Why Is ‘Staking’ At The Center Of Crypto’s Latest Regulation Scuffle

Barely six months ago, Ether (ETH) led a strong recovery in crypto prices ahead of the big tech upgrade that would eventually make ‘staking’ available to crypto investors.

A majority of people have hardly wrapped their heads around this concept, but now, the price of Ether is dropping amid growing fears that the Securities and Exchange Commission (SEC) could heavily crack down on it.

On February 9, Kraken, one of the biggest cryptocurrency exchanges in the world, shut down its staking program in a $30 million settlement with the SEC, which stated that the firm failed to register the offer and sale of its crypto staking-as-a-service program.

The night before, Coinbase CEO Brian Armstrong warned all his followers on Twitter that the securities watchdog might want more widely to end staking for United States retail customers. SEC Chair Gary Gensler told CNBC’s “Squawk Box”:

“This should put everyone on notice in this marketplace. Whether you call it to lend, earn, and yield, whether you offer an annual percentage yield – that doesn’t matter. If someone is taking [customer] tokens and transferring to their platform, the platform controls it.”

Staking has majorly been seen as a catalyst for the mainstream adoption of crypto and a massive revenue opportunity for crypto exchanges like Coinbase. A clampdown on staking and all staking-related services may have some damaging consequences for the exchanges and Ethereum together with other proof-of-stake blockchain networks. To understand all this, it helps to have a fundamental understanding of the activity in question.

Here is everything you need to know:

What Is Staking?

Staking is described as a means for investors to earn some passive yield on their crypto holdings by locking tokens up on the network for some time. For instance, in case you want to stake your Ether holdings, you would do that on the Ethereum network. The bottom line is it enables investors to put their crypto to work in case they do not want to sell it anytime soon.

How Does Staking Work?

At times, staking is known as the crypto version of a high-interest savings account, but there is a major flaw in the comparison: crypto networks are decentralized and banking institutions are not.

Earning interest via staking is not similar to earning interest from a high annual percentage yield provided by centralized platforms like the ones that encountered lots of trouble in 2022, like Celsius and BlockFi, or Gemini in January.

These offerings were more similar to a savings account: people would deposit their crypto with centralized entities that lent these funds out and promised rewards to the depositors in interest that ranged up to 20% in some cases. Rewards are known to vary by the network but normally, the more a user stakes, the more they earn.

On the contrary, when you stake your cryptocurrency, you contribute to the proof-of-stake ecosystem that keeps decentralized ecosystems like Ethereum working and secure. Hence, you automatically become a ‘validator’ on the blockchain, which means that you can verify and process the transactions as they pass through if you are selected by the algorithm.

Notably, the selection is semi-random – the more crypto you stake, the more likely you will get selected as a validator. The lock-up of the funds works as some form of collateral that can get destroyed whenever you as a validator act insincerely or dishonestly.

This is true only in the cases of proof-of-stake networks like Polkadot, Ethereum, Cardano, and Solana. A proof-of-work network like Bitcoin utilizes a different process to confirm transactions.

Staking As A Service

In many cases, investors will not be staking themselves – the process of validating network transactions is just impractical on both the institutional and retail levels.

That is where the crypto service providers like Coinbase, and previously Kraken, come in, Investors can give their cryptocurrency to the staking service and the service does the staking on the investors’ behalf. Whenever you are using a staking service, the lock-up period is mainly determined by the networks (like Solana and Ethereum), and not third parties like Kraken or Coinbase.

That is also where it gets a bit murky with the SEC, which said last week that Kraken needed to have registered the offer and sale of the crypto asset staking-as-a-service program with the securities regulator.

While the SEC is yet to give any formal guidance on what crypto assets it considers securities, it mainly sees a red flag in case somebody makes an investment with a reasonable expectation of profits that would get derived from the work or efforts of others.

Coinbase has nearly 15% of the market share of Ethereum assets, as highlighted by Oppenheimer. The sector’s current retail staking participation rate is 13.7% and growing.

Proof-of-Work vs. Proof-of-Stake

Staking works just for proof-of-stake networks like Polkadot, Ethereum, Cardano, and Solana. A proof-of-network, like Bitcoin, utilizes a different process to confirm the transactions. The two are just the protocols used to secure crypto networks.

Proof-of-work needs specialized computing equipment, like high-end graphics cards to authenticate transactions by solving highly complex math problems. Validators get rewards for every transaction that they confirm. This process needs lots of energy to complete.

Ethereum’s massive migration to proof-of-stake from proof-of-work improved its energy efficiency to nearly 100%.

Risks Involved

The source of return in staking is different when compared to the traditional markets. There are no humans on the other side promising returns, but instead, the protocol itself pays investors to run the computational network.

Despite the strides that crypto has made, it is still a nascent sector dominated by technological risks and possible bugs in the code are a major challenge. In case the system fails to operate as anticipated, it is likely that investors could easily lose some of their staked coins.

Volatility is and has mostly been a somehow attractive component in cryptocurrency but it comes with several risks. One of the most notable risks that investors encounter in staking is a drop in the price. At times a large drop can result in the smaller projects hiking rates to make possible opportunities more attractive.