Last week, the Securities and Exchange Commission published a staff statement that staking – the practice of locking up certain cryptocurrencies to participate in the validation of transactions and earn rewards – does not constitute a security. This is the latest in a series of moves designed to strip away obstacles to the integration of crypto and finance.
Donald Trump made no secret of the fact that, as president, he would promote the interests of the crypto lobby. Given the amount of money they spent on his campaign, that’s hardly surprising.
Delivering on that promise required the removal of SEC head Gary Gensler, who robbed Trump of the pleasure of firing him by stepping down the day before his inauguration. The SEC under Gensler was not popular with the crypto community and for good reasons. Its practice of regulation-by-enforcement and refusal to provide a coherent framework for classifying securities or registering as a legitimate cryptoasset services provider made the US a strangely hostile international outlier, and courts refused to uphold some of its most high-profile anti-crypto decisions.
The SEC’s new crypto-tsar is Hester Peirce – a long-standing and vocal critic of the SEC’s tactics under Gensler. Peirce heads up the SEC’s crypto taskforce, which has wasted little time in dismissing pending enforcement actions and issuing pro-crypto statements. Peirce’s power is likely to be increased or consolidated by the impending disbandment of the SEC’s US Fintech Innovation hub.
Is staking a security?
Among the most impactful of these is the statement on 29 May that staking is not a security. Staking is an activity unique to proof-of-stake blockchains like ethereum. Those who wish to participate in the validation of the network, providing transaction security, set up a node on the network, which allows them to create new blocks on the blockchain.
In proof-of-work blockchains like bitcoin, the security is provided by searching for the solution to a cryptographic algorithm, which is immensely energy intensive. In proof-of-stake blockchains, the security is provided by requiring validators to have skin in the game. Those who wish to can ‘stake’ or commit their holdings via a smart contract, locking them up so they cannot be transferred or used. If they propose invalid blocks (states of the world that do not reflect real transactions), they risk losing their stake. By proposing valid blocks, they earn newly minted coins and transaction fees.
This behaviour alone was very unlikely to ever be deemed a security. The issue is that the minimum staking amount on ethereum is 32Eth, equivalent to approximately $80,000 at today’s price. Locking up $80,000 is not something everyone can do, so there is plenty of demand for staking-as-a-service, in which businesses set up nodes, then take people’s Eth, pool them and stake them, distributing the rewards (minus a fee). At this point, securities law hawks might perk up.
The Howey Test is the classic criterion for determining whether something is a security (although its application is more nuanced than the Gensler administration sometimes liked to suggest). The Howey Test states that a security involves the investment of money in a collective enterprise with the reasonable expectation of profit derived from the entrepreneurial or managerial efforts of others.
Staking-as-a-service clearly involves the investment of Eth (not exactly money, but close enough) in a collective enterprise with the reasonable expectation of profit. The SEC states that the efforts of service providers taking custody and pooling assets for staking are ‘administrative or ministerial’ and not entrepreneurial or managerial and therefore do not make staking-as-a-service businesses securities offerings.
That does not mean it’s open season on staking. There are a variety of ancillary services that could well count as securities. One interesting variety is the issuance tokens against staked Eth. The locked-up tokens cannot be used but, since they are immobilised, it is possible to tokenise them. The tokens representing the staked Eth trade at a discount to the nominal price of the staked Eth and the rewards they are projected to earn. These are known as liquid staking derivative tokens and they are very likely to be considered a security.
On one hand, staking is a useful and relatively innocuous function. Increasing the range of people able to participate in it enhances both the decentralisation and the security of the network. Allowing regulated institutions to offer staking services is a democratisation of a financial function.
On the other hand, the SEC is rapidly and enthusiastically washing its hands of the responsibility of supervising significant areas of the crypto ecosystem. Commissioner Caroline Crenshaw, who has stepped into Peirce’s role of crypto policy critic, believes that, in doing so, they are running ahead of legislation – ‘taking action based on anticipation of future changes while ignoring existing law’, citing two cases where courts upheld the SEC’s decision to penalise staking-as-a-service programmes as securities. Crenshaw highlights that the pooling and protection from slashing losses that some staking-as-a-service programmes offer have been found in court to constitute managerial efforts, and that it is far from clear how the SEC’s latest statements map to practice.
Serious questions about protection for investors
Beyond the edge cases, there is a larger point at stake (ahem) here. If staking is not a security, then what protections exist for customers? If staking custodians are not subject to the requirements that custodians of securities are subject to then it is not clear to whom and on what grounds customers would appeal if their assets are not treated fairly. While securities held by brokers are protected by a well-established legal framework laying out ownership rights, Crenshaw points out that ‘there is no equivalent legal framework to protect investors who turn their crypto over to a staking service’ and that therefore ownership rights will vary between staking services.
Of course, with Trump in the White House, the legislative agenda is likely to catch up with the SEC’s statements in time but, even if it does, if the SEC is so keen to put these matters outside its jurisdiction, then there is a serious question to be answered: what will the equivalent architecture of investor protection be for the crypto industry? Without securities laws and the securities regulator, do rules, supervision and enforcement capacity all need to be conjured from scratch?
There were problems with Gensler’s approach, but we are looking now at the regulatory equivalent of whiplash. While the rapid removal of investor protections is being greeted warmly by the crypto industry (previously so keen to tout its willingness to be regulated), the absence is at best surely a two-edged sword.
Lewis McLellan is Editor of the Digital Monetary Institute, OMFIF.
Join OMFIF on 12 June to examine opportunities in US cryptoasset regulation.
Image source: White House
Interested in this topic? Subscribe to OMFIF’s newsletter for more.