In mid February 2023 the US SEC disallowed and fined the popular crypto exchange Kraken for implementing what they term as crypto “staking.” Other crypto exchange giants like Coinbase have promised to challenge this in court.
But what exactly is staking? One simple analogy is that it is somewhat similar to depositing your money in a bank and earning interest on it.
THE BASICS OF BLOCKCHAINS
When you pay someone with crypto, that transaction record gets appended into the list of transactions in the blockchain. In traditional finance, the bank (run by people) confirms that the payment has been received by the recipient. However, since the objective of crypto and blockchains as written by Satoshi Nakamoto in his 2008 Bitcoin white paper was to eliminate the need for the trusted “man in the middle” who can get tempted because of human weakness, computer scientists had to find a way to ensure that the blockchain could validate correct transactions, and reject fake ones.
WHAT IS STAKING?
Staking is a term used for Proof of Stake (PoS) type of blockchains like Ethereum. It’s called staking because these designated node validator operators are putting their crypto or pooling a group of people’s crypto to stake. If the validator has the minimum amount of tokens (whether from one holder or a pool of holders), it might get designated to validate transactions in exchange for the fees collected from the lender or borrower, sender or receiver. Over the long term, that is a lot of money.
You may ask, why do you need to stake? It’s simple. Running a validator node costs time and money. In short, like a bank it is also a business. Buying the server hardware is expensive. Paying someone to run and maintain it, the energy that the server consumes, the parts that need replacement on that server has a cost. Even the opportunity cost and the time of the owner worrying about risks has a cost. The only reason someone would run a node is because the net revenue from transaction fees he/she can collect from running a staked validating server is larger than the cost of setting it up and running it.
When a single person (or a group of people) stake their Ethereum (or other blockchains) into a validation server, it is in their best interest to make sure that the node performs as designed, else they won’t receive their cut of the transaction fees and their staked crypto will be confiscated or “slashed” by the system. The value of the crypto staked is a behavioral incentive not to validate fake transactions.
SEC VS THE CRYPTO EXCHANGES AND IMPACT TO INVESTORS
One criticism of PoS systems levied by Gensler and the SEC, unlike PoW systems like Bitcoin that rely on the first one out of a group of competing servers to solve a math problem, is that predesignating the servers can put too much power into the hands of those who have money to buy the tokens and operate those validators. Gensler and the SEC argue that it fits into the definition of “common enterprise” that defines what a security is in the 1933 Securities Act and 1946 Howey case.
However crypto leaders like Brian Armstrong of Coinbase have stated publicly that they will challenge this in court. The purpose after all is to decentralize the ownership of the network to as many people who don’t know each other so they can’t connive to defraud the public users of the system.
At stake (pardon the pun) is the future of most of the altcoins like Ethereum and majority of the other crypto that are using PoS for their means of validating transactions. It remains to be seen what the future of staking and Proof of Stake cryptos will be given this looming legal challenge in the courts.
WHAT IF YOU WANT TO STAKE?
Generally if you want to stake, there are two alternatives. One is through centralized exchanges like Binance, Coinbase, and other incorporated entities that sell crypto and offer these services. However, as of mid 2023, the SEC has not yet allowed this and is in fact going after exchanges that offer it as a service to Americans. Abroad however, depending on the jurisdiction, it remains legal.
The second option is to stake your tokens using Decentralized Finance (DeFi). This means staking it in your Decentralized Exchange (DEX) or using a wallet like Metamask or Trust Wallet.
There are also two types of staking that depends on how long you will keep the tokens there. The traditional type of staking is that you keep your tokens with the validators for a long time while you earn a share of the transaction fees. The second is quick in and out entry into staking, often called Liquid Staking. For Ethereum, the most popular of these are Rocketpool, Lido, Frax, and a host of new offerings.
IT’S THE FUTURE
It is understandable that the traditional finance sector is disturbed by staking as it basically competes with bank deposits, which are generally considered low by the public. However, it is part of the future that will revolutionize finance.
Getting your feet wet with it, even with small amounts, is not necessarily a bad idea.