The legal status of staking in the crypto world
With BTC, ETH and other cryptocurrencies trending higher in the fourth quarter of 2023 and into 2024, it's a good time to revisit a topic I've been thinking about lately. What is the legal status of staking?
The basics of staking
According to Coinbase, staking has many uses, but is most simply defined as “a way to earn rewards while holding onto certain cryptocurrencies.” These rewards are often provided in the form of the cryptocurrency staked. However, it is also common for a project to provide staking rewards in the project's local currency.
For example, a Layer 2 project on the Ethereum blockchain could require staking in ETH but provide staking rewards in the form of a token representing a unique currency or other asset within that dApp (decentralized application).
Staking vs. Yield Farming vs. Mining
When it comes to lawyers, everything matters when determining the definition of stake. This is especially true if the asset or reward being staked is a common cryptocurrency. The crypto world is known for taking existing concepts, inventing new terms and mixing old with new terms. These include terms such as yield farming, mining and staking.
Yield farming and staking are related terms. Staking occurs when the owner of a cryptocurrency provides or lends cryptocurrency to a protocol to support its operations. Yield farming is a term that combines finance (yield) and gambling (agriculture).
While mining may differ from yield farming and staking, it is crucial for any Web3 project founder to clearly understand what their mining protocol achieves from a legal perspective. What is the underlying relationship between the dApp and the user base? Understanding the mechanics without getting overwhelmed by the terminology will help you figure out whether your protocol is tiptoeing or crossing the line into regulated territory like securities.
What is a security under the US Securities Act?
When I searched for “staking cryptocurrency” on Investopedia, this article was at the top of the results list: How to make passive income with cryptocurrencies. Does this sound like investment speak to you? For me it does.
According to the US Securities Act of 1933 (and I have shortened this definition significantly)
The term “security” means any debt securities, stocks, … securities futures contracts, security-based swaps, bonds, … certificates of indebtedness, … interests in profit-sharing arrangements, … transferable shares, investment contracts, … undivided interests in oil, gas or other mineral rights … option or privilege on a security , … or a group or index of securities … or a certificate of participation or an interest in … or a warrant or a right to subscribe or purchase any of the above.
The accepted definition of an investment contract goes even further and goes back to the Howey test. It is the Supreme Court's primary test of what constitutes a security (or an investment contract that constitutes a type of security). The Howey test consists of four parts:
- An investment of money or other consideration
- In a joint company
- With the expectation of winnings
- Derived solely from the efforts of others.
If you are somewhat familiar with how the common law works, you will know that each of these words in the Howey test has been expanded in subsequent cases since the original decision was issued. And you know, many regulators have been wrestling for several years with how to classify blockchain companies and their offerings from a securities perspective.
Are there securities risks when offering staking rewards?
Many of our company's Web3 customers involved in DeFi offer or want to offer staking services. Most of our customers operate worldwide and team members are spread across multiple countries. Some founding teams are based in the US, while others have no significant ties to the US.
For projects with companies and operations outside the US, countries with a current or upcoming comprehensive crypto regulatory regime (e.g. EU, Switzerland, Liechtenstein, Cayman Islands and Singapore) will most likely require registration to provide staking services. Projects that operate outside of these countries often operate in a regulatory gray area.
In the US, we received some important signals from the SEC in 2023. In February, Kraken settled with the SEC for $30 million for its staking utility and agreed not to offer staking services in the United States. In June, the SEC (in coordination with 10 states) filed a lawsuit against Coinbase over, among other things, its staking-as-a-service program. Coinbase has decided to fight this case rather than settle (at this time).
Although the SEC has suffered some setbacks in the Ripple and Grayscale cases, we do not see the news as a clear legal justification for the engagement for several reasons:
- The Ripple court ruled that Ripple's direct or institutional sales of XRP to hedge funds and on-demand liquidity providers were sales of unregistered securities.
- The Ripple court has not ruled on whether the secondary sales on DEXs (decentralized exchanges) would constitute a sale of securities, so we have no additional clarity at this point.
- The Grayscale court decision had nothing to do with staking, so we have no additional clarity here either.
At best, these cases help the industry because they show that the SEC's arguments have some weaknesses – perhaps – depending on final court decisions that will be months, if not years, away. This is what we saw when the BTC ETFs were approved this week. We may get legislative help by then. In the meantime, we will continue to monitor legal developments from both a legislative and enforcement perspective.
Diploma
In summary, staking is one of the most common practices in the DeFi market, but from a legal perspective in the US it is almost certainly the same as issuing debt. This is especially true for projects that issue earnings in well-known cryptocurrencies. The SEC continued its tough stance on securities issuances in 2023 after reaching a significant settlement with Kraken over their staking utility.
We do not expect the SEC to change its stance on staking services. Coinbase has decided to take action against the SEC on this issue, and we will continue to monitor this closely to help our customers and readers understand the contours of this rapidly changing and exciting area of law.
For more information, see:
When is a token a security? Lessons from the SEC v. Ripple case
Which industries can benefit from smart contracts?
Is Web3 dead? Not from where we sit
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
Comments are closed.