As more of the crypto ecosystem adopts proof of stake over the more energy-intensive proof of work protocol, crypto users around the world are “being introduced to the benefits of ‘staking,” according to an update from Coinbase (NASDAQ:COIN).
Paul Grewal, Chief Legal Officer at Coinbase, notes that this shift has “come with debates over what moving to proof of stake means at the regulatory level. Given the importance of this technology, getting regulation wrong could do serious harm to the development of the crypto industry in the US.”
At Coinbase, they’ve been committed to “providing their users with a secure, compliant platform to access the cryptoeconomy since day one, and their staking products are not securities,” Grewal claims.
But there are “a lot of products in the market called staking and many of them work very differently,” Grewal noted. He also mentioned that he’d focused on core staking services (protocol-based, on-chain staking), “like the ones Coinbase offers, which are a vital aspect of crypto and blockchain technologies.”
As explained in a blog post, staking serves “a similar function to mining, in that it’s the process by which a network participant gets selected to add the latest batch of transactions to the blockchain and earn some crypto in exchange.”
Staking allows anyone, anywhere, “to contribute to the security of a blockchain and to be rewarded for their efforts.” But while anyone “can participate in staking activities, the average crypto user will generally use a service provider like Coinbase to keep the servers running and software up to date.”
However a crypto owner chooses to stake, “they provide a critical service to the crypto ecosystem, allowing proof of stake blockchains to operate seamlessly,” Grewal wrote in a blog post.
He added that the reason your crypto earns rewards while staking assets is “that you are putting your crypto to work in exchange for a payment from the blockchain itself.”
Cryptocurrencies that allow staking use a ‘consensus mechanism’ called Proof of Stake, to ensure that “all transactions are verified and secured without a bank or payment processor intermediary.” If you choose to stake your crypto, it “becomes part of that process, but it remains your crypto at all times.”
At Coinbase, their core staking service is “offered through our Coinbase Earn program, which allows users to stake certain assets for a recurring payment from the blockchain protocol.”
They also help users “to stake through products like Coinbase Wallet and Coinbase Cloud, which allows developers to run their own validators or leverage our secure public validators’ non-custodial staking on 25+ networks.”
Is staking a security?
As noted in the update from Coinbase:
“Staking is not a security under the US Securities Act, nor under the Howey test, which the SEC uses to determine whether an investment contract is a security. The Howey test comes from a 1946 Supreme Court case – and there is a separate discussion to be had about whether that test makes sense for modern assets like crypto. Regardless, staking fails to meet the four elements of the Howey test: investment of money, common enterprise, reasonable expectation of profits, and efforts of others.”
The update also mentioned that staking services “do not constitute an investment of money, even under an expanded definition” that includes any “specific consideration” that is given up “in return for a separable financial interest.”
When a customer asks us to stake some of their crypto, “they aren’t giving up one thing to get something else – they own exactly the same thing they did before.”
Staking customers “retain full ownership of their assets at all times, as well as the right to “unstake” those assets consistent with the underlying protocol,” Grewal clarified.
He further noted:
“Second, staking services do not meet the “common enterprise” prong of Howey because assets are staked on decentralized networks. Stakers are only connected by blockchain technology and they validate transactions through a community of users, not a common enterprise. The fortunes of users are not tied to those of Coinbase because staking rewards are determined by the protocol—not by anything that Coinbase does. Therefore, this does not meet the case law definition of common enterprise.”
“Third, staking services fail to meet Howey’s “reasonable expectation of profits” element. To determine this, courts look at whether a customer is attracted to an asset based on the prospects of a return on investment or a desire to use or consume the item purchased. Staking rewards are simply payments for validation services provided to the blockchain, not a return on investment. They are set by the blockchain protocol and are the same whether the customer stakes on their own or through an intermediary like Coinbase. The only difference is that a user who stakes on their own may need to buy a dedicated computer and pay to keep it running, while the customer who stakes through Coinbase, pays us a fee to do those things on their behalf.”
“Finally, staking services do not pay rewards based on the “efforts of others.” Service providers’ staking services are not entrepreneurial, managerial, or a significant factor in whether customers receive staking rewards or the amount of rewards received. The relevant blockchain protocol governs which validator nodes receive rewards and the amount of rewards paid for each token staked by that node. Service providers simply use publicly-available software and basic computer equipment to perform validation services and do not perform any managerial efforts. These are IT services, not investment services.”
The purpose of securities law is “to correct for imbalances in information. But there is no imbalance of information in staking, as all participants are connected on the blockchain and are able to validate transactions through a community of users with equal access to the same information.”
Trying to superimpose securities law onto a process like staking “doesn’t help consumers at all.”
Instead, unnecessarily aggressive mandates “will prevent US consumers from accessing basic crypto services in the US and push users to offshore, unregulated platforms.”
Blockchain technology can “spur significant economic growth in the US and staking is a safe and critical aspect of that technology.”
Coinbase supports “sensible regulation” in their industry.
But regulation by enforcement that “does nothing to help consumers and drives innovation offshore is not the answer.”