Why Gary Gensler is right on Kraken

August 7, 2023

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.

Gary Gensler teaching ‘Blockchain and Money’ at MIT in 2018
Gary Gensler teaching ‘Blockchain and Money’ at MIT in 2018  — think what you want, but listen to the course. He gets it.

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’:

The Howey test is judged based on three criteria:1. The investment of money2. In a common enterprise3. With an expectation of profits to be derived solely from the efforts of the promoter or a third party

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:

  1. Returns aren’t dependent on the blockchain performance, rather on Kraken:
Defendants market the Kraken Staking Program by touting specified investment returns for certain staking-eligible crypto assets on the kraken.com website, on social media channels, and through advertisement emails. Defendants determine these returns, not the underlying blockchain protocols, and the returns are not necessarily dependent on the actual returns that Kraken receives from staking.

2. Returns that stakers will receive are due to Kraken’s managing, not the core blockchain:

Defendants advertise that their significant efforts, discussed in more detail below, provide investors with constant and regular returns (called “rewards”), more so than investors could achieve if they tried to implement a staking strategy on their own without the benefit of Defendants’ scale and expertise.

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:

Among other things, Defendants advertise regular investment returns and payouts, no staking minimums, their technical expertise in staking, and an easy-to-use platform created by Defendants. In addition, Defendants offer investors instant rewards accrual and the ability instantly to unstake (essentially, to take back the assets immediately).

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):

Through the Kraken Staking Program, Defendants have offered and sold investment contracts without registering the offer or sales with the SEC as required by the federal securities laws, and no exemption from the registration requirement applied. The absence of any registration statement means that investors have lacked material information about the Kraken Staking Program. Missing material information includes, but is not limited to, the business and financial condition of Defendants, the fees charged by Defendants, the extent of Defendants’ profits, and specific and detailed risks of the investment, including how Defendants determine to stake investor tokens or purportedly hold them in reserve and the extent of these purported liquidity reserves, or whether tokens are put to some other use.

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