Attack of the Regulatoors (Plus Frax in Review Feb 13th, 2022)

In just the last week two major actions have been taken against crypto exchange Kraken and stablecoin issuer Paxos.

Samuel McCulloch
Samuel McCulloch
Feb 13, 2023

Kraken’s Staking-as-a-Service gets harpooned by the SEC

Last week, Coinbase CEO Brian Armstrong dropped an ominous tweet that he had heard “the SEC would like to get rid of crypto staking in the U.S. for retail customers.” Less than a day later, news broke that Kraken had agreed to settle with the SEC for not registering the offering and sale of its crypto staking program. Kraken agreed to cease offering of the service and also to pay a $30m fine

Here are the the key argument of the SEC’s opinion:

• Staking-as-a-service and pooling of staked assets provides and advantage over self staking.

• Kraken’s customers were “passive” participants, providing their assets to Kraken to actively manage.

• While on-chain staking yields are determined by code, Kraken’s yields were internally and opaquely determined.

• Kraken kept returns which exceeded the marketed range of yield and did not disclose this to customers. Nor did Kraken properly disclose their fees or operating costs for the staking program.

• Not all tokens were staked. Kraken held back some liquid tokens for itself to use at their discretion.

• Staking rewards were also payed out weekly, whereas self-staking follows no schedule.

• Some staking protocols require minimums, however Kraken did not. Also, depositing the token to Kraken’s staking program did not require paying fees, which are required to stake on chain.

Staking on Kraken, the SEC argues, was fundamentally different than self-staking. This made the service and product offering fall under the purview of the SEC and they argue Kraken should have registered the offering with the SEC.

“Whether it’s through staking-as-a-service, lending, or other means, crypto intermediaries, when offering investment contracts in exchange for investors’ tokens, need to provide the proper disclosures and safeguards required by our securities laws,” said SEC Chair Gary Gensler. “Today’s action should make clear to the marketplace that staking-as-a-service providers must register and provide full, fair, and truthful disclosure and investor protection.”

The SEC further said that Kraken “offered investors outsized returns untethered to any economic realities, but also retained the right to pay them no returns at all. All the while, it provided them zero insight into, among other things, its financial condition and whether it even had the means of paying the marketed returns in the first place.”

Crypto is stuck in purgatory right now. Without new laws to govern explicitly how certain assets, products and services can be sold, regulatory agencies will continue to use their enforcement powers to penalize companies after the fact. I doubt Kraken intended to violate securities laws, it’s just impossible for them to receive valid legal advice with how opaquely the regulators determine what’s acceptable.

In a dissenting opinion, Commissioner Hester Peirce stated that she didn’t know “whether SEC registration would have been possible” for Kraken as “crypto-related offerings are not making it through the SEC’s registration pipeline.” She goes on to say that the SEC has known about staking programs for a long time, and could have issued guidance. Instead, she says the SEC “chose to speak through an enforcement action” in a manner which is “not an efficient or fair way of regulating.” Calling her agency “paternalistic and lazy,” she notes that this is obviously not the way to govern. Companies like Kraken need a “public process to develop a workable registration process that provides valuable information to investors.”

Two consequences arise from the settlement. First, all other centralized staking services are questionable if their terms of service match in anyway what Kraken had provided.

Coinbase quickly issued a statement on how their cbETH staking derivative was markedly different from Kraken’s program. Unlike Kraken, which just laid off 30% of its workforce and is facing revenue reductions in the bear market, Coinbase has vowed to fight the SEC over its staking program. The settlement is in now way a final judgement, Kraken admits no guilt. Congress or the courts are going to have to decide this question eventually.

Second, all of the staked ETH that Kraken was managing must be unstaked and returned to its customers when Shanghai is deployed. At the time of the settlement, Kraken is managing 1,233,728 ETH  or 8% of the total market share for staked ETH. Full withdrawals, which Kraken will need to execute, have a churn limit function that controls the amount of nodes that can exit each epoch.  Currently there are 514,790 active ETH PoS validators,  leaving the churn limit at 7.


What this means that is only 7 full withdrawals can be processed each epoch (6.4 minutes). Assuming Kraken needs to unstake approximately 30% of their ETH for their US based customer, it will take 98 days at a minimum if Kraken is the only entity unstaking. Pair this with every other LSD/staking service providing full withdrawals at the same time, and it could mean the initial exit queue for ETH validators could extend well past 1 year initially. Its almost as if Kraken needs a better way to allow investors to exit through a DEX??? Hmm, once again, all road lead to Frax.

In the wake of the Kraken enforcement action, investors piled into LSD tokens, as the move is thought to be a further argument for decentralized asset products. FXS was up initially, but declined over the weekend. It’s too early to tell the knock on effects for all staking services and LSD’s, but this is a wakeup call to the industry that fully decentralized on-chain solutions are needed to escape any classification as a security.

Paxos Sued By The SEC, Ends Relationship With Binance

Just 3 days after the Kraken settlement, the SEC announced that it was planning to sue Paxos for its sale of Binance USD, alleging it was an unregistered security.  Today, the New York Department of Financial Services ordered Paxos to stop issuing Binance USD.

"Paxos has informed us that they have been directed to cease minting new BUSD by the New York Department of Financial Services (NYDFS)," the NYDFS said. "BUSD is a stablecoin wholly owned and managed by Paxos. As a result, BUSD market cap will only decrease over time. Paxos will continue to service the product, manage redemptions, and will follow-up with additional information as required."

Paxos is a US based limited purpose trust company, and all of the collateral held by the company is backed 1:1 with US dollar-denominated reserves, fully segregated and held in bankruptcy remote accounts. “New and existing Paxos customers will be able to redeem their funds in US dollars or convert their BUSD tokens to Pax Dollar (USDP), a regulated US dollar-backed stablecoin also issued by Paxos Trust," the company said. They further stated that they plan to offer redemptions until at least February 2024.

CZ came out to try and put out the fires in the wake of the news:

The issue surrounds the relationship Paxos had with Binance and the issuance of Binance wrapped-BUSD. NYDFS only approved Paxos-issued BUSD to be issued on Ethereum. Through its own channels, Binance took custody of this Ethereum based BUSD and issued its own Binance-Peg BUSD, issuing 30% of the supply on BSC as this separate token. Binance did not always maintain the 1:1 peg and Paxos was aware of this.


As of writing, Binance Peg BUSD is fully backed. But based on the data, Binance manipulated the BUSD mint process in the past to issue unbacked BUSD.  Binance had full control over the BUSD on BSC and did not disclose these risks to buyers.

The NYDFS shutdown of BUSD is also probably linked to the ongoing money laundering / sanctions violations enabled through Binance. The embattled company helped Iranian firms trade $8bln in crypto despite explicit US sanctions. The Department of Justice is still investigating the issue.

If Binance was issuing an unbacked money like instrument, this would raise cause for labelling it an unregistered security by the SEC. If this is the reason, the scope of the SEC’s case would not be cause for concern for other stablecoin issuers. The SEC learned a lot in the wake of the [Tether debacle](, when the company failed to disclose collateral loses of 80% incurred by Crypto Capital. Tether later settled with the NYDFS and paid a fine of $18.5mln.

What does this mean for Frax? Well nothing at the current moment. Until the SEC publishes their complaint, it will be unclear the scope of their enforcement. For what it’s worth, the SEC is loathe to enter into drag out cases that can go on for years, like the XRP case. They have a history of going for settlement against actors who would rather not fight for years in court. For now the stablecoin business model is safe, but the recent actions by the Biden administration are worrying.

If you are interested in learning more about the orthodox view on stablecoins, watch our interview with Economist Arthur Wilmarth.

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Not financial or tax advice. This channel is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. This video is not tax advice. Talk to your accountant. Do your own research.

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