The Breakdown - ‘A Paternalistic and Lazy Regulator’: What the SEC-Kraken Staking Settlement Means for Crypto

Episode Date: February 11, 2023

On this edition of the “Weekly Recap,” NLW goes over the latest front in the crypto wars. On Thursday, the Securities and Exchange Commission announced a $30 million settlement with Kraken over their staking-as-a-service program. The move is rumored to be part of a much larger offensive against crypto involving numerous government offices.  Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsor today is “Foothill Blvd” by Sam Barsh. Image credit: Alex Wong/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.  

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDesk. What's going on, guys? It is Saturday, February 11th, and that means it's time for the weekly recap. A quick note before we dive in, there are two ways to listen to the breakdown. You can hear us on the Coin Desk podcast network feed, which comes out every afternoon, and also features other great CoinDesk shows, or you can listen on the Breakdisc. down only feed, which comes out a few hours later in the evening.

Wherever you listen, if you are enjoying the show, I would so appreciate if you would leave a five-star rating or review, it makes a huge difference. All right, so if you've been listening along, the last couple days have been a bit of history and background trying to set up why things seem so much more antagonistic right now. And in many ways, what I've been arguing, or at least trying to display, is that there is some amount of reaction and counter-reaction going on as part of this larger shift in tone. However, as we've been talking about the Pinser movement to cut off bank access for the crypto industry, a much clearer and louder opponent has also been making waves.

That opponent is, of course, Gary Gensler and the SEC. And on Wednesday night, that conversation heated up in a big way. Brian Armstrong, the CEO of Coinbase tweeted that evening, We're hearing rumors that the SEC would like to get rid of crypto staking in the U.S. for retail customers. I hope that's not the case, as I believe it would be a lot of. a terrible path for the U.S. if it was allowed to happen. Staking is a really important innovation in crypto. It allows users to participate directly in running open crypto networks. Staking brings many positive improvements to the space, including scalability, increased security, and reduce carbon

footprints. Staking is not a security. We need to make sure that new technologies are encouraged to grow in the U.S. and not stifled by lack of clear rules. When it comes to financial services in Web3, it's a matter of national security that these capabilities be built out in the U.S. Regulation by enforcement doesn't work. It encourages companies to operate offshore, which is what happened with FTCS. Hopefully, we can work together to publish clear rules for the industry and come up with sensible solutions to protect consumers while preserving innovation and national security interests in the U.S.

Now, as soon as Brian dropped this thread, speculation around the implications of it absolutely lit up the Twitter night sky. What was clear to everyone is that despite the lack of clarity, there was clearly something going on. Now, this reignited a larger question that has been. been discussed fervently in the community since the Ethereum merge narrative really kicked up last year. The question has been, would a transition to proof of stake make it more likely that the

SEC considered Ethereum to be a security, or at least certain activities around Ethereum to be securities programs? ETH's status as a commodity or a security has been contentious for years. In a 2018 speech, Bill Hinman, then director of the Division of Corporate Finance at the SEC, that Ether was not a security. New SEC chair Gary Gensler has never appeared happy about that and has distanced the SEC from the Hinman ruling. In one interesting twist in Ripple's lawsuit with the SEC, the SEC tried to have the Hinman letter thrown out as not representing their official position. Unfortunately for them, the SEC's legal team had consulted with Bill Hinman on his speech,

so the judge denied the SEC on that point. Regardless of those particulars, this has been lurking as one of the big questions and certainly one of the biggest areas, if not the biggest areas of Ethereum Fudd. So when it came to Brian's Twitter thread, and then alongside it, a Bloomberg report that Cracken had been under investigation by the SEC for offering unregistered securities to U.S. customers, the debate started swirling around exactly what was going on behind the scenes. If the SEC was going to go after staking, would they be arguing that staking itself was a security? Would they be arguing that staking with a centralized third party would constitute a security? Would they just be labeling Ethereum a security outright? From a technical and legal perspective,

there is a lot of nuance here. Coin Center head of research, Peter Van Valkenberg, wrote a whole article about this last January. Quote, a misconception we sometimes see from policymakers looking at cryptocurrency networks is that staking and staking rewards are some kind of security or interest-bearing lending activity that should be subject to regulation. While it's true that some of these activities will qualify for regulation, there are several different activities under the staking umbrella that we sometimes see conflated. When a custodial exchange offers customers staking rewards, it is the exchange itself that is paying the customer at a rate determined by the exchange, rather than the rewards being the natural products of participation in a POS consensus mechanism. In another section, Peter

writes, the cryptocurrency itself may not be a security, but the promise to hold it and stake it safely and profitably on the network, as well as provide a liquid market for future sales that the cryptocurrency may be a security. And the point here is that Peter and Coin Center aren't writing about any one particular asset or context, they're just saying that this is a big umbrella, and that we need to deal with it in its complexity, not in its generality. Okay, so we've got Coinbase's CEO sounding the alarm. We've got Bloomberg reporting that something is coming with Cracken. What actually ended up happening? On Thursday afternoon, the SEC did indeed announce a settlement with Cracken. Under the terms of the agreement, Cracken would immediately

end its crypto staking as a service platform, as well as pay a fine of $30 million to settle charges of offering unregistered securities. The SEC complaint alleged that Cracken had been offering the program to customer since 2019, and that they touted that its Staking Investment Program offered an easy-to-use platform and benefits that derive from Cracken's efforts on behalf of investors, including Cracken's strategies to obtain regular investment returns and payouts. So they're basically making an investment contract argument saying that the value was coming from others' efforts, i.e. Cracken's efforts. Gensler was quoted as saying, 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. Today's actions should make clear to the marketplace that staking as a service provider must register and provide full, fair, and truthful disclosure and investor protection. Gensler also released one of his cute little promotional videos that he uses to announce enforcement actions in a way that he clearly hopes increases his celebrity. It made a stake, Steak-S-E-A-K-E-Joke like six times, and as always was just galling, beyond belief. Anyways, logistically, Cracken is automatically unstaking all U.S. client assets and pro-rating their final rewards. For ETH assets that aren't able to be unstaked yet,

they will return those assets to client wallets where they will no longer earn rewards. There are, of course, big financial implications here for the companies involved. Coinbase controls 11.5% of all Ethereum validators, while Cracken controls an additional 7%. What's more, the staking business made up 11% of Coinbase's total revenue in Q3 last year, so they have a massive incentive to ensure this product is not regulated out of existence. Join CoinDesk's Consensus 2023, the most important conversation in crypto and Web3, happening April 26 through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse.

Immerse yourself in all that blockchain technology has to offer creators, builders, founders, brand leaders, entrepreneurs, and more. Use code, breakdown, to get 15% off your pass. Visit consensus.coindex.com or check the link in the show notes. So what did crypto Twitter think about all this? James Murphy met a lawman writes, SEC announces settlement with Cracken.

Cracken agrees to stop offering staking as a service. Cracken will pay $30 million fine. None of the money will go to restitution because there aren't any actual victims. The SEC war on crypto, just getting started. Adam Cochran writes, my God, they really are coming for everything all at once. the U.S. is just handing other countries the win on blockchain. He then also wrote something that

was a very similar sentiment. So the SEC got buddy-buddy with SBF and almost gave them an exception to offer more services in the U.S. but then goes after Cracken and Coinbase, the two most compliant U.S. exchanges for services that the SEC previously refused to provide guidance on. Gensler is not a regulator. He is an agent of an anti-crypto agenda who only aims to wield his power as a cudgel for those he doesn't agree with. There is a lot of sentiment out there that Gensler is just in it for his own political career, which is a position that I pretty much wholeheartedly agree with. The point for him is these terrible videos. It's positioning, it's face recognition, it's being seen as tough by standing

up to a loud industry that many in D.C. don't like. Defi Pulses, Scott Lewis wrote, Gensler's multi-year arc to build his personal political brand at the expense of the SEC's reputation for good governance is tragic. So many good people have passed through the SEC, and many more are still there, and what is happening right now is just not okay. bankless asked, what's the play here, man? He writes, So Gensler is driving crypto-staking away from the centralized exchanges they can tax and control, and towards the decentralized options they have no ability to tax and control. What's the game here? You know you could have controlled us better from the exchanges, right, Gary?

And many, like Adam, as we heard before, and others, pointed out that this was just likely to push people offshore. Cracken founder Jesse Powell responded to James Murphy, noting that the SEC failed to mention that this was just a settlement for the U.S. Crackenstaking program, saying, quote, doubt the existence of anything outside of our borders has ever crossed their mind. Certainly would explain the lack of any appreciation for global competitiveness and the focus on enforcement against U.S. companies. Now, let's talk about for a minute whether there is nuance in the specifics going back to what Coin Center was writing last year. Crypto lawyer Mike Selig said, SEC characterizes Cracken's custodial staking product as a security. Focus is on the fact that

Cracken allegedly pooled customer crypto to provide superior and more consistent yield relative to non-custodial staking options. SEC view is not that staking in itself is a security. Paul Grewell, the chief legal officer at Coinbase writes, Well, we now know the rumors Brian Armstrong referenced yesterday were true. SEC has settled claims against Cracken for particular staking products. What is equally true? These products are basically yield products. True on-chain staking services like ours are fundamentally different.

For example, our customers' rewards are tebivoccur. to realities. They depend on the rewards paid by the protocol and commissions that we disclose. We don't play games. Our customers have a right to their rewards. We can't just decide not to pay any rewards at all. Our customers' assets always remain theirs and are accounted for transparently in regular public audits. Our finances are a matter of public record. We provide deep insights into those finances every quarter. We've been providing staking services to our customers for years, and these services were described at length in our public filings when we became a public company in 2021. Rules making clear these distinctions would provide real clarity to

to the industry and our customers. The public shouldn't have to parse complaints in federal courts to understand what a regulator expects. Now, I agree wholeheartedly with that last point about regulators needing to provide clarity. I did think it was a little weird to use this moment to try to take what I think some would see as a victory lap. But still, the discussion around this was one of the most interesting parts of the whole affair. In a separate tweet, Jesse Powell again wrote, I don't see a material difference versus competing products. I don't think that any minor differences matter to the SEC, which views all forms of custodial staking as problematic. I expect more settlements or lawsuits to follow imminently as they make the rounds with

their example. He also quote tweeted Paul's thread saying, I honestly hope somebody proves in court that there is a legal, user-friendly version of custodial staking that can be offered to U.S. customers. It'll be a brutal, lengthy, expensive fight and a massive distraction, but the industry and the USA will be extremely grateful. Jesse also engaged in a conversation with Zero X Fubar, who wrote, Why did Cracken not pursue this legal battle? Jesse says risk-adjusted return. Fubar says locally for your company or globally for the industry. Jesse says for our company. I do think a different company with different corporate structure, shorter operating history, some product marketing TOS differences might make a different decision. Bigger balance sheet wouldn't hurt either. They picked the bottom of

the bare market waited for us to do a 30% layoff. They have all of our financials, lots of leverage. Maybe we looked weak. This is more about FTX than it is us or staking, but the timing was not great. Potential finds obscene. I think that's super, super telling. And listen, when it comes to the actual substance of whether or not there are versions of staking that are okay or not and what the SEC expects, I don't think anyone in this industry is unwilling to have those conversations. I don't believe by and large that the industry thinks they should be able to get away with doing anything, and I think there are plenty of lawyers who are just reading SEC tea leaves who would love a more in-depth conversation. But the position that the SEC has consistently put this industry in,

and this has been the case for a long time going back before Gensler, is for every company in this space to have to hire a fucking phalanx of lawyers to come up with arguments for what is likely or not likely to be accepted and then go fight that later, rather than any sort of proactive engagement or guidance. So when it comes to that tweet from Paul that Coinbase's products are fundamentally different, it might be true, but I don't think the substance of the argument is what matters. I think it's fundamentally naive at this point to assume that Gensler's SEC is acting in a good faith way that would actually distinguish between these models. It's been four years since the SEC's last proactive guidance.

Feels much more likely to me that the biggest difference in practice is that a company like Coinbase has a bigger war chest and because of that, potentially, more appetite to fight. Jake Chavinsky from the Blockchain Association writes, settlements are not law. They're a decision that the economics of settling are better than fighting no more. The SEC thinks staking as a service is a security. Cracken didn't admit or deny that either way. It may be a tough question, but the SEC hasn't answered it either way today.

Now, to the extent that there is a bright spot here, it's probably in the network decentralization argument. In fact, Alex Gladstein asked Dr. Paul Dylan Innes, aka Polar Punk Labs, if this was good for Ethereum, and he said, good for the Ethereum protocol because it gets people off exchanges, encourages solo staking with own node, removes potential U.S. influence over U.S. exchange pools, forces Ethereum users to take decentralized principles seriously. How Press agreed, saying every time regulators restrict exchanges, it just, pushes more and more businesses on chain. The knee-jerk is always to think that this is negative, but it really isn't. Still, for those who are watching this from a 10,000-foot view, it's kind of less

about the details and more about the attack itself. Just after this was announced, the IRS also made an announcement, saying that they'd be seeking a court approval to enforce a summons for Crackens user data, which they said has gone uncomplied with since being issued in 2021. And then just after that, Coindex published an article saying that the New York Department of Financial Services is investigating stablecoin issuer Paxos. They say that the full scope of the investigation is unclear, but there's lots of speculation that it's Binance-related. NYDFS published Stablecoin guidance in June directing issuers to ensure their stablecoins are fully backed with assets segregated from the issuer's funds and attested to regularly. And of course, just last month, we got the big news that Binance

BUSD was sometimes not fully backed, which, as we talked about at the time, Paxos must have been just livid about. All in all, this is swirling up tons of rumors that there is more to come. his tweets update, additional actions are coming from the SEC. Sources say exchanges and stablecoin issuers will be getting Wells notices in the coming days and weeks, specifically mentioned Circle and Paxos. A Wells notice is a notification issued by regulators to inform individuals and companies of completed investigations where infractions have been discovered. He usually takes the form of a letter which notifies recipients both of the broad nature of the violations uncovered, as well as

the nature of the enforcement proceedings to be initiated against the recipient. Eleanor Territ, a journalist at Fox Business, tweeted last night, scoop. Gary Gensler is embarking on a midnight massacre in an attempt to bring all of crypto under his control. In the coming weeks, the SEC, the NYDFS, and the OCC will all be bringing a myriad of enforcement actions against exchanges, banks, and entities that mint tokens in an attempt to label the majority of them as securities. I'm told Gensler's strategy is to bring as many enforcement actions as possible, while the 118th Congress is still getting its bearings. Markets, of course, did not like all of this. Bitcoin fell down under 22,000, about 4.3% down since

yesterday, Eath understandably fell down a little more, over 6%. It is worth noting that not everyone is convinced that this is entirely based on the Crackin news. Pantoshi tweeted many blaming Fudd for yesterday's move down. I do think the market gave plenty of warning signs of weakness, failed breakouts, lack of momentum, distribution-like structure on Bitcoin and many alts with complacency shoulders. So maybe it was just the classic situation of FUD coming into structural market weakness. I guess, though, at the end of the day, that the short-term market reaction is probably the least relevant part of all of this. Bankless's David Hoffman wrote,

U.S. regulators in the Biden administration have begun a full frontal assault against crypto. It's politically motivated. It's unconstitutional. And it's exactly why we need crypto to separate money from state. This sucks, but we'll survive, as we always do. And it will end by saying that in that fight we're not completely alone. Tom Emmer, the GOP majority whip in the House, says to be clear. Staking enables more people to participate in building the next generation of the internet.

Gary Gensler's regulatory purgatory strategy hurts everyday Americans the most. leaving them in the dust while these opportunities are accessible offshore. Perhaps even more profound is the dissent from SEC Commissioner Hester Purse, which I'll now read in full. She writes, Today the SEC shut down Cracken's staking program and counted it as a win for investors. I disagree and therefore dissent. Cracken operated a service through which its customers could offer their tokens up for staking. The customers earned returns and the company earned a fee.

The commission argues that the staking program should have been registered with the SEC as a securities offering. Whether one agrees with that analysis or not, the more fundamental question is whether SEC registration would have been possible. In the current climate, crypto-related offerings are not making it through the SEC's registration pipeline. An offering like the Staking Service at issue here raises a host of complicated questions, including whether the staking program as a whole would be registered, or whether each token staking program would be separately registered, and what the important disclosure should be, and what the accounting implications would be for Cracken. We have known about crypto-staking programs for a long time. Although it may not have made a difference, I should have

called for us to put out guidance on staking long before now. Instead of taking the path of thinking through staking programs and issuing guidance, we again chose to speak through an enforcement action, purporting to, quote, make clear to the marketplace that staking as a service providers must register and provide full, fair, and truthful disclosure and investor protection. Using enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating. Moreover, staking services are not uniform, so one-off enforcement actions and cookie-cutter analysis does not cut it. Most concerning, though, is that the that our solution to a registration violation is to shut down entirely a program that has served

people well. The program will no longer be available in the United States, and Cracken is enjoined from ever offering a staking service in the United States registered or not. A paternalistic and lazy regulator settles on a solution like the one in this settlement. Do not initiate a public process to develop a workable registration process that provides valuable information to investors. Just shut it down. More transparency around crypto staking programs like Crackens might well be a good thing. However, whether we need a uniform regulatory solution, and if that regulatory solution is best provided by a regulator that is hostile to crypto in the form of an enforcement action is less clear.

The fight isn't coming, friends. It is here. Now is the time to think deeply and engage deeply. Let's get to it. Until tomorrow, be safe and take care of each other. Peace.