Expect the SEC to use its Kraken playbook against staking protocols

Some observers have suggested the SEC’s action against Kraken will push users toward DeFi protocols. The reality is that the SEC is coming for those as well.

The United States Securities and Exchange Commission (SEC) settled with Kraken on Feb. 9 for an action taken against the exchange’s staking rewards program. Kraken paid a $30 million fine and agreed to halt the program.

Set aside for a moment the irony that the SEC is going after a solvent firm in the crypto space with a decade-long reputation as a good actor. Kraken has been helping settle verified Bitcoin (BTC) claimants from the hacking of rival exchange Mt. Gox over a decade ago. It invented the use of Merkle Root data to create verifiable proof of reserves. It allowed customers to effectively crowdsource audits of the asset side of the balance sheet by verifying what’s in their account against data on-chain.

And while Sam Bankman-Fried urged customers to keep their tokens on FTX for obvious reasons, Kraken founder Jesse Powell has always been a “not your keys, not your coins” guy. Meanwhile, the SEC was asleep on FTX, Terra and Three Arrows Capital. This week the SEC acted like a beat cop who pulls over a commuting soccer mom and throws the book at her to act tough on crime after a streak of robberies.

100% yes it has/will happen and 100% yes, we will be forced to comply. If you're worried about it, don't keep your funds with any centralized/regulated custodian. We cannot protect you. Get your coins/cash out and only trade p2p.

— Jesse Powell (@jespow) February 18, 2022

We have to set aside other political hypocrisy in this affair, like politicians decrying proof-of-work (PoW) blockchains yet now seeking to outlaw staking on proof-of-stake (PoS) blockchains. Or that Kraken tried to come into compliance with the SEC by applying for an Alternative Trading System license but got crickets in response.

The SEC emphasized that Kraken’s staking program was custodial, pooling investor assets together. Some on Twitter were quick to comment that this is actually great news for crypto. “Hey, look, SEC Chairman Gary Gensler is parroting our motto of ‘not your keys, not your coins.’ This just means more decentralization of staking in PoS blockchains.”

Related: Staking ban is another nail in crypto’s coffin — and that’s a good thing

Not so fast. Lido and Rocket Pool are innovative alternatives to centralized exchange staking programs, but they also pool together tokens. Pooling is essential for most retail investors to stake in Ethereum due to the minimum stake of 32 Ether (ETH) (~$50,000). The SEC’s enforcement playbook against Kraken will eventually be used against those protocols. The SEC is adept at warping the definition of security in the statute to cover all sorts of crazy things, from sales of chinchillas to online gambling to orange groves. The SEC will eventually apply its playbook to more decentralized staking protocols if the founders aren’t sufficiently anonymous.

It is a mistake to assume that Gensler believes in the cypherpunk philosophy behind the motto “not your keys, not your coin.” The SEC’s proposed reforms to regulating alternative trading systems last year — which would force developers who write smart contract code to register as exchanges — demonstrates how he views decentralized finance (DeFi) better than anything, as this is impossible.

It’s becoming clear from a pattern across financial regulators and the White House that the subtext in the administration’s policy toward crypto is that it should be choked off. The White House is against proof-of-work; the SEC is hitting proof-of-stake delegation, and the banking regulators are using subtle tools of examination to encourage banks to deny bank account access to anyone with “crypto” in their name even if the customer in question doesn’t actually hold crypto.

Related: My story of telling the SEC ‘I told you so’ on FTX

By all means, if your proof-of-work chain would operate more securely, effectively, or fairly under a proof-of-stake system, make the transition like Ethereum did. But don’t switch to proof-of-stake out of some hope it will protect you from regulatory or political risk because it won’t.

As a securities law professor, I can put on my analysis hat and find some aspects of Kraken’s staking rewards program that increased the risk of it being deemed a security, particularly some of the advertising communications. But that doesn’t mean the program should end or that a fine of this nature is warranted when there has been no fraud or investor harm.

Instead, a working rule set for custodial intermediaries offering this unique financial product should be drafted, as the SEC has done in the past for asset-backed securities, real estate investment trusts, oil firm master limited partnerships, etc. There are legions of securities lawyers working in the crypto space who would help the SEC write the rulebook today if given the opportunity. They could do so through an open SEC call for comment on crypto regulation, as I urged Gensler to adopt when I advised him. SEC Commissioner Hester Peirce’s dissent over this fine also calls for a set of reasonable rules.

Until that is possible, the only hope forward for crypto is ongoing legal challenges to administration overreach and protocol builders that stay true to the cypherpunk philosophy of Timothy May.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.