How the SEC Could Reshape Ethereum’s Staking Landscape for the Better

A surprise settlement last week between the U.S. Securities and Exchange Commission (SEC) and Kraken, a leading crypto exchange platform, raised existential questions for the future of “staking” on blockchains like Ethereum.

Ethereum experts and blockchain analysts say the seemingly adverse industry development in the U.S. may bring benefits, such as helping to decentralize the Ethereum network and forcing service providers to clarify how they earn yield for retail investors.

The settlement, first reported by CoinDesk, forced Kraken to wind down its staking-as-a-service offering to U.S. clients. Previously, the service allowed retail investors to “stake” some amount of cryptocurrency with blockchains in exchange for yield.

So-called proof-of-stake blockchains like Ethereum enlist users to stake crypto assets as a form of security guarantee in exchange for rewards, similar to interest payments. Proof-of-work networks like Bitcoin, by contrast, are operated by a more energy-intensive process of crypto “mining.” (Ethereum famously transitioned from proof-of-work to proof-of-stake last year.)

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

The Kraken-SEC settlement could spell doom for a growing class of staking-as-a-service products, which allow users to stake with lower up-front costs or technical know-how than typically required. Around $25 billion worth of ether (ETH) is currently staked on Ethereum, with 18% of that stake held by Coinbase and Kraken – the two largest platforms with staking services.

The Kraken settlement, classifying the exchange’s staking-as-a-service offering as a security, may have ramifications for the staking landscape at large. “Decentralized” staking services like Lido and Rocket Pool are scratching their heads as to whether the SEC’s viewpoint on staking might actually benefit them in the long term. The “solo-stakers” that help run Ethereum sans intermediary also see a silver lining in the SEC’s action, since it could potentially make the network more secure and decentralized, down the road.

Ethereum staking requires a minimum of 32 ETH (~$50,000). Staking without an intermediary means setting up a computer to act as a “node” on the Ethereum network – a complicated task that can incur financial penalties if done improperly.

The barriers have left room for exchanges like Kraken and Coinbase to help retail investors stake – primarily as a way to earn interest. Both platforms eliminate the 32 ETH requirement by pooling user funds together, and they do all the heavy lifting of spinning up a node themselves.

But as SEC commissioner Hester Peirce noted in a fiery dissent to the agency’s crackdown on Kraken, “staking services are not uniform, so one-off enforcement actions and cookie-cutter analysis does not cut it.”

In legal filings, the SEC said it took particular issue with the mechanism by which Kraken calculated the yields it paid to users: “The defendants determine these returns, not the underlying blockchain protocols, and the returns are not necessarily dependent on actual returns that Kraken receives from staking,” the commission wrote.

Coinbase insists that its own service is different. “True on-chain staking services like ours are fundamentally different,” Coinbase’s chief legal officer Paul Grewal argued on Twitter. According to Grewal, Coinbase differs from Kraken in that it directly ties user payouts to the rewards earned via staking.

Though Coinbase CEO Brian Armstrong says he would be willing to fight the SEC should they come after Coinbase’s staking offering like they did Kraken’s, what comes next is unclear.

As CoinDesk reported last week, analysts at Coinbase admitted in a report that the developments around Kraken will likely affect the “pace of staking growth going forward.”

In the immediate aftermath of the SEC ruling, investors seemed to think it was good news for “decentralized” staking platforms. The LDO token behind Lido, the largest decentralized staking service, briefly jumped 10% following last week’s news around Kraken. Lido and similar protocols remove access barriers to staking similar to centralized services, but they run their operations entirely on smart contracts – the self-executing computer programs that live on blockchains.

“There's not a crypto exchange management team that's working on your behalf pooling your money,” Lex Sokolin, the chief cryptoeconomist at the Ethereum research and development firm ConsenSys, told CoinDesk.

It’s that key differentiator – the lack of a centralized company or management team – that decentralized offerings hope will earn them less scrutiny from regulators. “My hope is that you're going to get a very different substantive view on the Lidos of the world, but I do think it's very much an open question, and it's a legal one and a difficult one,” Sokolin said.

Lido currently accounts for 29% of the total share of staked ETH (competing services, like Rocket Pool, are significantly smaller). Should the centralized staking-as-a-service model disappear entirely, it wouldn’t be surprising to see Lido’s footprint grow even larger.

Some members of the Ethereum community see a silver lining in the SEC’s enforcement action, telling CoinDesk that it could help shift control over the network (and other blockchains) to a larger set of people.

According to Jaydeep Korde, whose company Launchnodes builds infrastructure to help people with 32 ETH spin up a node themselves, staking services like Kraken’s undermined crypto’s goal of creating a “decentralized” financial system. “Having new intermediaries who, through a magic black box, give you an interest rate doesn't strike me as being that different to what we have right now,” Korde told CoinDesk.

According to Korde, the news about Kraken may finally push those with 32 ETH towards solo-staking, where they opt to run their own nodes rather than hand control to a third party.

“I think this is good for decentralization,” said Ben Edgington, a product manager at Ethereum research and development firm ConsenSys. On a proof-of-stake network like Ethereum, one’s stake equates to their power over the network; if one party accounts for enough of Ethereum’s stake (around 50-60%), they can theoretically slow it down or block certain kinds of transactions. “In terms of the protocol and the health of the protocol, having a large centralized entity controlling a lot of the stake is not ideal,” said Edgington.

In contrast to Ethereum’s old proof-of-work system, where a handful of big mining syndicates amassed a disproportionate amount of influence over the network, Ethereum’s new proof-of-stake model was supposed to make the network harder to centralize. “It's always been our aim that Ethereum is an army of tens of thousands of solo node operators, not three or four large data centers,” said Edgington.

The growth of staking-as-a-service platforms (among other factors) risked jeopardizing this goal, but the SEC’s settlement with Kraken could help make Ethereum’s proof-of-stake system harder to monopolize.