The SEC sends a clear message to the crypto industry that registration is required | Husch Blackwell LLP
The Securities and Exchange Commission (SEC) has once again flexed its regulatory power in its latest and clearest message to the cryptocurrency market that SEC registration is required for most decentralized financial activities, this time aimed at “staking services” – a means of earn rewards on crypto assets. In this new case filed on February 9, 2023, the SEC argued that Kraken’s crypto betting service should have been registered with the SEC. Kraken agreed to a settlement with the SEC that requires it to stop offering its crypto betting services in the US and pay a $30 million penalty. A federal judge must approve this settlement before it takes effect.
Cryptocurrency staking is a way in which crypto transactions are verified using a proof of stake consensus mechanism, which is a means of verifying transactions on proof-of-stake blockchains using validators who hold a certain amount of a cryptocurrency and who receive rewards in exchange. for validating blockchain transactions. The second consensus mechanism is proof of work, which is used in Bitcoin transactions. Staking is a process where cryptocurrency holders voluntarily give their crypto to take part in validating transactions on the blockchain – in other words, checking that the ledger “adds up” and that all transactions on the blockchain are valid. In return, validators, who cannot use their cryptocurrencies involved in the validation process for a period of time, receive a share of the transaction fees or newly created cryptocurrencies. This reward is then passed on to customers at centralized exchanges who have agreed to stake their assets. From a customer’s perspective, it is a way to receive a return on cryptocurrencies, by agreeing to have them “put to work” or “locked in” for a certain period of time. Staking is only possible on proof-of-stake blockchains, such as Ethereum.
Kraken offered these betting services. According to Kraken’s website, users needed less than a penny of Ethereum to earn a return on investment of 4% to 7% a year. In contrast, to earn stake rewards directly from a crypto network, holders may need to unlock approximately 32 of their Ether, valued at approximately $50,000 as of today. This difference in capital requirements led some to question how Kraken can guarantee the four to seven percent returns on such small stakes. “Kraken didn’t just offer [holders] outsized returns untied to any economic reality, but also retained the right to pay them no return at all, said SEC Enforcement Director Gurbir Grewal.
In its enforcement action, the SEC stated that Kraken has failed to provide customers with proper disclosures about how their cryptocurrency will be used and should be required to register its betting services with the agency. “Do they lend, borrow or trade with them? Do they mix them with their other businesses? Where do the rewards come from? Are you getting your fair share?” SEC Chairman Gary Gensler asked, adding, “There is currently no reliable way as an investor to know the answers to these important investment questions.” In the settlement with the SEC, Kraken neither admitted nor denied the SEC’s claim that the betting service should have been registered.
Gensler says the action should put other crypto exchanges on notice, and that these platforms should come into compliance with securities laws. Kraken said it would continue to offer bets to customers based outside the US. In a statement, Coinbase, one of the largest cryptocurrency platforms, said the betting program was not affected by Kraken’s settlement with the SEC because its own service is “fundamentally different” from Kraken’s.
SEC Commissioner Hester Peirce, who has advocated leniency and accommodation in the SEC’s stance on crypto firms, criticized the enforcement action against Kraken. “A paternalistic and lazy regulator settles for a solution like the one in this settlement: don’t initiate a public process to develop a workable registration process that provides valuable information to investors, just drop it,” Peirce said in a statement.
It is important to note that the Kraken settlement does not create new law, but could serve as pressure for Congress to pass legislation that places tighter restrictions on the cryptocurrency market.
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