Regulating Crypto by Enforcement and Stealth Will Set the U.S. Back
Call me naive, but I’ve always resisted the conspiracy theory that the anti-crypto stance adopted by certain U.S. regulators is meant to strangle this industry and protect the financial establishment it seeks to disrupt. I’ve preferred to see it as a wrong-headed but well-intended effort to protect consumers.
Recent events have me wondering if something more sinister isn’t afoot. (And that maybe I am naive.)
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First, all indications are that the Securities and Exchange Commision will outright prohibit companies from providing staking services to retail customers in the U.S., products that give investors an opportunity to share in the token rewards that proof-of-stake blockchains deliver to validators. Following a hint from Coinbase CEO Brian Armstrong Wednesday that such a ban was coming, news broke Thursday that, in response to an SEC lawsuit, Coinbase competitor Kraken is indefinitely abandoning the staking service it offered to its U.S. customers and paying a $30 million fine.
Second, per observations from Castle Ventures general partner Nic Carter and Blockchain Association chief policy officer Jake Chervinsky, and evident in other signs such as Binance’s problems with U.S. dollar bank transactions, it seems regulators are pressuring U.S. banks to stop servicing crypto companies.
These latest moves will make it even harder for average U.S. citizens to participate in this industry, limiting it to large institutional investors, while various innovative startups looking to disrupt those same rent-seeking intermediaries will struggle to access liquidity. It’s hard to understand how these actions serve to protect consumers or further other policy objectives such as expanding financial inclusion. It feels as if government agents are deliberately trying to force this industry into the hands of Wall Street fat cats.
But here’s the thing: Making it hard for Americans to invest in and build crypto projects won’t stop people outside of the U.S. from doing so. Hardline actions here will just push activity overseas. And while the U.S. might continue to generate business in “institutional crypto,” it will miss out on the true innovations occurring at grassroots levels.
To be fair, SEC Chair Gary Gensler has been warning for some time that staking services could constitute unregistered securities, which would mean that exchanges such as Coinbase could be barred from listing them.
The argument hinges on the income-like earnings that validators of proof-of-stake blockchains earn in the form of new tokens and transaction fees when they lock up pre-existing tokens, putting them at stake in a mechanism intended to keep them honest. It could be argued that the promise of fresh token income meets one part of the all-important Howey Test, which posits that for an investment instrument to be a security the investor needs to have an expectation of return. And from the complaint against Kraken, it appears that the exchange’s role as an intermediary managing the pool of staked token investment meant that, in the SEC’s eyes, it tripped up another Howey prerequisite: that the expected returns are “derived from the effort of others.”
Fine. In a letter-of-the-law sense, the SEC’s backlash against staking may have some standing. But why do this now, and in such a brutal way, shutting down a well-functioning program in the U.S. without offering a company to get its program into an SEC-compliant structure?
In a statement explaining her lone dissent on this action, SEC Commissioner Hester Peirce argued that the core problem is the overall inaction around creating a workable regulatory framework for crypto assets:
“Whether one agrees with [the Commission’s Kraken] analysis or not, the more fundamental question is whether SEC registration would have been possible. In the current climate, crypto-related offerings are not making it through the SEC’s registration pipeline. An offering like the staking service at issue here raises a host of complicated questions, including whether the staking program as a whole would be registered or whether each token’s staking program would be separately registered, what the important disclosures would be and what the accounting implications would be for Kraken.”
Read more: Dan Kuhn – Crypto Would Survive an SEC Crackdown on Staking
The timing here may be related to Ethereum’s development. It is less than six months since the second-largest blockchain successfully migrated from proof-of-work to proof-of-stake in what became known as the “Merge” and comes just before the blockchain launches its Shanghai upgrade, which will allow holders of locked ether tokens to unlock them.
The action also comes just one month since the Commodity Futures and Exchange Commission declared ether to be a commodity – i.e., not a security – which suggests there might be a little turf war here. Determining the policy treatment of Ethereum is a key marker in the race to establish a regulatory standard for blockchains.
More importantly, what is the greater purpose here? Securities law exists to protect small investors – specifically, unaccredited investors of lower income and wealth who are deemed to be less sophisticated and more vulnerable to abuse by the founder of an investment project than wealthier individuals and institutions. How is it that these retail investors in Ethereum are at risk now that they have a chance to earn yield on their tokens, but supposedly weren’t at risk when Ethereum was a proof-of-work chain with zero yield?
Whatever the motive, the SEC’s move raises issues around the thorny matter of centralization risks in Ethereum’s validation network. Immediately after the Merge, concerns grew that a small pool of corporate-run staking pools were validating the bulk of Ethereum transactions and could collude to censor transactions. If hedge funds and venture capitalists are free to stake but small investors are not, doesn’t that risk rise?
A solution, my colleague Daniel Kuhn writes, might lie in decentralized alternatives to Kraken’s offering, such as Lido and Rocketpool. But, given that U.S. regulators have signaled a belief that decentralized protocols aren’t outside their purview, is there not a risk the SEC would deem these projects illegal too and go after their founders and developers, in the vein of Tornado Cash (the Ethereum “mixer” that was sanctioned last year by the U.S. Treasury Department)?
For now, it would seem there’s nothing stopping individual investors from staking the 32 ether needed to be a validator, but not everyone has that kind of money to put away (almost $50,000 at today’s prices). And, let’s be honest, doing this on your own is too complicated for Joe Public. Eventually, small U.S. investors might be able to gain easier staking exposure through tightly regulated exchange-traded funds, but the SEC has yet to approve a bitcoin exchange-traded fund, let alone an ether ETF.
Another outcome is that retail investors’ priorities might shift back to proof-of-work chains such as Bitcoin. But it’s baffling that the SEC would want to promote that considering it’s also devising guidelines for environmental, social and governance (ESG) standards and Bitcoin’s carbon footprint is now massively larger than Ethereum’s on account of the latter’s move to proof-of-stake.
In all of this, it seems we can expect to remain baffled because the SEC rarely offers comprehensive guidance on its crypto thinking.
Gensler and his defenders might counter that he has consistently warned that most, if not all, tokens are securities. But the industry’s gripe goes beyond that. It’s that, other than the occasional public invitations to “come in and talk to us,” there’s been no real effort to collaboratively develop a regulatory framework that accommodates the unique, decentralized features of this technology. Worse, industry leaders say, the SEC practices “regulation through enforcement,” with the Kraken suit being a case in point, which leaves everyone on their toes.
The practice might be a good way for the SEC to show off its bureaucratic clout but, without a clear legal framework for how to move things forward and reduce the risk of such enforcement actions, it fosters uncertainty and fear. And that’s antithetical to innovation and entrepreneurship.
New “Operation Choke Point”
Meanwhile, an even more stealthy regulation-by-enforcement approach is playing out in banking supervision.
As Nic Carter explained in his blog post, the widespread reports that U.S. banks are being instructed not to service crypto providers comes with no official communication from any regulator. He compared it to “Operation Choke Point,” a stealth campaign during the Obama administration to restrict fund flows to fringe but entirely legal services such as gun stores, marijuana dispensaries and porn providers.
Without a clear legal framework for how to move things forward, these enforcement actions foster uncertainty and fear
The new, unannounced policy was likely a factor in Signature Bank’s move to close the international arm of Binance’s account, which led the world’s biggest crypto exchange by volume to announce that it was temporarily suspending U.S. dollar transfers.
I got wind of the crackdown last month when the London-based head of an Eastern European bank told me that SWIFT, the U.S.-headquartered international bank messaging service, was telling banks it would not permit large transfers to providers of “crypto” services.
The banker’s comment got me thinking: What defines “crypto?” Therein lies another problem: Banks have some discretion in how they will carry out these instructions. Do we honestly believe they will stop dealing with BNY Mellon, the world’s largest custodian bank, because it now custodies bitcoin? Would Microsoft have its bank accounts shut off because it works on blockchain and metaverse projects?
These events underscore the crying need for U.S. regulatory clarity around cryptocurrencies, specifically in the form of new legislation from Congress. The SEC’s actions against staking tokens might be technically in line with the Howey Test precedent and with the commission’s guiding statute, but those Depression-era laws now seem woefully out of date. And as the Blockchain Association’s Chervinsky noted, when there’s a vacuum in legal clarity, regulators tend to default to the kind of stealth operations described above.
Meanwhile, other jurisdictions – big ones such as the European Union and Japan, and smaller ones such as Bermuda – are moving forward with clear rules of the road for digital assets, cryptocurrencies and blockchains. That’s going to mean that innovation and trading activity that would otherwise have occurred in the U.S. will shift offshore.
Obviously, regulators in Washington, D.C., are under pressure to take action against “crypto” right now, given the high-profile blowups of last year. But doing so in this ad hoc, seemingly capricious, counterproductive fashion will ultimately backfire.