The Future of Crypto Staking

Decentralized finance may benefit from the SEC’s decision to shut down staking by cryptocurrency exchanges

By Mike Martin

The U.S. Securities and Exchange Commission has forced the Kraken cryptocurrency exchange to shut down its staking service and pay $30 million in fines.

It’s part of a crackdown on such staking services. Let’s examine the mechanics of staking and explore the reasons why shutting them down may benefit decentralized finance (DeFi).

Unlike Bitcoin, the Ethereum network is a “proof-of-stake” (PoS) blockchain that adds transactions through a process called validation.

Anybody can theoretically become an Ethereum validator. To be eligible, you “stake” the native currency of a blockchain. For Ethereum, this native cryptocurrency is ether (ETH).

Each ether you stake acts as a lottery ticket: Every few minutes, Ethereum randomly chooses a staked coin to do the math required to add the latest block to the Ethereum blockchain. The more coins you stake, the greater the chance you’re selected.

If the network selects a coin you’ve staked, you become a validator and must do the math required to validate all the transactions within the latest block.

Validators receive cryptocurrency as payment for their work.

However, to run your own validating node (computer), you have to stake at least 32 ether. With ether trading at around $1,575, the minimum initial investment to become an Ethereum validator today exceeds $50,000.

Staking in pools

I personally don’t know a single person who runs a validating node, yet I know a lot of people who stake crypto. They accomplish it by joining staking pools.

In pools, users rely on the computers of third parties to do the validating on their behalf. In exchange for their work, these parties typically keep a small portion of the validating fees they earn.

Coinbase, for example, may be receiving the equivalent of 5% APR from staking the crypto in these pools, but only pay out 4% APR, keeping the difference.

Fed chair Gary Gensler says there’s no guarantee exchanges are actually staking their customers’ crypto to certify blockchain transactions.

Staking with exchanges

Staking pools exist both in centralized exchanges and decentralized finance protocols, but the federal government is strongly regulating the former.

Why would the SEC shut down Kraken for simply allowing retail investors to participate in yield-earning programs usually reserved for those wealthy enough to stake 32 ethers?

Because the agency can’t guarantee the exchanges are actually staking their customers crypto, according to SEC chair Gary Gensler.

“You, the investor, should receive important disclosures,” Gensler said. “For example, what do they actually do with your tokens? Are they really staking them? Are they lending, borrowing or trading them?”

Gensler’s statement shows staking-as-a-service falls under the SEC’s definition of security. That means companies offering staking services must follow strict investor-protection guidelines and meet disclosure requirements.

In the eyes of the SEC, Kraken failed to alert the public to the risks inherent in its staking program. As a result, it was fined $30 million and forced to shut down its staking division.

Staking in DeFi

U.S. businesses like Kraken and Coinbase fall under the jurisdiction of the government. But what about decentralized entities that have no one to fine them or shut them down?

This is where DeFi protocols like Lido and Rocket come in.

Like Kraken, decentralized protocols offer staking-as-a-service. Unlike Kraken, however, they’re decentralized. That means there’s no central authority for the SEC to point a finger at. They would be battling every participant on the protocol.

For sure, the SEC will likely someday modify its definition of security to regulate these protocols or make them inaccessible to citizens, but that day will likely be years down the road.

In the meantime, inflow to these staking protocols has been surging since the Kraken shutdown. One of the largests DeFi protocols to benefit has been Rocket Pool (RPL).

If you’re nervous about the government shutting down your crypto-staking exchange, take control of your cryptocurrency by opening a self-custody crypto wallet. Besides giving you direct access to your private keys, staking protocols with self-custody wallets almost always pays a higher yield than centralized exchanges.

Mike Martin is head of content at tastycrypto, which recently introduced a self-custody digital wallet.