On February 9th, 2023, the United States Securities and Exchanges Commission (SEC) hit Kraken with a $30 million fine as a punishment for “failing to register their crypto asset staking-as-a-service program”. This sent a shockwave of FUD across the entire industry, especially since big U.S. based exchanges such as Coinbase also hold millions of dollars of user funds in their PoS validators nodes.
This event re-ignited a debate among community members about the good, the bad and the ugly of custodial and non-custodial staking services. However, a crucial topic was missing in this conversation, and that’s what we want to cover today: why the location of your validator matters.
When choosing a validator, most users will focus on the commission charged, the amount of stake they already have, and their historical performance. But most of the time it can be hard to tell which country a validator is based in, and so this is overlooked. As we saw with the recent Kraken case, this information is crucial and may be even more important in the future.
Besides the location of a validator mattering at the individual level, it also plays an important role in the overall health of the network. A high concentration of validators from a specific country or region jeopardises the security of a decentralised blockchain since any disruption, either legal or technical (i.e. electric or internet failure), could make it easier for unwanted actors to gain control over the network.
Taking Polygon as an example, 32% of the validators are physically located in the United States. Similarly, another 20.6% of validators are in Europe. Although both places offer better access to infrastructure than other regions, it’s still troubling that 52% of the validators are in only two jurisdictions where new regulations could eventually disrupt their services.
If we see the Ethereum geographical distribution of the nodes, we found that almost 47% are in the United States, 12% in Germany, 4.68% in Singapore and only 3.68% in the United Kingdom. On the other hand, Solana has a better landscape, as of their latest Validator Health Report, there is a bit more balanced equation with 20.4% of the validators in the United States, 21% in Germany, 9.5% in Ireland, 8.3% in the Netherlands and 7.8% in the United Kingdom.
As we can see in three major networks, there is a tendency to geographical centralisation in the validators market.
The regulation of crypto assets in the United Kingdom is still being developed. However, there are positive signals about the stance of the country being open to the blockchain industry. Rishi Sunak, the current Prime Minister, during his tenure as Finance Minister, was an advocate of the crypto industry.
In 2022 and 2023, there were official announcements from the UK government about their goal of becoming a crypto hub. In April 2022, a press release was sent out explaining the vision to achieve this goal by creating conditions for stablecoin issuers and service providers to operate and invest in the UK, with appropriate regulation providing financial stability and high regulatory standards. The measures also included the establishment of a financial market infrastructure sandbox to enable firms to experiment and innovate, a Cryptoasset Engagement Group to work more closely with the industry, and exploring ways of enhancing the competitiveness of the UK tax system.
Earlier this year, in January, amid the turmoil caused by the FTX collapse, the United Kingdom government, now under Sunak, reiterated its ambitions of becoming one of the countries leading the adoption of blockchain technology and cryptocurrencies.
As a validator based in the UK, we have been closely following the developments, for example as a member of the lobby group DCGG, and generally, we are optimistic about the future UK regulation for the industry.
Although there has not been a formal move to regulate staking, the latest movements of the SEC shows that it is likely things may get tougher for staking service providers in the United States. Mainly, the focus of the SEC has been on whether or not crypto assets are securities, and therefore, should be subject to the current regulation in the matter which covers, for example, traditional stocks.
Coinbase has responded to the SEC’s question on whether staking is a security. They argue that staking is not a security under the US Securities Act or the Howey test, which the SEC uses to determine whether an investment contract is a security. Staking fails to meet the four elements of the Howey test, including investment of money, common enterprise, reasonable expectation of profits, and efforts of others.
The centralised exchange further argued that trying to apply securities law to staking is unnecessary and may prevent US consumers from accessing basic crypto services. They emphasise the importance of sensible regulation in the crypto industry but suggest that regulation by enforcement that does nothing to help consumers and drives innovation offshore is not the answer.
In the European Union, last year the parliament approved the MiCA regulation. Although this law comes to set the ground for a broader regulation of the industry, it mainly focuses on a framework for token issuers and custodial services providers. In its current form, the legislation doesn’t specifically talk about the treatment the regulators will give to staking. The head of the European Central Bank, Cristine Lagarde, back in June 2022, called for drafting some rules around lending and staking since “it possessed a risk to the financial wellbeing of users”.
In conclusion, the recent SEC fine on Kraken for failing to register their crypto asset staking-as-a-service program has sparked a conversation about the importance of the location of validators in the cryptocurrency industry. The concentration of validators in specific regions can threaten the security of decentralised networks, especially if new regulations or disruptions occur.
As the industry continues to grow, regulators around the world are working to develop laws to govern cryptocurrencies and staking. The UK government has expressed its openness to the industry and aims to become a crypto hub, while the SEC in the United States has been focusing on whether or not crypto assets are securities. In the EU, the MiCA regulation has been approved, but it does not specifically address staking. The location of validators will likely continue to be a crucial factor for users and networks, and it will be important for the industry to monitor regulatory developments to ensure its growth and stability.