Top Stories of the Week - 2/10

In the newsletter this week, we cover the SEC’s settlement with Kraken over its staking-as-a-service program, positive regulatory developments in the United Kingdom, and another example of the trickiness of defi governance. Subscribe here and receive Galaxy's Weekly Top Stories, and more, directly to your inbox.

SEC Sues Kraken Over Staking Services

The U.S. Securities and Exchange Commission (SEC) has sued cryptocurrency exchange Kraken for their staking-as-a-service program, who settled with the regulator and agreed to pay a $30 million fine and close its staking operations. “Today’s action should make clear to the marketplace that staking-as-a-service providers must register and provide full, fair, and truthful disclosure and investor protection.” said Gary Gensler, Chairman of the SEC in a press release. In response to the SEC’s charges, Kraken has agreed to halt all of its staking operations and pay $30 million in disgorgement, prejudgment interest, and civil penalties.

The revelation comes a day after Coinbase CEO Brian Armstrong tweeted, “We’re hearing rumors that the SEC would like to get rid of crypto staking in the U.S. for retail customers.” Kraken had provided staking services for 14 different cryptoasset protocols, and it is the third largest staking provider on Ethereum, managing roughly 7% of total ETH staked. Coinbase is second with 12% of ETH staked and Lido is first with nearly 30%. Like Lido, which issues stETH (a liquid staking derivative – LSD – token), Coinbase issues cbETH. (Kraken issued no such LSD). The Block’s Frank Chapparo tweeted an image of a statement apparently made by Coinbase Chief Legal Officer Paul Grewal indicating that Coinbase would not be winding down their staking program despite the SEC’s recent enforcement action against Kraken. His statement reads: “What’s clear from today’s announcement is that Kraken was essentially offering a yield product. Coinbase’s staking services are fundamentally different and are not securities.”

Grewal and others are referring to some of the specific allegations made by the SEC in their complaint against Kraken. Specifically, the SEC alleges that Kraken marketed its staking program as an investment opportunity with “the highest fixed-rate returns in the industry.” This marketing, the SEC alleges, led Kraken’s customers to expect Kraken to “expend efforts to generate the investment returns,” creating a reasonable expectation of profit in the minds of Kraken’s customers. According to the SEC, this induced customers to enter into an arrangement with Kraken in which customers transferred complete control over their tokens to Kraken, under terms of service which permitted Kraken, in its sole discretion, to “determine these returns, not the underlying blockchain protocols, and the returns are not necessarily dependent on the actual returns that Kraken receives from staking.” The SEC also dings Kraken for a lack of disclosure, saying “defendants have disclosed only the information that they wish, not the information required by law.” The complaint accuses the exchange of providing insufficient information to users to allow them to ascertain how much they would earn from staking or what other activities Kraken may engage in to earn additional yield for customers beyond staking.

While Coinbase’s CLO refers to some of the specifics of Kraken’s program and argues that it’s those specifics that made Kraken’s product a security and not Coinbase’s, it appears both from the complaint and the press release that the SEC isn’t making such a distinction. Since news of the SEC’s enforcement action against Kraken became public, ETH, which is the native crypto asset of the world’s largest proof-of-stake blockchain by market capitalization, has trended downwards, dropping over 5% in less than 3 hours.

SEC Chair Gary Gensler has previously indicated that retail staking services may violate securities law based on the fundamental criteria of the Howey Test. The Howey Test is a test used to determine whether a transaction qualifies as an “investment contract” (and therefore a security) as defined by the Securities Act. Broadly, staking services like Kraken’s require users to send their crypto assets to a third-party with the expectation that the third-party will stake those assets on their behalf and deliver a yield in return. These operations, according to the SEC, check off the four elements of the Howey Test, which states that a transaction qualifies as a security if it involves:

• an investment of money,

• in a common enterprise,

• with an expectation of profit,

• derived from the efforts of others.

It is unclear to what extent the SEC’s enforcement of securities law will extend to decentralized staking protocols such as Rocketpool and Frax Finance, as well as permissioned smart contract protocols such as Lido. Lido, the largest staking provider on Ethereum, recently announced new plans to not only enable staked ETH withdrawals at Shanghai, but also an early implementation of the “Staking Router” which is designed to support permissionless onboarding of new validator node operators. Separately, Kraken has also been summoned by the U.S. Internal Revenue Service (IRS) for questioning.

Our take

The enforcement action against Kraken over their staking services may cause all retail-focused and U.S.-based staking-as-a-service businesses to shut down their operations. Though Coinbase argues their staking services differ materially from that of the staking services offered by Kraken, it remains unclear whether the SEC will agree. If the recent enforcement action by the SEC is as it appears targeted against all staking-as-a-service businesses in the U.S., this will have wide-reaching impacts on proof-of-stake (PoS) blockchains. On Ethereum, the largest PoS blockchain by market capitalization, at least 20% of total ETH staked is controlled by U.S.-based exchanges (Kraken & Coinbase). At minimum, the unstaking activity of Kraken will impact 7% of total staked ETH supply. In a blog post, Kraken specified that staked ETH will continue to earn rewards until Shanghai and immediately following the upgrade be returned to users. Other staked non-ETH assets that can be withdrawn from other PoS protocols will be automatically unstaked and returned to clients’ wallets. In a blog post from 2021, Kraken boasted that the total number of assets staked through their exchange exceeded $5bn. The exchange will now have to work through un-staking these assets spread across 14 different PoS protocols, which is a massive operational lift on the part of Kraken.

Increased unstaking activity as a result of the SEC’s enforcement against Kraken may cause long validator entry and exit queues right after the activation of Shanghai, putting the limits of the protocol for managing staked ETH deposits and withdrawals to the test. A large amount of ETH unstaking should cause staking yields to rise for those validators who remain, which may help incentivize users to stake back on to Ethereum either by operating their own validator node infrastructure or by using alternative staking providers, particularly offshore or decentralized ones (or to stake themselves with their own Ethereum node, which is of course possible albeit cumbersome for average people). Due to its dominance as the top staking provider on Ethereum, Lido is best poised to eat up a greater share of the staking market as Kraken or others wind down their operations. However, the longer the queue for validator exits, the more likely that liquid staked ETH derivative tokens will trade at a discount to ETH due to the superior liquidity of ETH to staked ETH derivative tokens.

Aside from the implications on Kraken and Ethereum’s upcoming Shanghai upgrade, broadly, the SEC’s charges against Kraken’s staking services highlights the very real vulnerabilities of centralized services and protocols to U.S regulators. Currently, there is a concerted effort to crackdown on the crypto industry in the U.S., not only evidenced by this SEC action but also by several other major regulatory actions, including guidance and statements from the Federal Reserve and other banking regulators, the IRS, DOJ, and state regulators like the New York Department of Financial Services. It is more important than ever for Ethereum core developers to prioritize upgrades that help boost the network’s censorship resistance and decentralization. -CK

Crypto Regulation Clarity in UK

The UK’s Treasury department (HMT) publishes a robust regulatory framework for digital assets that significantly enhances regulatory clarity for crypto in the UK. The announcement is in two forms of publication, a consultation and call for evidence on Future Financial Services Regulatory Regime for Cryptoassets, and a response to the Consultation on Cryptoasset Promotions. HMT intends to utilize existing regulations for the industry, such as the UK's Financial Services and Markets Act 2000 (FSMA), rather than developing a bespoke regime.

The Treasury's language clearly expresses the UK's continued interest in establishing a well-regulated crypto hub. The Consultation seeks to expand the list of “specified investments” (Part III of the Regulated Activities Order (RAO) to include crypto assets. The inclusion of crypto in the list of "specified investments" through the RAO will require entities carrying out crypto related activities "by way of business" to seek existing authorisation.

The Consultation is focusing on regulating crypto related activities rather than tokens themselves. Activities highlighted by HMT include: issuance, payments, exchanges, lending, custody, governance, validating, and investment activities. The regulatory jurisdiction for the defined activities includes all crypto related activities that are carried out in or to the UK. This is a significant shift, and will capture both activities provided by UK firms (whether to clients in or outside of the UK) as well as activities provided by overseas firms into the UK. The UK's approach of regulating activities entails that asset backed tokens (PAX Gold), algorithmic stablecoins (FRAX), and unbacked tokens (BTC, ETH) will presumably follow the same regulatory framework. However, a separate regime (similar to the payments and e-money rules) will apply to fiat-backed stablecoins via statutory instrument due to be laid in H1 2023.

Our take

The UK is effectively positioning itself vs. Europe by attempting to bring crypto regulation within the scope of existing regulation as opposed to drafting bespoke regulation (which Europe has done with its Markets in Crypto Assets (MiCA) regulation). Unlike other jurisdictions, the UK has also clearly explained how various crypto-related activities, including things like trading, custody, lending, and borrowing can fit legally within the existing framework. That type of clarity and effective integration should drive more institutional comfort with crypto in the UK. (Copper, one of the UK’s most prominent crypto firms, announced it was hiring more employees shortly after the announcement.) Along with the work the UK Law Commission has done and the Financial Markets and Services Bill, the groundwork is laid for regulators to interpret and license. While the FCA, UK’s markets regulator, will have the final say to apply these frameworks, the positioning and direction appears clear and positive.

The UK’s progressive stance and comprehensive approach to laying the underlying groundwork for it to take effect makes clear that this government, particularly under Prime Minister Rishi Sunak’s leadership, intends to make the United Kingdom a hub for the future of finance. (It’s worth noting that a Feb. 8 cabinet reshuffle also saw the creation of the Department for Science, Innovation, and Technology (SIT), which will be responsible for the UK’s crypto growth ambitions – crypto has a voice in the cabinet). While there are some items that have not yet been addressed, such as DeFi as a whole or novel custody schemes like MPC, the overall thrust of the framework and depth of its effort to integrate with the existing system provides significant clarity. This clarity, and the depth of the approach, stands in stark contrast to the current regulatory environment in the US. -AT/GP

Another Day, Another Spicy DeFi Governance Vote

After missing a “temperature check” on deploying Uniswap V3’s code to the BNB chain, a16z crypto brought in its 15mm undelegated UNI tokens to vote against deployment until further review. The votes, which consisted of an informal but critical off-chain vote for picking infrastructure and a second, final decision on actual deployment, come just two months before the V3 business license expires, making its code freely forkable. (Uniswap famously added a clause to its V3 license which prohibits copying its code for 2 years as a method to deter and delay would-be forkers like SushiSwap).

Crucially, a16z wasn’t able to back its portfolio company, generic messaging protocol LayerZero, in the first vote due to technical issues with their custodian. Instead Wormhole, another bridging solution, won, bringing in 28mm votes to LayerZero’s 17mm. Voting on whether Uni V3 will be deployed is ongoing (closes Friday at roughly 9 am EST). Regardless of the outcome, there is 40m UNI currently publicly aligned against a16z’s desired outcome.

Our take

There’s a lot to unpack here, but it’s clear that decentralized governance remains messy, with technical issues, delays, and of course, voter apathy plaguing forums (less than 8% of UNI holders have voted, 2% below the usual 10% turnout). Public discourse has honed in on a16z’s role as UNI holders and investors in other protocols - should they side with the solution with more technical merit or is it ethical for them to align voting with their portfolio?

In either case, owning UNI grants immutable rights in governance regardless of motivation for voting. Said differently, UNI’s immutable power of Uniswap’s deployment is a feature, not a bug. But the delay, along with infighting in the forum (and DeFi governance more broadly) highlights again governance issues the industry is still grappling with. (For more information on Governance in DeFi, read this Galaxy Research whitepaper).

For one, the BNB case provides another example of the tradeoffs of decentralization. As some investors have noted, a company or single group controlling Uniswap would certainly enhance efficiency, but at the cost of some immutability and permissionlessness. While governance can improve some issues, like special interests, will never go away. One idea comes from traditional finance, where three service providers handle the bulk of proxy voting for most equity holders—maybe a DAO could be formed to do the same? But importantly, in the long-run, much of this specific type vote won’t matter, as permissionless blockchains and expiring licenses will provide an alternative for dissidents: just fork it! -WJS

Other News

• SBF appeals releasing identities of co-signers

• Gemini & Genesis bankruptcy agreement, Gemini to contribute $100m

• DCG sells shares in Grayscale to raise funds.

• Binance U.S suspends USD transfers for users

• Bitcoin miners Hut 8 and US Bitcoin are merging to form a new company called Hut 8 Corp, based in the U.S.

• Lido moves ahead with V2 upgrade as Shanghai edges closer

• Arbitrum announced Stylus to support multiple programming languages in EVM+

• DEX aggregator CoW Swap falls victim to $180,000 hack

• Saudi Arabia partners with The Sandbox for future metaverse plans

• Aave launches native stablecoin on Ethereum testnet

• DeFi giants join forces on Twitter to promote decentralization