(Bloomberg) -- U.S. regulators effectively snuffed out Coinbase Global Inc.’s plan to pay users 4% interest in exchange for lending out their cryptocurrency. Oh well. The exchange still pays holders of some tokens rates as high as 5%. How is that possible? Through a common crypto-world practice known as staking, which compensates owners of certain coins for a variety of reasons -- including some similar to the payments made to Bitcoin miners. Coinbase, which calls it “the easy way to earn,” launched a staking program on the Ethereum 2.0 blockchain in April and had 1.7 million customers participating by the end of June. Like many new innovations in the digital-asset world, it’s unclear how staking programs like these should be treated under decades-old laws and court decisions. And yet even as Coinbase pulled the plug on its lending program last month under the threat of legal action from the Securities and Exchange Commission, it continues to offer payments in exchange for staking coins. 

“This is part of a broader dichotomy happening where the innovators are innovating at a much faster clip than ever before, and the regulators, the legal system and lawmakers can’t keep pace,” said R.A. Farrokhnia, professor at Columbia Business School and executive director of the university’s Fintech Initiative. “That gap always existed between innovators and regulators. But that’s becoming almost a chasm now.”

While other crypto exchanges such as Binance and Kraken and a variety of decentralized-finance platforms also offer staking pograms, Coinbase is subject to a higher level of scrutiny because it is a publicly traded company in the U.S.   

A spokesperson for the SEC did not reply to a request for comment, so it’s unknown whether the commission considers interest-bearing staking programs to be securities that fall under its purview. Various lawyers have provided their takes, with differing opinions as to whether staking service arrangements fulfill the so-called Howey test to determine whether they qualify as investment contracts subject to securities laws. In letters released Monday seeking more information from three cryptocurrency platforms, the New York Sate Attorney General’s office asked them to “identify and describe each lending, loan, interest, or deposit/earnings product you offer.”

Read More: Two Crypto Firms Ordered Shut by N.Y. Attorney General

Coinbase’s latest quarterly filing with the SEC acknowledged the legal questions associated with paying users in exchange for coin staking: “We also offer various staking, rewards, and lending products, all of which are subject to significant regulatory uncertainty, and could implicate a variety of laws and regulations worldwide.” The exact tax implications of staking payments are also unknown, the company said, “and it is unclear what guidance may be issued in the future” on the tax treatment of these and other crypto transactions. 

When asked last week whether the regulatory uncertainty surrounding the staking program had changed at all since the company received the SEC’s Wells notice, a Coinbase spokesperson said: “We don’t have anything additional to add here though I’m sure you saw our news out this AM.” 

That was a reference to the company’s proposals about how the government should regulate the industry. Coinbase argues that responsibility for digital-asset markets should be assigned to a single government entity and that a self-regulatory organization, like those that already exist in traditional markets, be established. Together, they should formulate new rules that permit the full range of digital-asset services including staking, the proposal reads. 

Currently, Coinbase offers users annual rates of 5% to stake the Ethereum and Cosmos coins, 4.63% to stake Tezos and 4% for Algorand. The payments are made in cryptocurrencies and earning them requires locking up holdings of coins whose value can be very volatile. For so-called stablecoins such as Dai and USD Coin, which are meant to track the dollar one-to-one, the offered payments are lower -- 2% and 0.15%, respectively. 

The way staking works involves tapping into the incentives programmed into cryptocurrency networks to keep them running efficiently and securely. In what are know as “proof of stake” blockchains, crypto assets are used as “stakes” -- sort of security deposits, as Coinbase puts it, that are offered up by participants in the market who want to earn compensation by providing the computing power needed to create and successfully validate blocks of transactions. 

If the blocks are validated successfully on a computer node, the stake is returned and the staker is compensated for the work. If the blocks aren’t validated correctly, the staker risks forfeiting at least part of their stake. 

Exchanges like Coinbase earn a cut by serving as the middleman for customers who want to stake the coins but not run the computer nodes needed to do so. Coins also can be staked for a variety of other reasons in decentralized financial networks, such as bookkeeping tasks or voting in polls that govern changes to the underlying computer code.  The activity is not without risk for Coinbase or its customer base. As the company explains in its filing: “If our validator, any third-party service providers, or smart contracts fail to behave as expected, suffer cybersecurity attacks, experience security issues, or encounter other problems, our customers’ assets may be irretrievably lost.”

As for the protocols that seize staked coins if the computing processes aren’t performed properly, a process known as “slashing,” Coinbase said: “If we or any of our service providers are slashed by the underlying blockchain network, our customers’ assets may be confiscated, withdrawn, or burnt by the network, resulting in losses for which we are responsible.” The risks go on, as risk factors do, but you get the drift. Still, Coinbase has made it clear it wants to build out the staking program further. Staking boosted the Coinbase revenue line for “Blockchain rewards” to $39 million in the quarter through June from $2.7 million in the prior year period.

“One of our priorities is to continue to add proof-of-stake protocols and other reward-generating assets to our platform to expand reward opportunities for our users,” the firm said in its last filing.

To Farrokhnia, the Columbia professor, staking is the type of newly possible activity that highlights the need for regulators to catch up with the innovation going on in the crypto world. “Given the fact that all of a sudden we can do things in financial services that we couldn’t do before, I’m sure the point in time comes in which people realize we just have to go back to the drawing board,” Farrokhnia said. “We need to come up with a new definition and a new regulatory paradigm.”

©2021 Bloomberg L.P.