Why Gary Gensler is right on Kraken
This week the SEC filed a suit against Kraken, the crypto exchange, alleging that their staking product is an unregistered securities offering. In response, Kraken has suspended their staking product in the United States. Crypto Twitter is quick to condemn Gary Gensler and the SEC for stifling innovation and harming US consumers, but if we break it down, we’ll see that in fact Kraken’s staking product is a security and by offering it in an unregistered fashion is skirting the consumer protection afforded by securities laws.
Why Kraken’s offering is a security
What a security is is defined in the now infamous Howey Case. As I wrote in ‘What happened to LBRY’:
Solo staking in a protocol doesn’t match the Howey test: while there’s an investment of money, there’s no common enterprise (Ethereum isn’t a company or enterprise of any sort for example) and there is no core promoter who you’re counting on to provide profits (For a more in depth break down of this you can listen and read here).
Kraken’s staking offering however isn’t this. To understand why Kraken’s offering conforms to securities law, we have to explore the product — which the SEC has done for us in the suit. The SEC claims that staking on Kraken is indeed an investment contract with Kraken where an individual will derive profits from the management of Kraken on their behalf in a way that is not aligned with a 1:1 staking approach. They show this by:
- Returns aren’t dependent on the blockchain performance, rather on Kraken:
2. Returns that stakers will receive are due to Kraken’s managing, not the core blockchain:
3. Kraken’s staking offering is significantly different from actual solo staking, making it clear that this isn’t classic staking, rather an investment product:
Together these three portions of Kraken’s staking offering make it clear that this is not regular staking. This is an investment in Kraken’s ability to manage your assets (ETH, ATOM, ADA etc) to pool them together with others and run the validators needed to receive stake rewards. If you’re not convinced, just read the last line in point 3: “Defendants offer investors instant rewards accrual and the ability instantly to unstake”.
What Proof of Stake protocol lets a staker instantly unstake? This goes against the whole premise of how proof of stake solves the ‘nothing at stake’ problem required to achieve BFT consensus.
This is significantly different from solo staking or even pooling together assets and having that co-managed by an external party that stakes it for you. In both of these scenarios the returns you’re expecting aren’t due to the managers (or ‘promoter’ in Howey Test jargon) ability to generate yield. Your profits come from the blockchain. Your collateral is staked and is subject to the blockchain, not a middle party — aka promoter. In Kraken’s case, the ability to withdraw immediately shows how mitigated this product is. They are a management company who are investing on your behalf and giving you a dividend in return — not any different from a REIT, or in fact, the original Howey citrus groves case.
Why does this matter for investor protection?
So what? Isn’t the Howey Test archaic and old? How does preventing US consumers from a yield opportunity protect them?
These are all legitimate questions and the answer the SEC gives is perfectly reasonable, and it lies at the core of why the Securities Act of 1933 was put into place: if you’re offering a security, as in an investment contract where you’re relying on a third party exclusively, the public needs to know the details about that third party. They need transparency. The SEC puts it really well (bold is my addition):
Essentially, the SEC is saying: you’re entrusting your funds completely to Kraken, they have provided you with zero information on what they’re doing with it. Who’s to say they aren’t comingling it? How are the funds managed?
Imagine thinking your ETH is staked safely, but because of a market panic people withdraw their ETH from Kraken — and according to their terms this can be done immediately, despite no such ability existing on the actual Ethereum Blockchain — and you end up rugged? This is a scenario that can occur according to Kraken’s product.
Securities regulation exist to make these cases illegal and less prevalent. They’ve been put in place to provide the public with more transparency regarding products where we rely on a third party, central actor. Are they out dated? A bit. Are they unfair in accreditation? Definitely. But if we as an industry don’t want another FTX to occur, we have to commit to offering the transparency traditional financial markets offer when it comes to securities and stop hiding behind the anti regulation façade.
Designing Tokenomics by Yosh Zlotogorski