There had already been rumors about the possible ban of crypto staking prior to the announcement of Kraken's $30 million settlement with the SEC, with Coinbase chief executive Brian Armstrong calling the regulation of crypto staking a "terrible path" for retail traders.
The news on Thursday had an impact on the crypto markets, with bitcoin falling more than 4% to a low of $21, 850 and Ethereum dropping 4.5% to around $1,572, according to CoinDesk data.
What is crypto staking?
Crypto staking is a way for crypto investors to earn passive income on their tokens. Staking lets users earn cryptocurrency as a reward for using existing crypto holdings to verify the accuracy of transactions on an underlying blockchain network.
Participants in a blockchain network pledge their coins to help validate new blocks of transactions. New cryptocurrency is minted every time a new block is added to a blockchain, and this cryptocurrency is distributed as a staking reward to those who pledged their coins. The more coins that are pledged, the more likely it will be used as a validator, and the higher the reward.
In the case of Kraken investors could earn a return as high as 21%, according to a statement from the SEC.
Staking isn't always an option for investors, and is only available when the cryptocurrencies use a proof-of-stake model instead of a proof-of-work model.
In a a proof-of-stake model, participants stake crypto behind a new block that's added to a blockchain, whereas in a proof-of-work model, participants use computational power and electricity to solve complex math in order to generate a new block. A proof-of-stake model is therefore less energy intensive than a proof-of-work model.
Why does the U.S. Securities and Exchange Commission care?
The U.S. SEC's decision to crack down on crypto staking derives from its concern that the risks are not disclosed fully to investors rather than from any aversion to the new technology.
"Companies like Kraken can offer investment contracts and investment schemes but they have to have full, fair, and truthful disclosure. This puts investors in a better position," said SEC Chair Gary Gensler in an interview with CNBC on Friday. "They were not complying with that."
Gensler's concern is with the risk that staking poses to investors, and claims that Kraken was not disclosing the risk of the technology to its investors clearly by registering with the SEC.
"Investors need that disclosure. What are you doing with the tokens? Are you trading against the tokens? Are you borrowing against the tokens? Are you using them for your own purposes?" said Gensler.
Industry experts have been vocal about the proposed regulatory changes.
"We need to make sure that new technologies are encouraged to grow in the US, and not stifled by lack of clear rules," said Coinbase's Armstrong in a Twitter thread earlier this week. "It's a matter of national security that these capabilities be built out in the U.S." Armstrong added that regulation by enforcement doesn't work, and that it's what encouraged FTX, the bankrupt crypto exchange once led by Sam Bankman-Fried, to operate offshore in the Bahamas.
In response to the move by the SEC, Kraken unstaked all U.S. clients assets enrolled in the on-chain staking program, though staking services are still offered for all non-U.S. clients through separate Kraken subsidiaries.
What does this mean for the industry and retail traders?
One aspect of staking may have taken a hit with the latest move by the SEC, but that won't stop investors from crypto staking in other ways, says one expert.
"It is important to clarify that this crackdown is for services that use pooled staking…and not direct staking," said Konstantin Boyko-Romanovsky, chief executive and founder of Allnodes, a cryptocurrency hosting and staking platform.
Pooled staking, also sometimes called staking-as-a-service, has a middleman using investors' assets as a product, which is what Kraken was doing. The benefit of this is determined by how the assets are managed.
In the case of direct staking, the user's rewards are determined by a blockchain, and users have control over their assets. Pooled staking gives smaller rewards than if the tokens were directly staked on the blockchain, but direct staking has a higher barrier to entry.
"This decision by the SEC may impact any cryptocurrency exchange that uses pooled staking but will not affect validators or services that allow users to stake to the protocol directly," said Boyko-Romanovsky in an email to MarketWatch.
Retail investors may turn to direct staking avenues as a result of the move by the SEC, said Boyko-Romanovsky. The barrier to entry is getting lower, as the services are becoming "increasing intuitive…with more user-friendly and secure options," he said. Boyko-Romanovsky also added that with direct staking, the user's funds remain in their digital wallets even if a platform fails.
With that being said, due to a lack of policies and guidance, the SEC is not ready to register cryptocurrency exchanges or similar entities offering staking and other financial crypto services.