The Legal Status of Staking in the Crypto World
With BTC, ETH, and other cryptocurrencies trending upward in Q4 2023 and into 2024, it is a good time to revisit an issue I have been thinking about lately. What is the legal status of staking?
The Basics About Staking
According to Coinbase, staking is multifaceted but can be defined most simply as “a way of earning rewards while holding onto certain cryptocurrencies.” Those rewards are often delivered in the form of the cryptocurrency staked. But it is also common for a project to provide staking rewards in the project’s native currency.
For instance, a layer-2 project on the Ethereum blockchain might require staking in ETH but provide staking rewards in a token that is a unique currency or other asset within that dApp (decentralized application).
Staking vs. Yield-Farming vs. Mining
With lawyers, everything matters in determining the definition of staking. This is especially true when the asset staked or the staking reward is a common cryptocurrency. The crypto world is famous for adopting existing concepts, inventing new terms, and blending old and new terms. These include terms like yield-farming, mining, and staking.
Yield-farming and staking are related terms. Staking occurs when the cryptocurrency owner sets aside or lends some cryptocurrency to a protocol to assist in its operations. Yield-farming is a term that blends both finance (yield) and gaming (farming).
Even though mining can be distinct from yield-farming and staking, it is crucial for any web3 project founders to clearly understand what their mining protocol is achieving from a legal perspective. What is the underlying relationship between the dApp and the user base? When you understand the mechanics, without overlaying any terminology, you can figure out whether your protocol is tiptoeing or crossing the line into regulated territory like securities.
What is a Security under the U.S. Securities Act?
When I searched for “staking crypto” on Investopedia, this article topped the results list: How to Earn Passive Income Through Crypto. Does that sound like investment language to you? It does to me.
According to the U.S. Securities Act of 1933 (and I have trimmed this definition significantly),
The term “security” means any note, stock, … security future, security-based swap, bond, … evidence of indebtedness, … participation in any profit-sharing agreement, … transferable share, investment contract, … fractional undivided interest in oil, gas, or other mineral rights … option, or privilege on any security, … or group or index of securities … or any certificate of interest or participation in … or warrant or right to subscribe to or purchase, any of the foregoing.
The accepted definition of an investment contract goes even further, hearkening back to the Howey Test. It is the Supreme Court’s preeminent test of what constitutes a security (or an investment contract, which is a type of security). There are four prongs to the Howey test:
- An investment of money or other consideration
- In a common enterprise
- With the expectation of profits
- Derived solely from the efforts of others.
If you are at all familiar with the workings of common law, you know that each of those words in the Howey test has been expanded on in subsequent cases since the original decision was issued. And you know that many regulators have been wrestling for several years with how to classify blockchain ventures and their offerings from a securities perspective.
Are there Securities Risks in Offering Staking Rewards?
Many of our firm’s web3 clients that are involved in DeFi either are providing or want to provide staking services. Most of our clients have global operations, with team members spread across several countries. Some founding teams are located in the US, while others have no significant US ties.
For projects with entities and operations outside the US, countries with a current or pending comprehensive crypto regulatory regime (e.g. EU, Switzerland, Liechtenstein, Caymans, and Singapore) will most likely require registration for providing staking services. Projects operating outside these countries are often doing so in a grey regulatory area.
In the US, we received some significant signals from the SEC in 2023. In February, Kraken settled with the SEC for $30MM over its staking services program and agreed not to provide staking services in the US. In June, the SEC (in coordination with 10 states) filed an action against Coinbase in part due to its staking as a service program. Coinbase has decided to fight this case instead of settling (at this point).
- The Ripple court held that Ripple’s direct sales or institutional sales of XRP to hedge funds and on-demand liquidity providers were sales of unregistered securities.
- The Ripple court did not touch on whether the secondary sales on DEXs (decentralized exchanges) would constitute a sale of securities, so we have no added clarity at this point.
- The Grayscale court decision had nothing to do with staking, so we have no added clarity there, either.
At best, these cases help the industry because it shows the SEC’s arguments have some weaknesses – possibly – depending on final court decisions that will be months if not years away. We saw that with the BTC ETFs being approved this week. We might get legislative help before then. In the meantime, we will continue to watch legal developments from both legislative and enforcement perspectives.
In summary, staking is one of the most common practices in the DeFi market, but from a US legal perspective, it is almost certainly equivalent to issuing debt securities. This is especially true for projects that issue yields in well-known cryptocurrencies. The SEC continued its hard stance in 2023 regarding the issuance of securities after notching a significant settlement with Kraken over its staking services program.
We do not expect the SEC to change its stance regarding staking services. Coinbase has determined to fight the SEC on this point, and we will continue to follow it closely to assist our clients and our readers to understand the contours of this rapidly changing and exciting area of law.
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