Why is the SEC Bearish on Custodial Staking? 

The Securities and Exchange Commission (SEC) is a government agency that is responsible for regulating the securities industry in the United States. Recently, the SEC has been considering limiting custodial staking, which is the practice of holding digital assets on behalf of clients in exchange for rewards. None of this has been settled yet, bt there are several reasons why the SEC is considering limiting custodial staking.

One of the main reasons why the SEC is considering limiting custodial staking is because of the potential risks associated with it. Digital assets are stored on centralized servers, which makes them vulnerable to hacks, theft, and other forms of cybercrime. If a custodian holding a client’s digital assets is hacked, the client could lose all of their assets, which could result in significant financial losses. This risk is particularly high for small investors who do not have the resources to secure their digital assets on their own.

Another reason why the SEC is considering limiting custodial staking is because of the potential for conflicts of interest. Custodians are incentivized to hold onto digital assets for as long as possible to earn staking rewards. This creates a potential conflict of interest where the custodian may prioritize their own interests over those of their clients. This could lead to a situation where the custodian decides to hold onto the client’s digital assets even if the client wants to sell them, which could result in significant financial losses for the client.

Additionally, the SEC is concerned about the lack of transparency in custodial staking. Digital assets are often stored in cold storage, which means that they are not accessible to clients. This makes it difficult for clients to monitor the security of their digital assets and to keep track of their rewards. This lack of transparency makes it difficult for the SEC to ensure that custodians are acting in the best interests of their clients. An example of this was recently displayed by the relationship between Voyager Digital and 3AC; Voyager supplied $670MM in loans to 3AC in exchange for payments that paid for Voyager’s USDC staking. When LUNA collapsed, so did 3AC and it ultimately led to the downfall of Voyager. We saw similar effects recently with FTX and Alameda. 

Finally, the SEC is concerned about the potential for market manipulation in custodial staking. Digital assets are still a relatively new and rapidly evolving market, and there is a risk that custodians may use their control over large amounts of digital assets to manipulate the market. This could result in significant financial losses for investors, which is why the SEC is considering limiting custodial staking to protect small investors.

In conclusion, the SEC is considering limiting custodial staking due to the potential risks associated with it, including conflicts of interest, lack of transparency, and potential market manipulation. This is a complex issue, and the SEC is still in the process of considering the best way to regulate custodial staking. What the SEC has to balance this “protectionism” against is the very real need for the US to stay at the forefront of investor technology.