SEC vs. Kraken: A one-off or opening salvo in an assault on crypto?

In a year of crypto upheaval, the U.S. Securities and Exchange Commission’s settlement with crypto exchange Kraken, which was announced on Feb. 9, has sparked another push. The head of the agency, Gary Gensler, took to the mainstream media last week to explain the agency’s actions in what appeared to be an attack on crypto staking, part of the verification mechanism used by a number of blockchain platforms, including Ethereum, the second largest network in the world. .

The immediate problem, according to the agency, was that Kraken was selling unregistered investment products. Indeed, he advertised big profits from cryptocurrency betting – up to 21%, Gensler. said

“The problem was that they didn’t disclose to investors the risks that investors were exposed to,” Gensler said. What’s more, the SEC’s action, which required Kraken to shell out $30 million and shut down its staking operation, could easily have been avoided, as he seemed to mean:

“Kraken knew how to register, others know how to register. It’s just a form on our website. They can come and talk to our talented people on the Disclosure Review Teams. And if they want to offer rates, we are neutral. Come on in and register because investors need this disclosure.”

However, not everyone in the crypto industry was completely satisfied with this answer. “I find the SEC phrase that “all crypto projects have to do is come and register” is incredibly offensive.” tweeted Morrison Cohen LLP Attorney Jason Gottlieb. “For many crypto products, there is simply no way to register.”

“Registering a staking program securities is not as easy as filling out a form on the SEC website,” Michael Selig, an attorney for Willkie Farr & Gallagher LLP, told Cryptooshala. “Public offering of securities is highly regulated and expensive.”

Others see the agency’s decision to blame Kraken as the first salvo in a general attack on cryptocurrencies by US regulators. “If approved by the court, the settlement marks a potential turning point for cryptocurrency regulation and the SEC’s broader efforts to bring the industry under its jurisdiction,” informed CNN. “The move could lead to wider crackdown,” suggested The New York Times, including possibly a betting ban for US retail investors.

But perhaps the industry overreacted. That is, staking, practiced by Ethereum and other blockchains as a way to reward network validators, may not come to the attention of the SEC at all. The agency may have been motivated primarily by consumer protection concerns, and in this case, it wanted to take Kraken as an example, especially in light of the November crash of FTX and the bankruptcy of various crypto lending firms.

“Yes, I’m sure they [the SEC] wanted to use Kraken as an example, especially because it offered the opportunity to earn up to 21%,” Carol Goforth, a university professor and Clayton N. Little, a professor of law at the University of Arkansas, told Cryptooshala.

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“Kraken sets returns on wagered amounts, not on the underlying blockchain protocols. […] To be honest, the way Kraken ran their program is like Howie’s investment contract,” she said. The SEC uses the Howey test to determine if a transaction qualifies as an investment contract, which then requires registration with the SEC.

Bill Hughes, Senior Legal Counsel and Director of Global Regulatory Affairs at ConsenSys, told Cryptooshala: “This is a one-time action that is intended not only to address the issue of Kraken’s supply but, importantly, to send signals across the space about what specifics of staking— as -a-service, in the opinion of the Securities and Exchange Commission, are problematic.” If the other betting service is not paying attention to these signals, they can also expect the SEC to take action, Hughes said, adding:

“I think the SEC is hoping that the market will pick up on the message and adjust accordingly as they will likely choose to move on to other matters.”

“The Kraken case in the US is primarily about sanctions against [Kraken’s] blatant and opaque behavior towards its retail customers rather than just offering rates as a service according toMarkus Hammer, an attorney and head of the Swiss consulting firm Hammer Execution, told Cryptooshala.

Ethereum in danger?

However, the market did not necessarily perceive this as a one-time action on the part of the agency. Ether (ETH) fell about 6.5% on the day of the settlement announcement, the biggest one-day drop since mid-December. As widely reported, last year Ethereum moved from a proof-of-work consensus mechanism to a proof-of-stake (PoS) consensus mechanism. This technical transformation, dubbed the “merger”, was hailed by many for drastically reducing the network’s colossal power consumption and reducing its carbon footprint. But some at least feared that Ethereum was now on the radar of US regulators due to its new staking protocols.

However, equating Kraken and Ethereum may be a mistake. As Matthew Hogan, chief investment officer of Bitwise Asset Management, told Cryptooshala:

“The SEC enforcement action against Kraken is not a forced action against Ethereum for using the Proof-of-Stake consensus mechanism. This was an enforcement action against Kraken for providing staking services. These are different things.”

What’s more, Ethereum can continue to function securely as a PoS network even if the SEC bans all U.S. staking services, Hogan said, though he doesn’t expect that to happen. “Activities will simply migrate abroad or be carried out directly by individuals,” he said. You can also stake more than enough ETH to ensure the integrity of the network. “The main result will be that US investors will lose both the opportunity and the risk associated with rates. However, the world would continue to exist.”

“These actions are not directed against staking platforms, but against the staking providers that organize and manage the pools,” Goforth said. “If the organizer controls the pools and rates of return,” as in the case of Kraken, “then this action assumes that the SEC will treat the program as involving the distribution of investment contracts.”

By comparison, she says, “if a blockchain protocol allows others to create pools,” as in the case of Ethereum, “it doesn’t necessarily follow the logic of that order.”

Hughes agreed. There is nothing in the SEC complaint to suggest that staking itself is problematic. “The SEC’s actions are focused directly on Kraken’s custodial staking program, which promised specific returns, pooled funds, and did not disclose risks or fees. It says nothing about staking ETH or the consensus mechanism of any other chain,” he said.

Ethereum also supports many use cases that have nothing to do with investing (such as elections). Just because a network has moved to a Proof-of-Stake consensus mechanism does not in itself mean that its native coin, Ether, should now automatically be classified as a security. One needs to look at “the nature of the underlying multipurpose blockchain and associated ecosystem,” Hammer said. Moreover, they will have to be evaluated blockchain by blockchain, he added.

First salvo?

All of this may be true, but could this really be the initial shelling of a broader post-FTX attack on cryptocurrencies and blockchain technology rather than just “investment solutions” offered by a few centralized service providers?

“The SEC tends to act in stages, introducing new enforcement actions based on previous enforcement actions,” Selig told Cryptooshala. “The crypto industry is reasonably concerned that the SEC is focused on custodial staking programs today, but will target broader staking in the future.”

Hughes leans towards a more limited view, mainly “because that’s what this complaint is about at first glance. Whether the SEC becomes more aggressive and uses the underlying functionality of the blockchain, time will tell.”

Blockdaemon CEO and founder Konstantin Richter seemed to agree. “With a complaint, the rate itself does not appear to be an issue,” Richter told Cryptooshala. “This indicates that institutional investors with the ability to stake can continue to operate without the use of a centralized custodial exchange.”

Hogan, for his part, isn’t so sure there won’t be a ban, and told Cryptooshala:

“Crypto is facing coordinated regulatory prosecution in the US. You see this crackdown in recent SEC statements and actions, as well as recent efforts by the FDIC, OCC, and the Federal Reserve to limit the crypto industry’s access to the traditional banking system.”

These actions are disturbing but not surprising,” Hogan continued. Numerous failures over the past year, such as FTX, Celsius, Genesis, BlockFi, Voyager, and Terra, “pointed to some significant risks in the crypto ecosystem and the need – in some cases – for better regulation.”

“This is far from the first salvo in the US attack on cryptocurrencies,” Goforth said. “The SEC has been relatively hostile to crypto assets for years; it looks like a continuation of that approach […] as it continues to allocate resources to enforcement on a case-by-case basis rather than offering a truly useful roadmap for compliance, for example by developing exceptions based on individual disclosures.”

“First inning of a nine-inning game”

Gensler may have been disingenuous when he suggested that exchanges like Kraken simply fill out a form on the SEC website. Registering with the SEC is a difficult task. “It’s an incredibly complex process that often costs a million dollars or more — in the form of lawyers, accountants and investment advisors — when an issuer first attempts to register a conventional security,” Goforth said. Also, getting approval can take a long time.

However, it does not necessarily follow that Gensler will pursue Ethereum and other PoS platforms. It can be recalled that the head of the agency once taught a course on blockchain technology at the Massachusetts Institute of Technology and is well versed in decentralized networks and their purposes. He probably understands that the technology offers all sorts of non-investment use cases, even PoS platforms with validators that have a “skin in the game” as they work to ensure the integrity of the network.

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Indeed, the Kraken settlement could only confirm that “the SEC still isn’t clear on when consumer protection rules apply to the crypto world,” Hammer said. Prior to the merger, both the SEC and the Commodity Futures Trading Commission viewed Ether as a commodity, not a security.

Overall, it may still be unknown if the SEC is engaging in limited regulatory action here or is instead launching the first salvo in the wider war on cryptocurrencies and blockchain technology. Most support the first interpretation, but as Hogan concluded:

“Whether the current regulation will stifle the cryptocurrency or eventually unlock its full potential, I think it is too early to tell. The right progress in regulation can be incredibly positive for a cryptocurrency, but overly restrictive or punitive regulation can be detrimental. […] We’re in the first inning of a nine-inning game.”

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