Crypto Staking is not Securities, Maybe ‘Steaking’ Is
There is a debate over whether crypto-staking products are considered securities or not.
Brian Armstrong, the CEO of Coinbase, has defended the company’s staking product and said in a Bloomberg interview that it is not a security. Armstrong also mentioned that customers never turn their assets to Coinbase and that staking is not a security under the U.S. Securities Act or the Howey Test used by the Securities and Exchange Commission (SEC) to determine whether an investment contract is a security.
However, Coinbase has reportedly received investigative subpoenas from the SEC regarding staking, stablecoin, and yield-generating products. Nonetheless, Coinbase’s chief legal officer asserts that the staking service is different and is not a security.
Crypto staking refers to the process of holding a certain amount of cryptocurrency to participate in the validation of transactions and earn rewards in return. It is a process by which an individual can hold and lock up their cryptocurrencies in a wallet or other digital platform, and participate in the consensus mechanism of a blockchain network in order to earn rewards. The consensus mechanism used in staking is typically proof of stake (PoS), which enables validators to be chosen based on the number of coins they hold and have locked up in their wallets.
Validators are then responsible for creating new blocks and verifying transactions on the network. In return for their participation, validators earn a percentage of the block rewards in the form of additional cryptocurrency. Staking is seen as a way to help secure a blockchain network, as it incentivizes users to hold onto their coins and participate in the network’s governance.
Staking on centralized exchanges can come with risks. Centralized exchanges control the staked assets and may not always distribute rewards fairly. Moreover, centralized exchanges are more susceptible to hacks and security breaches, which can result in the loss of staked assets.
In February, the SEC cracked down on cryptocurrency firms and centralized exchanges. The SEC aims to protect investors by enforcing securities laws, imposing fines, and promoting transparency. Kraken, a cryptocurrency exchange platform, has paid a $30 million settlement to the SEC after being charged with violating securities rules by offering an unregistered securities program known as staking. The SEC claimed that Kraken marketed the staking platform as an investment opportunity and generated nearly $15 million in net income from U.S.-based users on revenue of $45.2 million.
As a result of the settlement, Kraken has ceased offering staking programs in the U.S. The company has also agreed to pay $30 million in disgorgement, prejudgment interest, and civil penalties as part of the settlement. The settlement highlights the need for companies to comply with securities regulations and register their staking services as securities offerings with the SEC.
One question that often arises in relation to staking is whether it is considered a security under U.S. securities law.
According to Coinbase, staking is not considered a security under the U.S. Securities Act or the Howey Test, which the SEC uses to determine whether an investment contract is a security. The Howey Test, which comes from a 1946 U.S. Supreme Court case, requires that an investment contract involve; an investment of money; in a common enterprise; with an expectation of profits; and, solely from the efforts of others. A transaction qualifies as an investment contract if it meets all four elements. Staking, however, fails to satisfy any of these prongs.
Firstly, staking does not qualify as an investment of money as customers do not give up any assets to receive staking rewards. The provision of staking services does not involve the exchange of assets or the transfer of ownership. Customers retain full ownership of their tokens and can unstake them at any time.
Secondly, staking does not meet the common enterprise prong of the Howey Test. Stakers on a blockchain network are not connected through a common enterprise or a central authority. Instead, they are part of a decentralized network that relies on consensus mechanisms to validate transactions. Stakers do not share profits or losses and are not part of a joint venture.
Thirdly, staking does not meet the reasonable expectation of profits element of the Howey Test. While stakers earn rewards for validating transactions, these rewards are not considered profits. The rewards are predetermined by the blockchain protocol and are not influenced by market conditions or the actions of service providers. Stakers do not have an expectation of profits beyond the rewards for validation services.
Finally, staking does not involve the efforts of others, a requirement under the Howey Test. Service providers offering staking services do not perform managerial or entrepreneurial activities. Instead, they provide tech services that allow customers to participate in the validation process. Service providers do not influence the rewards or the decision-making process on the blockchain network.
In the case of staking as mentioned above, the customers hold and control their assets and participate in the network’s validation process, which is considered an essential function of the cryptocurrency system. Thus, the SEC’s definition of a security does not apply to staking, as the rewards earned through staking are considered an inherent feature of the cryptocurrency network rather than solely from the efforts of others.
It’s important to note that the SEC has recently been cracking down on cryptocurrency-related activities, including crypto lending and staking and it is possible that their interpretation of the U.S. Securities Act could change in the future. Other countries may have different regulatory frameworks, so it is essential to be aware of local regulations and seek professional advice when engaging in cryptocurrency activities.
New York Attorney General Letitia James filed a lawsuit against KuCoin, a Seychelles-based cryptocurrency exchange, for allegedly violating securities laws by offering tokens that meet the criteria for securities without registering with the attorney general’s office. The lawsuit also alleges that KuCoin misrepresented itself as an exchange and lacked registration for that function as well. The lawsuit claims that this is the first time a regulator has claimed Ether is a security in court. The lawsuit specifically cites SEC v. Ripple as a precedent.
As an alternative, some investors may prefer decentralized exchange (DEX) platforms for staking, as they offer greater privacy, lower fees, and operate on a peer-to-peer network method. Crypto staking on a centralized exchange involves depositing and holding crypto assets to participate in staking activities, but it comes with risks and regulatory scrutiny. Investors should weigh the pros and cons and consider alternative options such as DEX platforms. I want to see what the SEC can do with decentralized exchanges and its series of Defi products.
I tend to agree with Gary Gensler when he said, “What does steak have to do with our securities law?”