The SEC Complaint
I’ve been grappling with the question “Is staking a security?” since the SEC complaint against three Coinbase employees, who the SEC argues engaged in securities fraud.
The employees are accused of sharing inside information about new cryptocurrency listings on Coinbase before they were publicly announced, allowing these insiders to buy crypto tokens before the inevitable jump in price after the announcement.
The part about profiting based on non-public information is most likely illegal.
But in order for the SEC to have jurisdiction here, and take them to court for securities fraud, they need to make the case that the cryptocurrencies they profited from are actually securities. A good portion of the complaint tries to make this case, and they claim that staking tokens gives investors “a reasonable expectation of profit based on the efforts of others.” This would mean the type of staking these tokens are engaging in are an investment contract according to the Howey Test.
According to the Howey Test, an investment contract is:
An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others
You can see the SEC use this exact wording in their complaint as they make their case:
Throughout the relevant period, Nikhil and Ramani repeatedly traded ahead of Coinbase listing announcements, trading in at least 25 tokens. At least seven of the listing announcements described above involved crypto asset securities. Nikhil and Ramani traded in securities subject to the federal securities laws because these crypto assets were investment contracts; they were offered and sold to investors who made an investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others.
…
As alleged in greater detail below, the issuers and their promoters solicited investors by touting the potential for profits to be earned from investing in these securities based on the efforts of others. These statements focused on, among other things, the value of the token at issue and the ability for investors to engage in secondary trading of the token, with the success of the investment depending on the efforts of management and others at the company.
So what does this mean for staking?
Does staking cryptocurrency for yield pass the Howey Test? Let’s go through it one by one:
An investment of money: Yes, you need to purchase cryptocurrency in order to start staking it.
In a common enterprise: Yes, typically you can only earn cryptocurrency in the same cryptocurrency that you stake. Staking involves verifying transactions for a public blockchain which can be considered a common enterprise.
With the expectation of profit: Yes, those who stake are making a bet that not only do they earn yield from staking but that the cryptocurrency rises in value over time. They are verifying transactions on the blockchain which can be considered a public good, but the reason they do it and the incentives behind staking are for personal gain.
To be derived from the efforts of others: Well, it’s complicated.
I believe staking directly with your own cryptocurrency does not meet this requirement, because an individual uses their own available resources to set up the validator and gain the rewards. If we look at it from this point of view, there is effectively no difference between mining bitcoin using your ASICs and staking, and no one is arguing that proof-of-work mining on your own is a security. There is no one in the middle of this interaction, no profits “derived from the efforts of others” in this equation. The blockchain is open for anyone to take advantage of if they have the initiative and the means, and you can only gain rewards from successfully validating transactions.
In another theoretical example, let’s say you find oil on your property. Congrats!
You make an investment of money to buy equipment to extract the oil.
You and some of your friends create a common enterprise and work together to extract it. Maybe even set up a small private company.
They help you with the expectation of profit. If you find enough oil, and you plan to pay them once you sell the oil, you’ll all be rich!
Did you buy or sell a security? No, because you did it on your own and the profits were never derived from the efforts of others.
However, if you sold shares in the drilling operation to outside investors and you did all the work of drilling and selling the oil, then you are selling a security.
In the same way, if you give cryptocurrency to someone else and they do the mining or staking for you, THAT is profit being “derived from the efforts of others.”
For example, when the SEC discusses the AMP token (emphasis on the “efforts of others” part):
In its November 2020 Amp white paper, Flexa explained that “participants stake Amp into pools that secure the network.” These collateral pools, comprised entirely of Amp, are what allow Flexa to operate. Or, as Flexa put it in the Amp white paper, the “Amp token serves as the singular type of collateral within Flexa to decentralize risk within the network.” If the collateral pools are profitable, investors who stake Amp can share in the profits.
…
Flexa’s August 2019 description of Flexacoin, Amp’s predecessor, also reinforced the potential rewards for investors: “Stakers don’t collateralize Flexa payments purely out of the goodness of their hearts. Rather, as incentive for deploying Flexacoin as collateral – and to compensate the risk they incur when collateralizing unproven apps on the network – stakers earn the network reward generated after every successful payment confirmation.” As described below, Flexa’s management team maintains these collateral pools.
And when describing DDX:
DerivaDEX further described the insurance mining program, stating that investors would have the ability to earn more DDX by “staking” DDX to a DerivaDEX “insurance fund.” In other words, investors would essentially contribute their DDX tokens to the fund, creating liquidity that could be used to insure parties if a transaction fails. As the insurance pool grows and earns fees, participants who staked their DDX may receive additional DDX tokens and thereby greater opportunities to profit.
Putting your stake into “pools” or “funds” where some other entity is doing the staking for you with your cryptocurrency funds, that is deriving profit from the efforts of others and is likely considered a security. They control the funds, they do the staking, and they distribute the rewards back to you (minus a fee of course). This sounds a lot like any other typical investment product.
So does that mean Stake Delegation is a Security?
Now this is where is starts to get interesting.
Delegating your stake, which is probably how most people stake their crypto, would probably be considered a security under this same definition.
Should it be? I don’t know, but if the SEC uses the same arguments above then they would likely see all stake delegations as securities.
For those of you who don’t know, stake delegation is when you don’t have enough of the cryptocurrency to start staking yourself or don’t want to bother with the hassle of running your own validator and decide to give it to someone else to stake for you for a fee.
Ex: Ethereum requires their validators to start staking 32 ETH, or as of right now over $60,000. Most people won’t have that much ETH, so they will want to delegate their stake to others, who will take a 1%-10% fee on the rewards they generate with your stake.
This means that others are doing the actual staking process for you and giving most of the rewards back to you. Which sounds an awful lot like “making an investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others.” Or in other words, a security.
Lido is doing something similar, where you convert your ETH into their stETH, they continue to stake the ETH for you through delegation and use the stETH as collateral for DeFi.
⚠ WARNING: NOT INVESTMENT ADVICE ⚠
I currently am staking through Lido, because public staking isn’t live on Ethereum yet and even if it was I don’t have 32 ETH. I also delegate my stake of Solana because I don’t know if my laptop could handle it and frankly don’t want to go through the hassle right now.
Personally, I’m afraid that if stake delegation suddenly becomes a security, then many of these services will either have to file with the SEC or stop staking as a service. Overall staking could become more centralized as a result and make many of these blockchains more vulnerable to manipulation and attacks. Security drops, the value of the cryptocurrencies drop, and it could create another vicious cycle in the crypto market.
On the other hand, this could also convince blockchains to prioritize making staking easier for casual users and more distributed. More innovation, more ways of doing things, and new and interesting solutions to solve transaction validation and consensus.
It’ll be interesting to see what happens.