By: Catherine E. Nicholson
Staking is a way of earning rewards while holding onto certain cryptocurrencies in a wallet or other designated account for a specified period of time. When a user stakes their cryptocurrency, they contribute to the validation, security, and maintenance of the blockchain network in reward for their efforts. A user stakes their cryptocurrency by locking up a certain amount of crypto as collateral. In return for staking, the user can earn rewards in the form of additional coins or tokens for the validation services they provided to the blockchain. The size of the reward typically depends on the amount of cryptocurrency being staked, the length of time it was staked, and the overall demand for the cryptocurrency.
The SEC is responsible for regulating the securities industry in the United States. Some of its key functions include registering and regulating securities offerings, enforcing securities laws, regulating securities markets, and educating investors.
The SEC requires companies that want to sell securities to register with the agency and provide detailed information about their financials and business operations. If the company fails to do so, they can be subject to civil fines, criminal charges, investor lawsuits, and injunctions. In general, it is illegal for a company to sell securities in the United States without registering with the SEC or qualifying for an exemption from registration. The SEC additionally has the power to investigate and prosecute individuals and companies that violate securities laws, as well as to regulate securities markets and educate investors.
A security typically refers to an instrument or investment product that represents ownership in a company, a debt obligation, or a right to ownership or payment. Securities are normally classified into two broad categories: equity securities and debt securities. Equity securities represent ownership in a company and entitle the holder to a share of the company’s profits and voting rights. Equity securities usually take the form of stocks and shares in mutual funds or Exchange-Traded Funds (“ETFs”). Debt Securities represent a loan to a company or government entity and most often offer a fixed rate of return. Debt securities typically take the form of bonds and Treasury bills.
The SEC has developed a legal framework to determine what types of financial instruments and investments are considered securities. This four-pronged test called the “Howey Test” is named after a landmark 1946 Supreme Court case where the central issue was determining whether a transaction or investment involves a security. The following four elements must be present for a transaction to be considered an investment contract: (1) investment of money; (2) the investment of money must be in a common enterprise; (3) there is a reasonable expectation of profits; (4) any profit comes from the efforts of a promoter or third party. If an investment meets all four prongs of the Howey Test, it is generally considered a security and the issuer must register with the SEC or qualify for an exemption from registration.
So, does crypto staking qualify as an investment contract and is it therefore regulated as a security? The short answer is no. Staking is neither a security under the U.S. Securities Act nor under the Howey Test.
Staking does not constitute an investment of money, even under the expanded definition that includes any “specific consideration” that is given up “in return for a separable financial interest.” When a user stakes crypto, they are not giving up their money in return to get something else; they own exactly the same thing they did before. Users that stake their crypto retain full ownership of their assets at all times, as well as the right to “unstake” those assets.
Staking fails to meet the “common enterprise” element of the Howey Test. Due to its decentralized nature, the assets that are staked on the network do not share a common enterprise. Rather, they are connected only through blockchain technology and they validate transactions via a community of users, not a common enterprise. Users’ rewards are not tied to any one entity because staking rewards are determined by the protocol, not by anything that an entity does. Therefore, this does not meet the definition of a “common enterprise.”
Staking services do not meet the “reasonable expectation of profits” element either. In determining this, courts look to whether a customer is drawn to an asset based on the chance of a return on investment or a desire to use or consume the item purchased. Staking rewards, in contrast, are simply payments for validation services provided to the blockchain, not a return on an investment. The reward is determined by the blockchain protocol and is the same regardless of whether the customer stakes on their own or through an intermediary like Coinbase or Kraken. The main difference is that a user who stakes their own needs to invest in a reliable computer must pay to keep it running. When using an intermediary like Coinbase, the user pays a fee to do those things on their behalf.
Staking services do not pay rewards based on the “efforts of others.” Service providers’ staking services are not entrepreneurial, managerial, nor a significant factor in whether users receive staking rewards or the amount of rewards received. The blockchain protocol governs which validator nodes receive rewards and the amount of rewards paid of each token that is staked by that node. Service providers simply use software that is publicly available and basic computer equipment to perform validation services. These are neither managerial efforts nor investment services – these are IT services.
The purpose of the SEC and securities law as a whole is to correct imbalances of information. However, there is no imbalance of information in staking as all participants are connected to the blockchain and are able to validate transactions through a community with equal access to the same information. Attempting to superimpose securities law onto crypto staking does not correct an imbalance and does not help consumers. Given the importance of this technology, getting regulation wrong in this area can do serious harm to the continuation of development of the crypto industry in the U.S.
Student Bio: Catherine Nicholson is a second-year law student at Suffolk University Law School. She is a staffer on the Journal of High Technology Law. Catherine received a Bachelor of Arts Degree in English and Spanish from the University of Connecticut.
Disclaimer: The views expressed in this blog are the views of the author alone and do not represent the views of JHTL or Suffolk University Law School.
