In today’s episode we’ll discuss staking, a way many cryptocurrencies verify their transactions, and how the SEC is “Kraken” down on crypto exchanges offering staking-as-a-service to its customers. See what I did there?
Welcome to GAAP Chats, the podcast dedicated to all things accounting, brought to you by GAAP Dynamics. I’m your host, Mike Walworth and Chris is on PTO so I’m one with my other, faithful partner, Bob Laffler. We hope you’ll join us on our journey today as we share our passion for accounting and help change the way you train.
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Bob: Nice homage to Pirates of the Caribbean. Davy Jones, was it?
Mike: Yep. Couldn’t resist.
Bob: Why exactly are we paying homage to Pirates of the Caribbean?
Mike: Because of this news story:
On February 9, Kraken, one of the largest crypto exchanges in the world, closed its staking program in a $30 million settlement with the SEC, which said the company failed to register the offer and sale of its crypto staking-as-a-service program.
Bob: Release the Kraken! Now I get it.
Mike: I guess you can say Kraken was released from a source of income!
Bob: Not to mention, an extra $30 million dollars!
Mike: For our listeners, Chris is on vacation this week so I am joined today by Bob Laffler, one of the owners of GAAP Dynamics. Thanks for filling in. As our resident expert on all things investment management, I’m really glad you’re here!
Bob: Happy to do it, Mike. I understand I have some really big shoes to fill.
Mike: Not really. Maybe only size 9. I think you’ll be fine! Look at that. I’m a poet and didn’t even know it! Anyway, before we get into the SEC case against Kraken and its crackdown on staking-as-a-service, perhaps we should provide listeners with a bit of background on staking.
Bob: That’s probably a good idea. Unless you are really into this industry, you probably don’t know much about what we are talking about at this point.
Mike: So, what in the heck is staking?
Bob: Staking cryptocurrencies is a process that involves committing your crypto assets to support a blockchain network and confirm transactions on that blockchain. Staking is available only on networks like Ethereum that operate using the “proof-of-stake” protocol. Bitcoin runs using “proof-of-work” to confirm transactions.
Mike: You had me at “hello,” but lost me a bit there. Can you dumb it down a bit?
Bob: I could dumb it down for you but Coinbase does a good job of explaining it on their page titled “What is staking?” I’ll try to summarize it for you.
Bob: It can be as simple or as complex as you want to take it. What I like about the Coinbase article is that it starts off very high level and says that staking is a way of earning rewards while holding on to your cryptocurrencies. So, essentially you are trying to get a little extra “added benefit” when you are just investing in cryptocurrencies in the first place. Cryptocurrencies are typically decentralized products. There are no central authorities like banks or credit card companies needed, and everything is done on the blockchain. As a result the computers in this decentralized network use what is called a “consensus mechanism” to arrive at the correct answer and make sure that transactions are legitimate. That is where the idea of staking comes in. As I mentioned earlier, there are different styles of consensus mechanisms. The two main consensus mechanisms are proof-of-work and proof-of-stake.
Mike: Let’s talk about proof-of-work first, which is the consensus mechanism used by Bitcoin and the first version of Ethereum. I think this is what people think about when they think about cryptocurrency. Is this where we talk about “miners” (not the West Virginia kind) and huge computer farms in BFEs sucking up a lot of energy?
Bob: So proof-of-work is kind of that traditional mechanism.Think of where you're basically solving these very complicated mathematical calculations and you need the big computers that are running 24/7 generating lots of energy. As a result, you're able to validate transactions by solving these difficult mathematical equations. So, you got people around the world basically, vying to be the winner of solving this equation to be able to validate the transaction and put it on the blockchain. And of course, when they do that, they earn a little reward for their hard work, which is essentially paid in the form of additional cryptocurrency. So that's kind of the traditional way we think of it. That solving of the algorithm.
Mike: I read that Ethereum sort of changed and moved away from proof-of-work and they went to this proof-of-stake, which supposedly was a bit more economical and environmentally friendly. So can you talk about proof-of-stake?
Bob: Sure. proof-of-stake was necessary because that second stage of Ethereum got much more complicated, right? If you look at Bitcoin's blockchain, it's relatively simple and straightforward. If you were to try to solve the equations on some of these newer blockchains, it would actually require more energy and more effort because of the complexity of the blockchain. So, proof-of-stake came around, which was kind of another way of getting consensus, and it ended up being faster and more efficient and certainly less costly. Basically what it is, is a way that you can get consensus through people standing-by and basically providing support or backing up a particular transaction. It's essentially vouching for a transaction on the blockchain. So, that's kind of the idea behind proof-of-stake. Now, the way that they do that is through essentially, on a project by project basis, to get people to vote their tokens right. You're going to get people to kind of stand up and say “I'm vouching for this transaction.” With the idea being if you're willing to put your own coins at risk to validate a transaction, then that, in addition to some mathematical calculations and formulas and knowing the blockchain and having that expertise, you're able to validate the transaction. I kind of equate it to our legal system where you almost have the bail system, right? Where if you want to let someone out of jail prior to their trial, you gotta put some money up. You gotta make sure that this person isn't going to cut off and run. Essentially, that's what proof-of-stake is. It's saying, look, I'm willing to put up the money here to say that this is a legitimate transaction. I'll put my cryptocurrencies on the line. There's a little bit of validation in that regard while we do some of the validity. Then once the transaction is proven to be true, the crypto coins that were put up as a stake, or “the bond”, are basically returned to the owners and of course they get a nice little fee with that as well. That’s usually in the form of cryptocurrency as well
Mike: I did some research on Ethereum before this podcast. Ethereum, or Ether coin, is currently trading, let's say around 1500 bucks right now. You can buy less than one coin of this stuff, right? You can buy like fractions?
Bob: Yes, it’s fractional.
Mike: Ownership. Okay, so let's say I own 20% of one Ether coin. So 20% of $1,500. What is that, like $300? So I own $300 of a fractional percentage. 20% of an Ether coin. How is that going to assist in this validation of this Ethereum blockchain? I mean, my ownership is too small. How does it work?
Bob: Well, exactly that's where some of these cryptocurrency brokerages come into play. Individual investors might not have enough to really put up to make any difference in a staking validation. But when we gather all these different investors, and they all put up their little measly shares of coins, and you put them together and aggregate them, then all of a sudden you have enough to do this. So, what you're seeing is companies like Coinbase, some companies like Kraken, for instance, what they were doing was they were taking all their clients coins and saying, “Hey, if you want to do this, we will get you involved in staking. We'll bring them all together. We have the knowledge, we have the expertise, we have the technology to be able to do these staking validations. We'll just use your coins to be able to put them up.”
So, as a result, the broker gets their fee. The cryptocurrency company certainly is going to get a piece of that action for doing staking services, and they'll pass a fee on to the individual investors who are putting up their fractional shares or whatever they're putting up.
Mike: I guess, theoretically anyone can be a validator, but there's a lot of sort of back office stuff. I mean, you still have to have pretty good computer systems. You have to have all the legal stuff in place. So, it just isn't viable for a small bit investor like me to do it.
Bob: Of course not. If you think about it, what you're doing is you're putting up your investment on behalf of someone else's transaction. You're taking on the risk that this is actually a legitimate transaction. So, not only are you putting up your coins, but you're going to do your own due diligence, your own work to prove that that is a viable and valid transaction. That's where these companies come into play. They do have the expertise that can do that. They just want the backing of the coins to put up as collateral.
Mike: So, staking-as-a-service. Help me with that. So, basically like a Coinbase or Kraken, they're collecting coins from different investors and putting all of those up as a stake. Tell me more about staking-as-a-service as these companies are describing it?
Bob: Basically what they're going to do is they're going to provide the service of collecting all these different investors’ coins. The idea here is you're a long term crypto investor, right? This is not for short term owners, because while you're putting them up as a stake, you can't sell them. They are basically held and can't be used for anything else until the process is over. The idea is, if you're a long term investor, what you're able to do is put up these coins to be used for staking and then over time, you get yourself a return for being able to do that. Not only are you continuing to invest in cryptocurrency, but now you're getting this added benefit of a return, which in some cases could be 25% or 35% return from these staking services.
Mike: So you looked it up a little bit. How does Coinbase describe it? Because it seems all so rosy when these guys are describing it.
Bob: Well, here's how Coinbase describes it:
But for a vast majority of participants there’s a simpler way to participate. Via an exchange like Coinbase, you can contribute any amount you wish, without needing to purchase or operate expensive validator hardware. Staking is available to most Coinbase customers in the U.S. and many other countries.
Mike: Well, I can tell you, it won’t be available to U.S. customers much longer! More on that in a moment. Bob, I seem to recall a class discussion question that you developed for last year’s U.S. GAAP Investment Management Update course. This self-study eLearning course is available for purchase on the Revolution, our online learning platform. But, Bob, in last year's e-learning course, IM update, I seem to recall a case study dealing with staking and staking-as-a-service. Can you maybe provide us a bit of a summary of that case?
Bob: First of all, when it comes to cryptocurrencies, the one thing we've seen over the past several years is investment companies' funds are kind of the leaders, right? These are the ones that are most commonly investing in cryptocurrencies. Obviously, we're starting to see other operating companies do it as well, financial services companies and so forth. Really, there's a lot of funds that have said, “hey, I'm willing to put a percentage of my portfolio into cryptocurrency.” We've seen a lot of issues related to cryptocurrency in the funds industry. One of the more recent examples we had was dealing with investment funds that are using their cryptocurrency for staking, right? They're putting their currency up, they’re long term investors, and they're putting up the staking. The issue that was addressed was when you are receiving income from staking services, does this impact your qualification as an investment company under ASC 946?
Mike: I mean, if you are deemed an investment company under ASC 946, then that means you have special accounting, right? Things like: all your investments are at fair value through the P&L, no consolidation, special reporting, etc. So if this special accounting, how could this staking impact that qualification as an investment company?
Bob: Well, that's where the heart of the issue is, Mike. Basically, in order to be an investment company, have all these special requirements, everything at fair value consolidation, like you said, you need to essentially be a passive investor, right? You essentially are holding your investments for the purpose of capital appreciation, investment income, or both. That's essentially all you're doing, right? You're taking people's money, you're providing professional management services, and you're putting it to work. You're just sitting back and watching the returns come in. When you start getting involved in other activities where you're actively doing other things to generate income, it could call into question whether or not you're really acting more like an operating company and no longer a fund who's just involved in passive investing. This idea where you're getting involved in staking and earning fees from these extra activities, that's where it starts to create a little bit of a gray area with qualification as an investment company
Mike: So, this class discussion, usually our class discussions, we sort of tee it up and then ask the class what they think. So, what was the answer? What was the final conclusion in your case study?
Bob: Well, the final conclusion, like so many of our class discussions, is it depends!
Mike: Why do people hire us then? I’m sure we talked about it! What is going on here?
Bob: Well, it's in the nuance of the situation. First of all, the issue was discussed by the AICPA Expert Panel for investment companies. They're an active group that basically involves some of the leaders in accounting and audit that are involved in this industry. They deal with these questions quite a bit. Their discussion on this topic was, not surprisingly, we've got a bit of an issue here. You're doing things that are not in the normal range of investment companies. However, we've seen other activities in the past that do this as well. Namely, what they mentioned was security lending activities. It's not uncommon for a fund to have long term investments in securities and basically say, well, while I'm holding these investments for a long period of time, why don't I get involved in lending out my securities. If there's another investor out there that wants to sell a security short or something like that? Sure. Borrow my securities. It allows them to get a little extra return from their investments.
The issue, of course, here was that, you know, securities lending, there's usually a relatively small margin, a small fee that you're earning from that particular activity. As I mentioned earlier, when it comes to staking, there's a lot of risk involved in staking. Therefore, the return, the fee is a bit higher than what we're used to seeing. That was really where the expert panel came in. They said, look, from our understanding, some of these staking fees can be quite significant and therefore the extent at which you're involved in that activity really can generate a substantial source of income that could throw you out of this definition of an investment company.
Mike: So basically, ASC 946 has these fundamental characteristics and then these typical characteristics. All the fundamental characteristics need to be met. If you bomb out on one of them, you're out. At the end of the day, it probably is judgment, right? Like you said, for these other types of “operating activities”, if it's just a little bit here and there, you're probably still an investment company. But if it's significant and you earn significant fees and it's a significant portion of your operation, then you're more like an operating company. At the end of the day, it's auditor judgment and management judgment, right?
Bob: Absolutely. I mean, every case is going to be different. It really comes down to how significant it is to that particular fund. They had other issues they brought over the years where you do lending and you get origination fees or when you do mining of cryptocurrency. We talked about that one a few years ago and how the extent of mining could potentially throw off this definition.
Mike: Well that's interesting, Bob. I just realized that the class discussion two years ago or three years ago dealing with mining, was just the proof-of-work validation. This is now proof-of-stake. One of the things you mentioned is the AICPA expert panel kind of likened it to securities lending, because that is essentially what the SEC is alleging in their charges against Kraken. In their press release on February 9th, here's what the SEC said:
The Securities and Exchange Commission today charged Payward Ventures and Payward Trading, both commonly known as Kraken, with failing to register the offer and sale of their crypto asset staking-as-a-service program whereby investors transfer crypto assets to Kraken for staking in exchange for advertised annual investment returns as much as 21%.
Mike: SEC Chair Gary Gensler said:
“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. 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.”
Bob: So, the SEC is basically saying that these contracts are securities and therefore they should be registered with the SEC and they must follow basically all SEC rules and regulations.
Mike: Yeah, you got it. I think the SEC doesn't want to see another FTX, and therefore they've decided to rein in the industry come hell or high water. In the same Press Release, Gurbir Grewal, Director of the SEC’s Division of Enforcement said:
“In case after case, we’ve seen the consequences when individuals and businesses tout and offer crypto investments outside of the protections provided by the federal securities laws: investors lack the disclosures they deserve and are harmed when they don’t receive them. Today, we take another step in protecting retail investors by shutting down this unregistered crypto staking program, through which Kraken not only 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 with 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.”
Bob: That's pretty damning. Kraken can't be the only company doing this, though, right? I mean, there's plenty of people that have been involved in staking.
Mike: Well, you're absolutely right, Bob. They are all doing it. A Wall Street Journal article from last week stated that Coinbase helps users put their crypto up for staking with a network, taking a commission from between 25% and 35% on any interest that the users might earn. That revenue stream is particularly important for the exchanges when crypto prices and trading volume are falling.
Bob: Too bad because it looks like the SEC is putting the kibosh on staking-as-a-service for these companies. Huh?
Mike: Only in the U.S., the SEC's tentacles don't stretch kind of beyond our borders unless, of course, the entity is listed in the U.S. Coinbase is listed as a Nasdaq company. But they're not going down without a fight. Coinbase CEO Brian Armstrong has pledged to fight if the SEC goes after Coinbase staking while the largest crypto exchange in the world “Binance” has said it is monitoring the situation.
Bob: I think when dealing with the SEC, the more measured approach taken by Binance is probably the right call.
Mike: Agreed. But let me tell you, this “crypto bro”, Brian, has a backbone. He said, and I quote, “Our staking product is not a security. Customers never turn their assets to Coinbase, for instance. and we really are just providing a service that passes through coins to help them participate in staking, which is a decentralized protocol.” Armstrong has disagreed with Chairman Gensler in the past and according to a recent Bloomberg article, the company said recently that it may not remove a particular crypto asset even if the SEC alleges that it is a security, and basically they want to take it to the courts.
Bob: I wonder how it's going to work out for them.
Mike: Well, that Bloomberg article also said that Coinbase has received investigative subpoenas from the SEC about, not only staking, but also stablecoin and its yield generating products. Coinbase posted a $557 million loss last quarter and saw its revenue tumble 75% as trading volumes plunged amid a series of prominent industry bankruptcies and scandals. Its shares traded at more than $400 when the company was first listed on the Nasdaq in April 2021, but today the stock is just north of $60 per share.
Bob: Wow. Nice move, “crypto bro”. Picking a fight with the SEC, that's probably not the way to go.
Mike: We'll have to see. Bob, I want to thank you for joining me today. And hopefully you will be back.
Bob: It was my pleasure.
Mike: That’s all for this episode of GAAP Chats, your source for all things accounting. Notes and resources from today’s episode are linked in the description and as always you can find us online at GAAPDynamics.com, and @gaapdynamics across social media. It’s never too late to become a GAAPologist! Head over to our website and subscribe to our blog so that you’re the first to know what’s new with GAAP Dynamics.
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