How policymakers should think about “staking”
The difference between on-chain and custodial staking
The difference between on-chain and custodial staking
A misconception we sometimes see from policymakers looking at cryptocurrency networks is that “staking” and “staking rewards” are some kind of security or interest-bearing lending activity that should be subject to regulation. While it’s true that some of these activities will qualify for regulation, there are several different activities under the “staking” umbrella that we sometimes see conflated. To help policymakers understand what is staking and what are the different activities related to it, today we published a backgrounder explaining proof-of-stake consensus mechanisms, related staking-as-a-service business models, and differentiating these activities from staking rewards or other rewards opportunities offered by custodial cryptocurrency exchanges. The backgrounder sticks to a just-the-facts explanation of the technology. Here we will consider when staking activities may trigger regulation and when they will not.
In general, as we’ve argued for many years (including before the CFTC) the particular choice of consensus mechanism for an open blockchain network should not have significant implications for public policy. We explain in our backgrounder that the economic realities of staking versus proof of work mining are not meaningfully divergent:
At the end of the day the economic activity that stakers are performing is not functionally different from proof-of-work miners: both are making a verifiable economic sacrifice in order to participate in the validation of consensus data and to potentially create the reward inherent in that validation.
And it is the economic realities of an activity, rather than the particular technologies involved, that are relevant to the application of, for example, securities or AML laws:
Even though they help maintain a public and verifiable list of monetary-like transactions, miners and stakers are not like banks or money transmitters or other financial intermediaries because they cannot misdirect or redirect the transactions they put into blocks. They perform a more modest function: merely communicating to the rest of the network that these valid transactions have occurred by placing them in blocks alongside proofs of work or proofs of stake.
Despite the similarity of the term “staking” to “stakeholding” or even “shareholding,” stakers are no more like shareholders of a company than are proof-of-work miners. Nor should the particular choice of consensus mechanism have any bearing on whether sales of tokens on that network are classified as regulated sales of securities. The fact that stakers risk their staked cryptocurrency is little different than miners risking the cost of their mining hardware and electrical consumption. Both miners and stakers earn rewards in some proportion to the amount they risk.
All that being said, the policy questions become more complicated when custodial cryptocurrency exchanges offer to take cryptocurrency you have deposited with them and stake it for you and in return give you resultant staking rewards minus a fee. As we write:
When a custodial exchange offers customers “staking” rewards it is the exchange itself that is paying the customer at a rate determined by the exchange rather than the rewards being the natural products of participation in a PoS consensus mechanism.
These distinctions may have important public policy implications. By promising a return on deposited funds, an exchange or other similar custodian may be issuing a security. Banks, of course, offer interest on deposits and that activity is not treated as securities issuance. However, in those circumstances, courts have found that interest bearing accounts fall out of the relevant test for securities issuance because the risk to bank customers is reduced by banking regulations and federal deposit insurance. The most relevant cases here are Reeves and Marine Bank. Cryptocurrency exchanges that are not chartered banks and not federally insured cannot rely on the same defense.
Alternatively, it may be argued that an exchange is not the one promising a reward, it is merely safeguarding the customer’s cryptocurrency, which on its own is not a security, and providing the customer with access to rewards they’d otherwise be entitled to if they custodied and staked the cryptocurrency themselves. However, existing court precedent suggests this line of argument will again fail to persuade. In Gary Plastic, Merrill Lynch offered certificates of deposit (CDs) to its customers alongside an option to sell the CD before maturity, as well as additional promises to find the best CD interest rates and collect on FDIC insurance on customers’ behalf should the original CD issuer fail. The court rightly found that CDs themselves were not securities but that the offer of both the CD and the additional promises were, taken together, a security. In the case of staking rewards the analogy should be clear. The cryptocurrency itself may not be a security but the promise to hold it and stake it safely and profitably on the network as well as provide a liquid market for future sales of the cryptocurrency may be a security under the Gary Plastic standard.
Finally, our backgrounder also explains non-custodial staking services:
Because of the difficulty inherent in keeping a computer reliably online, many companies now offer staking services. In these relationships, a company maintains the computers that communicate with the blockchain, but the user of the service retains control over the staked cryptocurrency used to prove stake.
We also explain why this activity should not be confused with staking rewards offered by custodial exchanges:
In the case of staking services, the service provider never has control over the user’s cryptocurrency and the protocol determines the size of the rewards rather than any policy internal to the provider.
Following the Gary Plastic standard discussed above, staking services should not trigger securities regulations. The customer is never depositing their money with the service provider, and the provider is not promising anything beyond technical capacity like server maintenance. That said, this area is rapidly evolving, and every particular economic arrangement should (and will) be judged on its own merits.