The SEC shook Kraken down for $30M, but it doesn't mean they had a case

Published at: Feb. 15, 2023

The settlement between Kraken (Payward Ventures) and the United States Securities and Exchange Commission set off alarm bells in the crypto community this month. Apparently, Kraken — one of the most compliance-minded crypto exchanges in existence — decided to buy its peace rather than fight with the SEC for years over whether it was offering unregistered “securities” through its staking program. The nature of the settlement is that Kraken neither admitted nor denied the SEC’s allegations, and the existence of the settlement, technically speaking, cannot be used as legal precedent for any argument either side of the issue might present.

That said, the settlement matters, as it will clearly chill crypto staking in the United States. As SEC Chairman Gary Gensler said, “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.” Gensler casts a wide net, indeed, for what the SEC considers to be “investment contracts,” and running staking out of business was perhaps precisely what he had in mind.

That the SEC was successful in pressuring Kraken out of $30 million does not, however, make the agency’s position legally or logically correct. As a preliminary matter, “staking” and “lending” are totally different things. Staking is the process by which one pledges one’s coins or tokens to a proof-of-stake blockchain, either directly or by delegating one’s coins to a third party, for the purpose of securing the network. Stakers are the ones through whom the blockchain’s consensus mechanism operates, as they “vote” on which blocks will be added to the chain. The process is algorithmic, and the reward is automatic when one’s position is electronically “selected” as the validator for a given block.

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. Kraken didn't admit or deny either way.It may be a tough question, but the SEC hasn't answered it either way today.

— Jake Chervinsky (@jchervinsky) February 9, 2023

Stakers don’t necessarily know who the other stakers are, nor do they need to know, as the fate of one’s stake is dependent only on following the rules of that blockchain as to “liveness” (availability) and other technical considerations. There are risks of “slashing” (losing your coins) for bad behavior or unavailability, but again, these are algorithmic remedies doled out automatically according to transparent rules built into the code. Put simply, in staking, it’s between you and the blockchain, not you and the intermediary.

Lending, in contrast, invokes the entrepreneurial and managerial skill (or lack thereof) of the people to whom you lend. This is a distinctly human enterprise. One does not necessarily know what the borrower is doing with the money; one simply hopes to get it back with a return. This counterparty risk is in part what the securities laws are intended to address. In lending, the relationship is between the lender and the borrower, which relationship that can take all kinds of unexpected turns.

The reasons why staking arrangements are not “investment contracts” (and thereby “securities”) are stated eloquently by Coinbase chief legal officer Paul Grewal in a recently released blog post. Put simply, merely serving as an intermediary does not render the underlying economic relationship an “investment contract.” Yet the SEC here does not seem to want to entertain the differences between service providers and counterparties.

It is true that third parties, such as Kraken, serve a custodial role in the staking relationship — that is, they may hold the private keys to the particular coins the client intended to stake. However, serving as a custodian of a fungible asset, especially where such a custodian holds collateral on a 1:1 basis to back every customer account, is a discreet service.

There is nothing to suggest that Kraken, Coinbase or any other staking-as-a-service provider, otherwise uses human judgment, intuition, grit or any other hallmark of one’s entrepreneurial or managerial ability, to advance or inhibit the staker’s purpose. One’s reward does not improve or decline based on how the intermediary performs. There should be (and are) rules and regulations for how custodians function, but possession does not, by itself, a security make.

Ari Good is an attorney whose clients include payments companies, cryptocurrency exchanges and token issuers. His practice areas focus on tax, securities and financial services compliance matters. He received his juris doctor from the DePaul University College of Law in 1997, his Master of Laws in taxation from the University of Florida in 2005, and is presently a candidate for the Executive Master of Laws in securities and financial regulation from the Georgetown University Law Center.

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.