their “staking” services and truly depositing all staking-as-a-service funds into staking protocols, but when considering the recent track record of the crypto industry, that can no longer be left up to trust and self-regulation. It is clear that the SEC considers these services an investment contract and certain disclosures and registrations with the commission will be required if they are to resume.

Kraken is not the only US-based exchange offering staking services. Other major exchanges like Binance.US and Coinbase also offer these services and the precedent provided by the SEC’s Kraken suit will undoubtedly allow them to attempt similar enforcement against both of those exchanges. Coinbase, which is a publicly-traded entity, saw its shares tumble by more than -14% yesterday as investors likely anticipate the potential end of their staking service will take a significant bite out of its revenues.

At this point, most staked tokens on PoS chains are held by users in self-custodied wallets, not “staked” on exchanges. If staking services are shut down on US-based exchanges, users of those platforms could easily send their crypto assets off exchange to their own self-custodied wallet and engage in actual staking there. However, for many, the world’s largest PoS cryptocurrency, Ethereum (ETH), may be an exception to that rule.

Currently, Ethereum is still in the process of transitioning from PoW to a fully operable PoS protocol. To stake on Ethereum, users currently must deposit a minimum of 32 ETH ($49,400) into the ETH 2.0 deposit contract. For now, however, users cannot withdraw staked ETH from that contract and will not be able to until Ethereum’s “Shanghai” upgrade in March. The 32 ETH threshold is a large sum for most retail investors who simply do not carry a balance close to that. This was one of the largest incentives for the creation of centralized staking protocols by exchanges. An individual may not have 32 ETH, but Coinbase or Kraken certainly do and they can “pool” your assets in with theirs to give you the benefits of staking (essentially paying their users interest) without having to accumulate a large sum of ETH. Many retail level ETH investors who were taking advantage of this passive income will no longer be able to do so if exchange-based staking services are shuttered. 

Per Nansen data, three of the top five deposit sources in the ETH 2.0 deposit contract are centralized exchanges, representing more than 26% of all ETH in the contract. MRP has previously sounded the alarm on centralization within ETH’s staking consensus mechanism, as well as potential SEC enforcement actions regarding intermediaries offering staking services, and we will follow up on this coverage in our coming Intelligence Briefings.

January 24, 2022: Bitcoin Mining is Back to Profitability, Hash Ribbon Shows Peak Capitulation May Have Finally Passed →

October 18, 2022: Fallout From Ethereum “Merge” Bolsters Bitcoin’s Hash Rate as Some Criticisms Still Linger →

October 7, 2022: Ethereum’s Post-Merge Era Conquers Key Goals, Yet Centralization and Regulation Concerns Linger →

August 8, 2022: BTC Rebound Set to Revitalize Crypto Miners Bent by Bear Market Pressure →

June 22, 2022: SEC Decision on Key Bitcoin ETF Application Looms as Grayscale Preps Lawsuit, Dissent Rises From Within →

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