What investors need to know about crypto ‘staking’

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Not even six months ago, ether led to a rebound in cryptocurrency prices ahead of a major technical upgrade that would make something called staking available to crypto investors.

Most people were barely familiar with the concept, but now Ether’s price is falling amid growing fears the Securities and Exchange Commission could crack down on it.

On Thursday, Kraken, one of the world’s largest crypto exchanges, completed its staking program in a $30 million settlement with the SEC, which said the company would stop offering and selling its crypto staking as- a service program have not registered .

The night before, Coinbase CEO Brian Armstrong warned his Twitter followers that securities regulators may want to end staking for US retail clients more broadly.

“This should alert everyone in this market,” SEC Chairman Gary Gensler told CNBC’s “Squawk Box” Friday morning. “Whether you borrow, earn, call it yield, whether you offer an annual percentage return – it doesn’t matter. If someone takes [customer] Tokens and transfer to their platform, the platform controls it.”

Staking has been widely seen as a catalyst for mainstream crypto adoption and a major revenue stream for exchanges like Coinbase. A crackdown on staking and staking services could have detrimental consequences not only for these exchanges but also for Ethereum and other proof-of-stake blockchain networks. To understand why, it helps to have a basic understanding of the activity in question.

Here’s what you need to know:

What is staking?

Staking is a way for investors to earn passive income from their cryptocurrency holdings by locking tokens on the network for a period of time. For example, if you decide to stake your Ether holdings, you would do so on the Ethereum network. The bottom line is that it allows investors to leverage their cryptos if they don’t plan on selling them any time soon.

How does staking work?

Staking is sometimes referred to as the crypto version of a high-yield savings account, but this comparison has a major flaw: Crypto networks are decentralized, banking institutions are not.

Earning interest through staking isn’t the same as earning interest from a high annual percentage return offered by a centralized platform like they got into trouble last year, like BlockFi and Celsius or Gemini just last month. These offerings were more akin to a savings account: people deposited their crypto with centralized entities that would lend those funds and promise depositors rewards (up to 20% in some cases). Rewards vary by network, but in general, the more you wager, the more you earn.

In contrast, when you stake your crypto, you contribute to the proof-of-stake system that keeps decentralized networks like Ethereum running and secure; You become a “validator” on the blockchain, which means you verify and process the transactions as they come through, if so chosen by the algorithm. The selection is semi-random – the more crypto you stake, the more likely you will be selected as a validator.

The freezing of your funds serves as a form of security that can be destroyed if you act dishonestly or disingenuously as a validator.

This only applies to proof-of-stake networks like Ethereum, Solana, Polkadot, and Cardano. A proof-of-work network like Bitcoin uses a different process to confirm transactions.

Staking as a Service

In most cases, investors don’t sit down themselves – the process of validating network transactions is simply impractical at both the retail and institutional level.

This is where crypto service providers like Coinbase and formerly Kraken come in. Investors can submit their cryptos to the staking service and the service performs the staking on behalf of the investors. When using a staking service, the lock period is determined by the networks (like Ethereum or Solana) and not by a third party (like Coinbase or Kraken).

This is where things get a bit murky at the SEC, too. On Thursday, securities regulators accused Kraken of failing to register the offering and sale of its crypto asset staking-as-a-service program.

While the SEC hasn’t provided any formal guidance on which crypto assets it considers securities, it generally sees a red flag when someone makes an investment with a reasonable expectation of gains that would come from the work or effort of others.

According to Oppenheimer, Coinbase has about 15% of the market share of Ethereum assets. The current retail industry staking participation rate is 13.7% and growing.

Proof of Stake vs. Proof of Work

Staking only works for proof-of-stake networks like Ethereum, Solana, Polkadot, and Cardano. A proof-of-work network like Bitcoin uses a different process to confirm transactions.

The two are simply the protocols used to secure cryptocurrency networks.

Proof-of-work requires special computer equipment, such as B. High-end graphics cards to validate transactions by solving highly complex mathematical problems. Validators receive rewards for every transaction they confirm. This process requires a lot of energy to complete.

Ethereum’s major shift to proof-of-stake from proof-of-work has improved its energy efficiency by almost 100%.

risks involved

The source of returns in staking differs from traditional markets. On the other hand, there are no people promising returns, but the protocol itself that pays investors to run the computing network.

Regardless of how far crypto has come, it’s still a fledgling industry fraught with technological risks, and potential bugs in the code abound. If the system does not work as expected, investors may lose some of their staked coins.

Volatility is and always has been a somewhat attractive trait in crypto, but it also comes with risks. One of the biggest risks investors face when staking is simply a fall in price. Sometimes a big drop can result in smaller projects raising their prices to make a potential opportunity more attractive.