With the announcement of charges against and a settlement with two subsidiaries of a prominent crypto exchange, Kraken, the U.S. Securities and Exchange Commission (SEC) appears to have a new target within the blockchain industry: staking-as-a-service.

The SEC’s complaint alleges that Kraken’s pooled staking program involved the creation of “investment contracts,” and thus securities, under the U.S. Supreme Court case SEC v. Howey,¹ and that by offering the program to investors, Kraken conducted an illegally unregistered securities offering in violation of the U.S. securities laws. To settle the SEC’s charges, Kraken agreed to immediately cease offering its crypto asset staking services and pay $30 million in disgorgement, prejudgment interest, and civil penalties.

Staking service providers, including many crypto asset exchanges, should consider whether to halt or restructure their staking programs, as the SEC has now forcefully indicated that it views many, if not all, pooled staking programs as offerings of securities. The action may also be a harbinger of additional enforcement by the SEC and raises interesting questions about the ability of banks to offer these programs.

Staking and the SEC’s Complaint

“Staking” involves “proof of stake” validation protocols that certain blockchains use. These protocols offer rewards to those who “validate”—or confirm—transactions on the blockchain. To become a validator and earn rewards, holders of crypto assets must first “stake”—or commit—crypto assets (typically, the “native” crypto asset on a particular blockchain). Validators may be selected based on several factors, including, most notably, the size of their stake. This incentivizes would-be validators to stake, or commit, greater quantities of crypto assets. Proof-of-stake protocols generally incentivize validators to add legitimate transactions (and thus “build”) a blockchain by rewarding them if they do and penalizing them if they do not, including by having the staked crypto assets “slashed” (or destroyed).

The SEC’s complaint notes several features of Kraken’s staking program that differentiated it from the staking and earning of rewards by individual users on blockchains:

• While individual users would have to actively make efforts to stake and earn rewards on a blockchain, the Kraken staking program was a passive investment opportunity where investors only had to open an account and transfer their crypto assets to Kraken.
• Instead of individual users staking their assets in the hope of reward, the Kraken staking service pooled crypto assets for staking, increasing Kraken’s chances of being chosen as a validator. Kraken determined the returns to each individual investor in the Kraken staking program and charged investors fees for the staking service.
• Unlike individual users, who could be deprived of the use of their crypto assets during the staking process, Kraken’s staking service promised users instant rewards and greater liquidity.
• Kraken did not stake all its users’ crypto assets, instead holding back a subset of the crypto assets as liquidity reserves, the amount of which was determined solely by Kraken.
• Kraken marketed itself as an easy one-stop-shop investor interface, helping users avoid the technical know-how required to stake tokens themselves.

Kraken’s efforts, along with its extensive marketing of the staking program as an investment opportunity, led the SEC to allege that the Kraken staking service was an “investment contract” in which investors pooled their assets for investment purposes, provided those assets to Kraken, and primarily relied on Kraken’s efforts to generate returns.² The SEC also noted that Kraken had marketed the advantages of the Kraken staking program over staking by individual users. The SEC concluded that Kraken has “led and will continue to lead reasonable investors to expect [Kraken] to undertake significant and essential technical, managerial, and entrepreneurial efforts" to generate returns.³

What’s at Stake?

If a staking program involves an offering of securities, that offering must be registered with the SEC or offered under an exemption from registration. Kraken had not done either. Currently, no offering of a “staking as a service” program is registered with the SEC, and most are not offered under an exemption—which would most typically involve an exemption for private offerings only to “accredited investors.”⁴

The Kraken action means that staking-as-a-service providers will need to consider halting or restructuring their programs to comply with the federal securities laws—for example, by limiting participation to accredited investors. Alternatively, these programs could be restructured to, for example, do no more than provide technology allowing customers to stake individually, without the extra features of a program like Kraken’s. The SEC’s complaint notes that individual users’ assets were not segregated during the staking process, and that Kraken engaged in marketing, discretionary allocation of assets as reserves, and other activities that helped generate returns. The distinctions between staking by individual blockchain users, on the one hand, and Kraken’s aggressively marketed staking service, with its various investor-friendly features, on the other, will likely be critical to how the SEC views those types of programs.

One pitfall to avoid is to assume that sufficient disclosures, smaller tweaks to the services provided by a sponsor, and/or decentralization alone will change the analysis by federal regulators of a staking program. Whether a program involves a securities offering is a fact-based, complex analysis, and there is no guarantee that the elimination or modification of one or even several aspects of a staking service will lead to a different result.

Operators of liquid staking protocols, which pool ETH from multiple holders to take part in Ethereum’s staking process, and which have grown in popularity since Ethereum’s switch to proof-of-stake, should take particular note of the SEC’s action and consider the issues above.

Further (S)Takeaways

Additional enforcement. Several months ago, we noted a significant new trend in SEC actions—increasing regulatory scrutiny of crypto asset exchanges, even those that claim not to transact in securities. The Kraken settlement is only the most recent example of that trend, which shows no sign of abating.

Especially in light of recent collapses and current turmoil in the crypto asset markets, the SEC is likely to pursue additional enforcement actions against staking service providers. Recall that the SEC’s initial enforcement action against crypto lending and “earn” programs has been followed by several actions against other lending platforms. The Kraken settlement may signal a similar wave of enforcement actions against staking service programs. Following the action against Kraken, SEC Chair Gary Gensler appeared to indicate that any yield product which involved a platform taking control of its customers’ crypto assets would potentially be required to register under the federal securities laws. This is yet another indication that the SEC is likely to take the broadest possible approach to the regulation of the activities of crypto asset exchanges in the months to come.

Interplay with banking guidance. The U.S. banking agencies previously stated that ancillary crypto asset custody services, such as staking, were among the crypto asset activities that they intended to provide additional clarity on questions of legal permissibility and safety and soundness expectations. As we recently noted, the agencies are keeping a watchful eye, and the Federal Reserve Board has recently indicated that it does not prohibit its supervised banks from providing safekeeping services for crypto assets. If related services such as staking would be permissible under the same authorities and rationale, then banks may be able to provide staking and possibly other related services such as crypto asset lending. Interestingly, issuances of securities by banks can be exempt from certain requirements of the federal securities laws.⁵ The interplay between the banking and securities laws and the agencies’ contrasting approaches to addressing crypto-related risks will be something to watch—particularly in light of the fact that the SEC has not generally allowed offerings of products like staking-as-a-service to be successfully registered, as SEC Commissioner Hester Peirce noted in her dissent to the action against Kraken.

If you have questions about the complaint, settlement, or other crypto regulatory matters, please contact a member of Wilson Sonsini's fintech and financial services group.

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[1] SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (discussing when an instrument is an "investment contract" and thus a security for purposes of the Securities Act of 1933).

[2] Howey, 328 U.S. at 299. In SEC v. Howey, the U.S. Supreme Court developed a four-part test for whether an asset is an "investment contract": the asset must involve 1) an investment of money in a 2) common enterprise with 3) an expectation of profit 4) primarily derived from the effort of others.

[3] See SEC Complaint against Kraken at ¶ 82.

[4] Accredited investors are individuals with a net worth over $1 million (individually or with spouse or partner), excluding primary residence, or with yearly income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and reasonably expects the same for the current year. An entity can also qualify as an accredited investor if it 1) owns more than $5 million in “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act of 1940, and 2) was not formed for the specific purpose of acquiring the securities offered.

[5] For example, offerings of securities issued by banks (as defined under the Securities Act of 1933 (“Securities Act”) are exempt from registration under Section 3(a)(2) of the Securities Act.