SEC probes Kraken for unregistered securities, threatens Coinbase staking

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The U.S. Securities and Exchange Commission (SEC) appears to have the Coinbase (NASDAQ: COIN) and Kraken digital asset exchanges squarely in its sights for dealing in unregistered securities.

On Wednesday, Bloomberg reported that the SEC is probing the San Francisco-based Kraken over whether the cryptocurrency exchange offered unregistered securities to U.S. customers. The report claimed that the probe was at “an advanced stage” and a settlement could be announced in a matter of days.

If that timeline holds, it would mark the second U.S. regulatory penalty imposed on Kraken in the past three months. Late last year, the U.S. Treasury’s Office of Foreign Assets Control (OFAC) fined Kraken $362,000 for failing to prevent Iran-based customers from trading in crypto in violation of U.S. economic sanctions.

While the size of the fine was mitigated by Kraken cooperating with OFAC, former Kraken CEO Jesse Powell didn’t make it easier on his company last August by slamming OFAC for its “unconstitutional” takedown of the Tornado Cash mixing service. Related or not, Powell announced his decision to step down as CEO just one month following this criticism.

More bad press is the last thing Kraken needs right now, as it struggles to survive this extended ‘crypto winter.’ In December, the company laid off 1,100 staff—nearly one-third of its workforce—and shut down its Japanese operations. This week, Kraken announced the closure of its Abu Dhabi office less than a year after it opened.

The SEC and its boss Gary Gensler lost patience with crypto bros’ flouting of securities laws last year, which saw enforcement actions up 50% from 2021. This no-nonsense approach has carried forward into 2023, which has already seen charges against the Genesis and Gemini lending platforms for offering unregistered securities and a $45 million backhand to Nexo over its lend-to-earn program.

This week, the SEC announced its 2023 examination priorities, including a focus on ‘Emerging Technologies and Crypto-Assets.’ The SEC plans to more closely monitor “the offer, sale, recommendation of, or advice regarding trading in crypto or crypto-related assets.” But, according to some reports, the SEC is planning to go much, much further than that.

A stake to the heart

The SEC was already reportedly investigating Coinbase for offering unregistered securities to customers and made no secret of its belief that many of the tokens listed on Coinbase qualified as securities under the Howey test. But while Coinbase, like Kraken, may face financial penalties for violating securities rules, the SEC may be planning a move that could cripple Coinbase’s entire operation.

Late Wednesday, Coinbase CEO Brian Armstrong posted a Twitter thread in which he reported “hearing rumors that the SEC would like to get rid of crypto staking in the U.S. for retail customers. I hope that’s not the case as I believe it would be a terrible path for the U.S. if that was allowed to happen.”

1/ We're hearing rumors that the SEC would like to get rid of crypto staking in the U.S. for retail customers. I hope that's not the case as I believe it would be a terrible path for the U.S. if that was allowed to happen.

— Brian Armstrong (@brian_armstrong) February 8, 2023

These ‘rumors’ have been circulating since last September, not long after Ethereum made its transition to a proof-of-stake consensus mechanism. While not naming any names, Gensler declared that crypto “staking services” appeared to trigger the Howey test because “the investing public is anticipating profits based on the efforts of others.”

Getting back to Brian, he went on to declare that staking “is not a security” and repeated the crypto exec’s go-to mantra that “regulation by enforcement doesn’t work.” Conveniently, that same argument was made this week in a motion to dismiss the civil charges the SEC brought against a former Coinbase product manager. That ex-staffer, Ishan Wahi, pleaded guilty this week to criminal charges related to insider trading on alt-coins before they were listed on Coinbase.

Brian also warned/threatened that “we need to make sure that new technologies are encouraged to grow in the U.S., and not stifled by lack of clear rules. When it comes to financial services and web3, it’s a matter of national security that these capabilities be built out in the U.S.”

However, Brian ended on an up-note with his hope that “we can work together to publish clear rules for the industry, and come up with sensible solutions that protect consumers while preserving innovation and national security interests in the U.S.”

The royal ‘we’

Brian’s use of the word ‘we’ may be a little overgenerous, as is his claim that America’s national security is under threat if he can’t collect fees from Coinbase customers staking their coins on his platform. But it’s understandable, given that retail customers—who pay higher commissions than institutional traders—cut their trading volume by nearly three-quarters in the third quarter of last year.

Coinbase is increasingly reliant on two revenue streams. The first is the deal it struck with the MakerDAO community to custody their $1.6 billion in USDC stablecoins. That deal coincided with the Federal Reserve hiking interest rates, allowing Coinbase to reap greater rewards for doing nothing.

The second is staking, which Coinbase offers on ETH, Cardano and Solana. The latter has seen its value tumble following the collapse of the FTX exchange, whose boss Sam Bankman-Fried was a Solana sugar daddy. Regardless, over the first nine months of 2022, revenue from ‘blockchain rewards’ (aka staking) was $213 million, up 77% from the same period in 2021.

With little sign that retail traders are flocking back to Coinbase—and JPMorgan reporting last week that 72% of institutional traders have “no plans to trade crypto/digital coins” this year—the exchange can ill afford to lose its staking revenue.

Coinbase recently cut another 950 staff positions, adding to the 1,100 layoffs reported last June. Like Kraken, Coinbase also announced its plans to exit the Japanese market. Coinbase also paid a $100 million penalty last month after New York’s Department of Financial Services uncovered “wide-ranging and long-standing failures” in Coinbase’s anti-money laundering and ‘know your customer’ requirements. Then there was the $3.3 million penalty for failing to register with Dutch authorities in a timely fashion.

With less than two weeks to go before Coinbase delivers its FY22 financial report, things could be, er, better. Coinbase shares fell nearly 3% on Wednesday, the second straight day of negative sentiment. In a strange coincidence, Brian hasn’t sold any shares since Monday, when he brought his 2023 sell-off total to $10.8 million. Think he knows something is coming?

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Ethereum, FTX and Tether—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.