SEC crackdown on crypto staking in the US could boost decentralization

The Ethereum network underwent the successful Shapella hard fork on April 12, allowing validators to withdraw their long-staked Ether (ETH) from the Beacon Chain after three years. In the first week of withdrawals, more than a million ETH was unstaked by validators.

However, from the second week onward, the number of ETH staked was higher than that of ETH withdrawn, indicating that validators are re-staking most of their ETH back into mining pools.

Staking is temporarily locking tokens on a network that uses a proof-of-stake (PoS) consensus mechanism. In a PoS network like Ethereum, users who wish to support the blockchain by validating new transactions and adding new blocks must “stake” a certain amount of cryptocurrency. In return, they receive rewards.

Staking ensures that a blockchain is only updated with valid data and transactions. Participants wanting to increase their chances of validating new transactions offer to stake large amounts of cryptocurrency as insurance.

Ether being re-staked is a big positive for the Ethereum network, but its future in the United States remains uncertain. Ethereum staking is getting tricky for many U.S.-based validators as staking service providers, particularly centralized exchanges, are fighting a regulatory battle with the Securities and Exchange Commission (SEC).

In February, Kraken crypto exchange settled with the SEC for $30 million and closed its staking services for U.S clients. The SEC claimed that the service qualified as a security and that Kraken must obtain the necessary license to operate.

Today we charged Kraken with failing to register the offer and sale of their crypto asset staking-as-a-service program, whereby investors transfer crypto assets to Kraken for staking in exchange for advertised annual investment returns of as much as 21 percent.

— U.S. Securities and Exchange Commission (@SECGov) February 9, 2023

Kraken withdrew its validator nodes for U.S. clients just a day before the Shapella upgrade to comply with SEC orders. The shutdown triggered an industry-wide debate on the future of staking services in the United States. Coinbase — one of the first crypto exchanges to go public in the U.S. — also provides staking services and is trying to force the SEC to answer a petition it filed regarding guidance for cryptocurrencies.

Coinbase CEO Brian Armstrong claimed that the SEC’s efforts to curtail staking service providers would prohibit retail staking in the United States. This might force many crypto platforms and staking service providers to move to offshore locations. At a time when the SEC is proactive in its enforcement action against crypto-staking services, the future of ETH staking looks shaky in the United States.

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Stephenie Lord Eisert, senior director of law enforcement at crypto intelligence firm Merkel Science, told Cointelegraph that cryptocurrencies are a global entity. Thus, a clampdown by one particular jurisdiction would only force service providers to move elsewhere.

“The proposed ban on crypto staking will not protect investors from fraud or scams. Instead, it will create a regulatory void that will be exploited by bad actors. Rather than banning centralized staking providers, regulators should focus on addressing the lack of guidance around both centralized and decentralized staking options,” she said.

Staking-as-a-service under threat in the U.S.

The U.S. is home to the majority of node operators on the Ethereum blockchain. Of the 9,849 active nodes, 5,214 are in the U.S., followed by 1,679 in Germany and 277 in Japan. The latest data from Etherscan indicates that node operators in the U.S. declined by 20% in the past week.

William Kraus, a partner at FisherBroyles law firm, told Cointelegraph that the SEC’s enforcement against Kraken shows the commission’s position on staking-as-a-service.

He added that this could prompt U.S. providers to respond in several ways, with some eliminating the service altogether, while others might implement changes to how they provide the service or publicly describe it. Some providers might decide not to change anything. However, the settlement has lessened ambiguity about staking, and providers must carefully consider the SEC’s position going forward, he said, adding:

“The U.S. certainly has not banned staking-as-a-service. Instead, the Kraken settlement establishes that the SEC considers at least some forms of staking to fall under its jurisdiction. The market response remains to be seen, but we can reasonably expect fewer, and perhaps more limited, offerings of staking-as-a-service to retail consumers in the U.S.”

Danny Talwar, head of tax at Koinly, told Cointelegraph that centralized staking providers account for almost a quarter of all staked ETH, with Coinbase (11.4%), Kraken (6.9%), and Binance (5.2%) leading the way.

Talwar said that if the SEC moves on with its enforcement action, staking service providers will be forced to look outside the U.S. to offer their services.

“If offshore exchanges with no Know Your Customer or Anti-Money Laundering compliance end up being major beneficiaries of the SEC cracking down on regulated, domestic, centralized exchanges, ‘consumer protection’ may be the least likely outcome,” he said.

The rise of decentralized staking

While U.S. regulators are clamping down on staking services, crypto proponents are trying to convince regulators that high-yield lending interests offered by centralized entities and staking rewards on the Ethereum blockchain are not the same.

Staking crypto on a blockchain like Ethereum contributes to daily transaction verification. Thus, Ethereum staking differs from lending rewards like those offered by BlockFi and Celsius.

On the other hand, the SEC is looking to brand all kinds of staking services under a standard banner, Konstantin Boyko-Romanovsky, CEO of staking service provider Allnodes, told Cointelegraph.

Boyko-Romanovsky said prohibiting centralized exchanges from offering staking services would further enhance decentralization. He also noted that the government’s approach might stifle adoption as many newcomers to crypto in the U.S. rely on centralized entities such as Coinbase for staking services.

He noted that staking pools might become more popular among retail stakers, explaining:

“Staking pools will probably experience an increase in participation from the United States, as the concept of staking pools democratizes access to staking opportunities and associated rewards. However, it is difficult to predict the exact extent of this potential influx, as it will depend on various factors such as mainstream acceptance and adoption, regulatory policies, scalability and ongoing innovation.”

He added that those interested in staking will likely find alternative means. “The focus of the regulatory bodies should be on creating precise and clear definitions for new and innovative concepts, such as staking. It would likely benefit customers more than attempting to force crypto instruments into existing fiat currency molds,” he said.

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The troubles of centralized staking services might work in favor of decentralized staking services and staking pools. After Kraken’s withdrawal of U.S-based validator nodes, most of these validators moved to Lido Finance, a decentralized staking pool service provider.

As @krakenfx ETH withdrawals where allowed, most of that went predictably into @LidoFinance. pic.twitter.com/Ud8vuvsvAT

— Seraphim (@MacroMate8) April 26, 2023

While it may help decentralization, the SEC’s stance on crypto staking could mean trouble for U.S.-based service providers. However, it remains to be seen whether firms like Coinbase uproot and move abroad, abandon significant market share in the domestic market, or make efforts to comply with SEC guidance and U.S. securities laws.