Hi everyone, this is Charles Hoskinson broadcasting live from warm, sunny Colorado. Today is February 14th, and we have a double header. I promised I’d make a video about the Kraken SEC settlement and a little bit more about what actually happened. I figured, why not make it a whiteboard video and actually get to the source material itself? So, without further ado, let’s go ahead and share my screen, and we can have a lovely conversation about what’s going on straight from the horse's mouth.
Okay, here is the document. This is the complaint, and we’re actually going to read a little bit verbatim and then write a little bit on the whiteboard about various things.
**Summary:** This case concerns the illegal unregistered offer and sale of securities involving the staking of crypto assets. In particular, defendants have offered and sold an investment contract to the general public, including U.S. investors, whereby investors transfer certain assets to Kraken for staking in exchange for advertised annual returns as much as 21%. They call this the Kraken Staking Program.
Let’s write this down right here. I’m going to do my best lawyer impression. The Kraken Staking Program is the thing that they’re most concerned about at the moment.
Staking concerns proof of stake validation protocols that certain blockchains utilize. These protocols offer rewards to those who validate or confirm transactions on the blockchain. To become a validator and obtain such rewards, holders of crypto assets must stake or commit crypto assets, typically the native crypto asset on the particular blockchain, such as Ethereum, Cardano, Polkadot, or Cosmos. Validators are selected based on the size of their stake, among other factors, creating an incentive to stake or commit greater quantities of crypto assets. The protocols incentivize validators to add legitimate transactions to the blockchain because validators are rewarded if they do so or could be penalized if they do not.
It says here that staked crypto assets can be slashed or destroyed. Cardano is not affected—just write that down. We’ll keep a tally.
The Kraken Staking Program is an investment program created by defendants that aggregates investors' crypto assets to enable Kraken to stake these pooled investor assets and achieve a competitive advantage in the staking marketplace. Through this pooling of crypto assets and defendants' efforts, the Kraken Staking Program purports to offer investors benefits that are not available to investors who stake on their own.
We’re starting to get into differentiators. They’re saying, "Hang on a second here. If you’re staking yourself, that’s one thing, but if you join this program (KSP), then suddenly you get some benefits that other people don’t." Among other things, defendants advertise regular investment returns and payouts, no staking minimums, their technical expertise in staking, and an easy-to-use platform created by the defendants.
We’ll tally that as number two: Cardano is not affected because regular payouts are automated by the protocols, and staking minimums are pretty minimal.
In addition, defendants offer investors instant rewards accrual and the ability to instantly unstake. Well, yeah, that’s Cardano as well. We don’t have bonding or any of this custodial nonsense, so we’re not affected.
Defendants market the Kraken Staking Program by touting specified investment returns for certain staking-eligible crypto assets on the Kraken.com website, social media channels, and throughout advertising emails. Of course, they want to make money; it’s business. Defendants determine these returns, not the underlying blockchain protocols. That’s another differentiator. With Cardano, the staking certificate protocol determines returns, and it’s transparent what the pool operator is getting versus you. Again, it’s not custodial.
Let’s check that right there—that’s number four: Cardano is not affected. The returns are not necessarily dependent on the actual returns that Kraken receives for staking, so that’s another big differentiator.
If interested in obtaining these returns, investors can transfer eligible crypto assets to the program. Ah, so that’s custodial; it’s not non-custodial. Right, Cardano is not affected. If interested in obtaining these returns, investors can transfer eligible crypto assets to the program, including by first purchasing tokens from Kraken’s trading platform for the market price of the token plus a fee or transferring eligible crypto assets obtained elsewhere to Kraken. Defendants pool these tokens, designating some for staking and some purportedly as a liquidity reserve.
Because they have bonding with Ethereum, your stuff is locked, and it’s the Hotel California—you can’t unlock it. So, I guess that’s another reason Cardano is not affected. Investors lose possession or control over the crypto assets when they transfer those assets to defendants. Well, duh, it’s a custodial program, and accordingly, they take on risks associated with the Kraken platform. That’s why they’re a regulated exchange; you have to be fair there.
Pooling and retaining control over tokens potentially reduces defendants' transaction costs and risks. In the case of tokens actually staked by defendants to proof of stake protocols, it increases the likelihood that defendants will be selected to validate blockchain transactions and therefore earn rewards. To be fair, that’s not completely true; it just reduces the variance. The probability of your particular tokens being selected is the same; it’s just the frequency that goes up, so you reduce the variance of the reward curve. But okay, I’ll forgive them for that.
Defendants advertise their significant efforts, discussed in detail below, provide investors with constant and regular returns called rewards, more so than investors could achieve if they tried to implement a staking strategy on their own without the benefit of defendants' scale and expertise. Well, it turns out, guys, that if you have ADA, your highest returns would come from a private pool. So if you hand it to somebody else, you actually get less than if you stake on your own. So you’re paying a fee for the expertise. Ah, see, that’s another difference there.
In April 2022, U.S. investors had over $2.7 billion worth of crypto assets invested in the Kraken Staking Program. That’s a lot, and Kraken earned approximately $147 million in net revenue from the program since its commencement. A substantial proportion of this net revenue, more than $45 million, is attributed to U.S. crypto holders.
By June of 2022, more than 135,000 unique U.S. usernames had transferred crypto assets to participate in KSP. Through the KSP, defendants had offered and sold investment contracts without registering the offer of sales with the SEC as required by federal securities laws.
Now, let’s be honest, SEC—would you actually give them permission to do this? No, and no exception from the registration requirement applied. It’s probably a fair statement, given the fact that 135,000 unique U.S. usernames were involved. So, there was no attempt to blacklist U.S. participants. Fair statement; I’ll give them that.
Missing material information includes, but is not limited to, the business and financial conditions of the defendants. Are we being intellectually honest there? Because there is a disclosure of business and financial conditions of the defendants, given that they’re a regulated entity already. So, there is some disclosure requirement there. Fair to say, is that going to people participating in this particular program? Okay, not under a securities viewpoint, but there is disclosure and oversight.
The fees charged by defendants are not transparent; that’s fair. The extent of the defendants' profits and specifics and detailed risk of the investment, including how defendants determine to stake investor tokens and reportedly hold them in reserve, and the extent of the proportional liquidity reserves and whether tokens are put to some use. This is a weakness of a custodial staking scheme that is not liquid. You have to balance liquidity, and these liquidity reserves are going to have to be actively managed for withdrawal. So, it’s almost like a fractional reserve bank. It’s really interesting. Cardano is not affected; let me put that there.
Investors had no insight into defendants' financial condition and whether defendants had the means of paying the marketed returns. Yeah, registration would solve that. Indeed, per the Kraken terms of service, defendants retain the right not to pay any investor return. Defendants have disclosed only the information that they wish, not the information required by law. Defendants continue to offer and sell the Kraken Staking Program without any registration statement. Again, you wouldn’t give it to them.
Meaning that until the illegal offering is enjoined, investors will continue to bear substantial risk, resulting in the defendants' violation of federal securities laws. Yeah, this is puffery. You know, substantial risk—let’s be honest here. They’re a regulated exchange under U.S. law, so the custodial risk, which is the primary risk here, is definitely subsumed by that regulation. They’re checked for that, assuming you trust U.S. regulation.
That said, there is a risk in operating the staking business because there’s a slashing component to Ethereum. If they mess that up, it’s absolutely true they could lose the funds of the user. The question is, would disclosures resolve that? No, but to be fair, Cardano is not affected.
Now, violations. They go into the specific act of the Securities section and they say, "Yeah, Securities Exchange Act of 1933, blah blah blah, ask for injunction." Now they go into the proceedings and seek relief, jurisdiction, and venue, inter-jurisdictional inter-district agreement, and then, of course, they allocate the particular defendants—Payward Ventures and these related entities. Then they talk about the particular statutory and legal framework as this boilerplate.
What’s really interesting is the SEC actually, at page seven of the document, talks about crypto assets and staking in general. They say the term "crypto asset" generally refers to an asset issued and/or transferred using distributed ledger or blockchain technology, including assets sometimes referred to as cryptocurrencies, digital coins, and digital tokens. So, they’re actually creating some foundational definitions here. This is a great opportunity in the document to introduce some clarity of how the SEC views things.
Unfortunately, above basic definitions, they don’t do that. It’ll become apparent in a second. A blockchain or distributed ledger is a peer-to-peer database spread across a network of computers recording all transactions in a theoretically unchangeable and digitally recorded package. The system relies on cryptographic activities for secure recording of transactions.
Then they say people can own these assets and hold them at blockchain addresses under their control. So, they introduce the idea of encumbrances. You’ll see that term used a lot—encumbrances. You bought into coverage with a private key, but we still don’t have a true legal definition of what actual ownership is or what the standard of ownership is. Because you own the stuff on Kraken, but you don’t control the private keys. Typically, someone controls an address and crypto assets held at the address with a private cryptographic key for that address. Anyone with the private key can sign and submit a transaction to the blockchain that will transfer the crypto assets at the address to another address.
Typically, in a single blockchain address, people can hold multiple types of cryptocurrency assets. True. Then they talk about a wallet and they discuss crypto trading platforms, on-chain, off-chain, network.
What’s interesting is on page 27, where they say blockchains typically employ a consensus mechanism to validate crypto asset transactions. A consensus mechanism describes the particular protocol used by a blockchain to agree on which transactions are valid to update the blockchain. It compensates certain participants with additional crypto assets. There can be multiple sources for compensation, including from fees charged to those transacting on the blockchain or from new crypto assets created or mined by the validation of transactions under the terms of the blockchain protocol.
So, that’s the inflation part of payment—your coinbase reward, coinbase being the term for new stuff being created, not the company. Compensation in the form of newly issued crypto assets may dilute the value of existing tokens. Well, if you’re not a modern monetary theory person, that’s true. If you’re an Austrian, you’d agree with that.
Validators who participate in confirming transactions on the blockchain may collect fees to participate in validation transactions. The consensus mechanism typically is a set of rules followed by the validator nodes or computers on a blockchain network running the blockchain protocol that are able to validate transactions. There’s proof of work and proof of stake—two major consensus mechanisms.
So, they talk about proof of work, but here’s proof of stake. This is what’s relevant for this. Proof of stake, used by blockchains such as Cardano, Ethereum, Polkadot, and Cosmos, involves the protocol selecting from crypto asset holders who have committed or staked a minimum number of tokens to validate transactions. Typically, users can stake their own crypto assets or they can delegate their crypto assets to a particular node for that node to use them in staking. Nodes often act as staking pools.
We call them SPOs, but okay. In general, the greater proportion of crypto assets staked by an individual or group relative to all staked tokens, the more likely the holder is to be selected as a validator and earn the ability to receive staking rewards. Thus, the most successful staking operations are those that maximize the chances of being selected by the protocol and thus rewarded with more crypto assets, typically by staking a large number of tokens and minimizing server downtime.
What’s interesting in this analysis is that the SEC didn’t talk at all about proof of work mining pools, and that’s relevant to Cardano because we have a similar model there—a superior one, but a similar model there over what’s actually happening with a lot of the Ethereum operations. But we’ll get to that in a second.
Minimizing server downtime, in addition, for some crypto assets, the probability of being selected as a validator increases when a node operator delegates its own tokens for staking alongside its customers. Typically, it’s customers. Ah, is it customers or partners? Depends on how you view it. Typically, crypto assets are unavailable for trading or other purposes when staked.
Ah, we got another one here: Cardano is not affected because we don’t do bonding protocols. We automatically distribute a portion of crypto asset rewards to the successful node operator. Cardano is not affected there because it distributes to both delegators and node operators. You don’t trust the node operator for protocol distributions to encourage more nodes to participate in validation protocols. Typically, cap rewards once the nodes reach a certain size. Yeah, that’s our K Factor. Hey, they referenced that—pretty cool.
As the cap is approached, node operators can start an additional node. Those multi-pool operators that we all hate. Staking of crypto assets is meant to incentivize good faith and honest validation of transactions, as staked tokens may be slashed or destroyed, and no rewards will be paid if transactions are not validated.
So, this is one half because no rewards are paid if transactions aren’t properly validated. If you screw up, you don’t get any money, but nothing is destroyed. It’s a non-slashing protocol, so we get a half: Cardano is not affected.
Typically, the protocol rewards a selected validator with additional crypto assets only if the validator successfully and correctly validates a new block on the chain. Yes, this whole section has nothing to do with us.
Another component of certain proof of stake is known as bonding and unbonding periods. This is one of the cruxes of why they’re getting upset at the Kraken Staking Program. What KSP is doing is bypassing the Ethereum protocol and creating artificial liquidity where the protocol doesn’t do that through a reserve pool. This is where they’ve deviated from the Ethereum protocol.
They say there’s a bonding and unbonding period. Another thing protocols charge crypto asset validators fees to stake and unstake tokens, requiring upfront refundable deposits. Yeah, that’s true. In addition, to take one stake, they require a delegation minimum amount to participate.
Then they get into how Kraken put this program together. Here we go. In December of 2019, Kraken launched its staking program as a means to participate in and profit from the proof of stake consensus mechanism of certain blockchains by obtaining investors' crypto assets, pooling those assets, and then staking some portion of those assets in order to obtain rewards—a portion of which Kraken distributes to investors and a portion which Kraken retains.
Kraken advertises the program offers investors worldwide, including most U.S. investors, an investment opportunity to participate in proof of stake consensus and receive benefits that may not be available to those investors if they stake on their own. For example, the defendants' program offers investors no staking minimums.
You’ll see a theme here of protocol deviation. So basically, the idea is that you have no upfront fees or deposits—purportedly. Okay, cybersecurity—that’s puffery. It simplifies an easy-to-use one-stop trading platform—puffery, because come on, guys, that’s regulated.
The ability, through Kraken’s efforts, to obtain returns based on Kraken’s participation in proof of stake activities for different types of tokens is a big difference. So right up here, Cardano is not affected—13 and a half.
Now, how about that? This is a big difference because if you look at the Cardano staking model, you have the SPO and people delegate to that. When they delegate to that, this collective unit is teamed together. They’re in a partnership together. The SPO is going to do the work of making the block and take a fee as the submitter, but this is a collective group, and the SPO has no access to the funds of this group, and these guys can leave at any time.
So you have non-custodial liquid staking, and you’re working together as a team in this non-custodial liquid staking to do something. What they’re saying here is you don’t make any decisions; Kraken is making all those decisions. They’re doing all the work; they control all the money, and you’re getting a passive return from that.
It’s a little bit different than you in Daedalus making a decision about who to partner with and how to work with that person and them getting it done. In addition, for most of the Kraken Staking Program’s staking-eligible assets, the program also offers investors instant reward accrual. So that’s another protocol deviation.
The ability to instantly unstake is another protocol deviation, and they demand the immediate return of crypto assets that have not complied with the unbonding period that would apply if the investor participated directly. They automatically have twice-weekly payout dates.
They even say it: the Kraken Staking Program has features that differentiate it from staking and earning rewards on your own—that passiveness. They go to a bunch of things that involve pooling. So, custodial risk—you have no say in how it’s operated, and them determining the returns in a non-transparent way, along with frequent regular payouts, protocols not guaranteeing that liquidity—that’s another protocol deviation.
Also, they’re not actually staking everything; they have to maintain a liquidity pool. So, what are they doing with that liquidity pool? Also, deviation from
People take their money and give it to an exchange, and that exchange does some things with it. It promises a return for doing that. How is that different, if you think about it intellectually, from any other investment product, like a money market fund? You take your money, give it to somebody else, don’t do anything, and then they get a return and share some of that return with you while taking their cut.
I like Kraken; I think they’re a great organization. We’ve had a phenomenal relationship with them for over a decade. This has nothing to do with them. This has everything to do with people experimenting. When people build certain products, regulators may step in and say that particular product is problematic for reasons X, Y, and Z. They haggle and negotiate about it, and sometimes they can remediate it; other times, they decide to discontinue it. That’s the perpetual risk.
This has nothing to do with cryptocurrencies like Cardano, Algorand, Polkadot, or Solana. At the end of the day, the protocol is not being utilized for these things. Nowhere in the Cardano, Polkadot, or Ethereum protocol is there a discussion about liquidity pool management done with smart contracts. Nowhere in these protocols is there a discussion about how they’re going to get the promised returns or how to keep the funds secure on their platform. That’s something for a specific business to decide and execute, and as a user, you have to trust that business and work with them. That’s the difference and the nuance.
The problem is that people shut down whenever any of these things happen. They go crazy, and their vision turns red. They say the issue here is that this is a systematic government crackdown on our entire industry. That may very well be true; I’ve heard about Operation Choke Point 2.
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