Securities Law Considerations for Staking Services
Depending on the proof-of-stake network, individuals staking their stokens (“stakers”) may (1) stake their own tokens; (2) delegate their right to validate transactions while keeping custody of the tokens; or (3) both delegate this right and transfer custody of the tokens for staking. Validating new transaction blocks earns stakers rewards in the form of created tokens. Delegating is meant to increase member participation by allowing for specialized services, known as staking service providers, to perform the staking function on behalf of individuals. Some have questioned whether such arrangements may resemble securities contracts, but as you’ll read below, it is clear that staking service providers should not be subject to securities laws.
Why the use of a staking service provider and subsequent rewards should not qualify as a security
Determining whether the use of a staking service provider qualifies as an investment contract requires analysis under SEC v. W.J. Howey Co. Per the Howey test, investment contracts involve (1) an investment of money (2) in a common enterprise (3) with the expectation of profit (4) based solely on the efforts of others. If one were to apply the four criteria of the Howey test to staking service providers, it becomes clear that some of these requirements will not be met, which ultimately suggests that staking services should not qualify as investment contracts subject to the securities laws.
Factor 1: “An investment of money”
The first question in need of answering is whether the staking of tokens constitutes an investment. Of course, central to that issue is whether or not the potential investor has assumed a risk of loss. The answer to that question is: it depends.
In networks that allow individuals to delegate staking rights to third-party services, the delegatory relationship does not create a risk of loss because the individual never relinquishes custody of the asset, i.e. the token. In fact, the only “risk” to this person is missing out on potential rewards.
In networks that require stakers to transfer custody of their tokens to a third-party in order to participate in the validation process, the stakers’ assets may be at risk. This is because the staked tokens are subject to the risk that the third party never returns custody of the assets.
Factor 2: “In a common enterprise”
Both common sense and the Securities Exchange Commission (SEC) have answered the question of common enterprise. A common enterprise is defined as an operation in which everyone’s profits are intertwined and interdependent on the work of other participants. In its Framework for “Investment Contract” Analysis of Digital Assets, the SEC clarified that delegating validation and sharing rewards guarantees that the staking service arrangement will satisfy this element.
Factor 3: “With the expectation of profit”
If analyzed before a court, the Howey test would require examination of the expectations or motivations of members who engage in staking in order to decide if these endeavors are made “with the expectation of profit.” While some third parties will advertise their services as profit-making mechanisms, most staking as a service arrangements will not fall under this category. Rather, they are more likely efforts to maintain the value of the member’s investment and secure the overall network. To illustrate this, it’s perhaps best to use an example:
Let’s say a non-staking network participant owns 100 tokens and thus 10% of tokens in a 1,000-token network. As other members participate in staking, 1,000 newly created tokens enter circulation via staking rewards. Non-participating members therefore experience a decrease in their interest in the overall network, from 10% to 5%. On the other hand, if all members participate in the staking and validation process, the network is maximally protected from attacks and other concerns like double spending, and every network participant’s interest in the overall network remains constant. In sum, failing to participate in the staking process can result in losses due to inflation. While this analysis depends on the specific function of a network, there is clearly an argument that expectation of profits is not the primary purpose of staking.
Factor 4: “Based solely on the efforts of others”
The issue concerning the “efforts of others” is where things get interesting. Here, the relevant question is whether the staking participant retains significant control over her assets. In many networks, this is usually the case; the staker can delegate staking rights while retaining custody of her assets. Moreover, individuals may revoke this delegatory authority. This means that an individual participating in staking via delegation to a staking service provider is able to exert control by their delegatory rights to other providers while receiving a substantially equivalent service.
The next consideration is what constitutes “essential managerial efforts” per the expansion of Howey. Generally, a staking service provider may only perform a particular function (validating transactions) in a specific way (according to a network’s protocol). Unlike a stock broker, they do not have the authority to manipulate or control the member’s assets, even if temporarily granted custody. In that sense, the efforts of a staking service provider are more operational than managerial. What’s more, the success of the entire network is dependent on cooperation across a decentralized network, meaning the success or failure of the broader network is independent of a discrete staking service provider’s actions.
Classifying staking service provider arrangements as investment contracts does not advance the intent of the securities laws
Staking service arrangements not only fail to meet the four criteria identified by Howey, but their application to securities regulation also fails to advance the intent of the securities laws. Congress passed the Securities Act of 1934 to create the SEC and instill in it the authority to monitor public companies. Crucial to this mission is the need for investors to have access to full and accurate information, so that they may make informed decisions. In an open proof-of-work network, there is no shortage of transparency or material information asymmetries created by a staking service arrangement. Thus, consumers can already make fully informed decisions regarding their choice of provider.