The SEC’s Crackdown on Ethereum Staking Has a Silver Lining

While this year’s price performance of the two largest cryptocurrencies has been impressive, with bitcoin (BTC) up over 46% year to date and ether (ETH) up over 37% YTD, the U.S. Securities and Exchange Commission (SEC) has been aggressively pursuing increased regulation on cryptocurrencies and has sued large cryptocurrency exchanges and custodians.

Earlier this year, Kraken, a U.S.-based crypto trading platform and custodian, settled with the SEC and agreed to discontinue its “Crypto Asset Staking-as-a-Service” program in the U.S. and to pay a $30 million fine.

This aggressive action from U.S. regulators has left many crypto investors concerned about the future of the industry. But while concerning, it may actually help the industry by increasing decentralization and provide much needed clarity.

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When Ethereum completed a successful network upgrade in 2022, shifting from a proof-of-work (PoW) blockchain to a proof-of-stake (PoS) network, this created an opportunity for individuals to earn blockchain rewards by running a network validator node and contributing to network security. Under the new PoS mechanism, the Ethereum network is secured by validators instead of miners, and those running a validator may earn rewards paid to them directly by the network, for their help in securing and running the network.

Running a validator on Ethereum requires more technical knowledge than many cryptocurrency investors have, which led companies to offer “staking-as-a-service” products to retail traders and investors. Kraken, along with others, offered their customers the ability to stake Ethereum collectively, in a commingled staking pool, to generate staking rewards.

While many investors appreciated these services, the SEC did not. Its public complaint states, “Kraken has offered and sold its crypto asset ‘staking services’ to the general public, whereby Kraken pools certain crypto assets transferred by investors and stakes them on behalf of those investors. Staking is a process in which investors lock up – or ‘stake’ – their crypto tokens with a blockchain validator with the goal of being rewarded with new tokens when their staked crypto tokens become part of the process for validating data for the blockchain. When investors provide tokens to staking-as-a-service providers, they lose control of those tokens and take on risks associated with those platforms, with very little protection.”

The SEC argued that this service, offered by Kraken and others, violates modern securities rules and “staking-as-a-service” products are unregulated securities offerings. While we’ve seen many crypto lending products fail (Gemini Earn, Voyager Digital and Celsius Network), crypto staking is quite different from lending, which has caused many to push back on the SEC’s claims.

Read more: How Does Ethereum Staking Work?

Staking is actually simpler to understand than crypto lending. Outsourced and pooled staking, in particular, is a process in which investors pool their tokens together and a centralized entity deposits the pooled tokens into a validator to secure the network. When the pooled assets earn a reward from the network, the controller distributes the earnings to the participants in the pool.

Also, while crypto lending is seen as a risky endeavor, staking does not involve lending pooled capital to hedge funds or traders. No leverage is involved, and it does not require underwriting or risk management practices that are seen in asset lending.

Although crypto staking is less complex and risky than crypto lending, the SEC still took issue with the process, effectively shutting down all U.S.-based “staking-as-a-service” product offerings.

So how does this change the Ethereum landscape?

Because Ethereum is now a proof-of-stake blockchain, staking assets in validators is crucial to network security and proper function.

Because exchanges are not allowed to offer staking services to their clients, none of the Ethereum currently held on exchanges will be able to contribute to network security. In order to be staked on the network, Ethereum will be required to be withdrawn from exchanges and staked via another method.

While the SEC’s actions have harmed the future of centralized staking services, which many would argue benefits retail investors in the long run, their rulings will ultimately push cryptocurrency to be more decentralized and distributed.

Read more: Proof-of-Work vs. Proof-of-Stake: What Is the Difference?

Companies like Lido and Rocket Pool offer “decentralized” staking services through their platforms. There’s also the option of running an individual node, directly on the Ethereum network – even though this requires significant technical savvy, and if done incorrectly, may result in loss of tokens.

The SEC does not have the ability to prevent users from staking ETH tokens themselves or from using a decentralized staking service. Many cryptocurrency advocates believe that these regulations only strengthen the future of cryptocurrency, by forcing them to adhere to the principles of decentralization and anonymity that they emerged from.

While recent regulations limit the number of centralized companies that can contribute to network security, it forces many individuals to pursue more decentralized options. One of the risks with centralized staking services is that one large institution, or a group of two or three, may gain majority power over the network if their service becomes large enough. This would put the network at risk of centralized control and manipulation. The SEC barring firms from pooled staking will force individuals to run their own node, which will increase decentralization and network security.

While the SEC regulations may temporarily halt crypto innovation in the financial sector, it will likely strengthen the use case of decentralized finance and increase the network decentralization and diversification. True to the very roots cryptocurrency was founded upon, SEC regulations seem to be forcing crypto to be truly independent from modern financial systems.