Cryptocurrencies

Preserving Staking Amid SEC Scrutiny: The Imperative of Redefinition

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By Chen Zhuling, founder and CEO of RockX

With Ethereum staking alone amassing a market cap exceeding US$36 billion, staking’s pervasiveness in the cryptosphere is indisputable. However, this unique mechanism by which blockchains are secured has been caught in the crossfire of the SEC’s ongoing battle against crypto, resulting from an intensified regulatory onslaught on staking enterprises. After Kraken, Coinbase is now faced with a similar allegation regarding its staking program for violating securities law. While it’s still too early to say how this will play out, the impetus is stronger than ever for the staking industry to rethink how it defines staking services going forward.

For the uninitiated, in contrast to speculative yield farming variants, staking represents a cornerstone of proof-of-stake (PoS) blockchains. Here, stakers commit a set quantity of native tokens, choosing a trusted validator to authenticate transactions on the blockchain. In return, they receive rewards — typically newly minted tokens and transaction fees — for their contribution. By verifying transactions and affirming their validity, staking plays a critical role in preserving the security and integrity of PoS networks.

Investors keen on reaping staking rewards without the requisite technical knowledge to run validators can leverage staking providers. These intermediaries facilitate the staking of users’ delegated assets on a network of their choice for a nominal fee. Importantly, the users’ funds always remain in their control with no custody ever taken by the staking providers. This creates a transparent business model where token holders can track their rewards across various networks in real-time, ensuring optimal deployment of their tokens for staking purposes. The system is designed to optimize rewards while maintaining complete control and security over their assets. 

However, with the surge of decentralized finance (DeFi) in 2020, the term “staking” has frequently been used in a totally different context, where token holders transfer their assets into a smart contract or DeFi protocol, which then manages the tokens to generate rewards, usually through liquidity provision, lending, or yield farming. With the total value locked in DeFi reaching record levels, centralized platforms (CeFi) have started proffering “staking” products to users willing to have their tokens locked or managed by these platforms, all in return for yields.

The issue with these models lies in their “black box” yield generation schemes, where users are left in the dark regarding the utilization of their assets and the origin of their yields — whether they stem from legitimate staking activities or other yield farming techniques.

Given staking’s technical intricacy and the loose application of its terminology, regulators naturally struggle with comprehending and designing an appropriate regulatory framework for the sector. This explains the SEC’s association of staking with crypto lending, a practice offering extremely high yields in return for lending out crypto assets.

Moreover, the SEC’s equating of staking with securities also means the industry will now face highly stringent stipulations. However, there is an argument to be made that staking, in its purest form, does not fit the definition of a security, according to both the US Securities Act and the Howey test — the latter used by the SEC to determine whether an investment contract constitutes a security. Coinbase, in February, published a detailed explainer in response to the SEC’s claim, further affirming this viewpoint. While regulatory oversight often contributes to more responsible business practices, companies looking to offer staking services in a compliant manner continue to face mounting uncertainty surrounding potential regulatory requirements.

Realistically, what options do they have right now?

Moving offshore: Not a sustainable solution

Shifting operations offshore, as some suggest, is not a long-term solution. The notion that overseas regulators will indefinitely maintain a lax attitude towards staking services is presumptive and shortsighted. With crypto regulations globally in a constant state of evolution, there is no assurance other jurisdictions won’t mimic the SEC’s stance.

Rather than resorting to regulatory arbitrage, staking companies should emphasize clarifying the nature of staking services they offer. Kraken’s case underscores the importance of differentiating between custodial and non-custodial staking and elucidating what each entails for investors. Unlike custodial staking where assets are parked with a centralized platform, non-custodial staking lets users retain complete control of their tokens — they can un-stake at any time after the initial bonding period set by the specific PoS protocol.

Given the different risks and operating mechanisms each staking variant carries, it is crucial for token holders to understand the distinctions between DeFi/CeFi staking and true staking, as well as custodial versus non-custodial staking.

Future-proofing staking by redefining it

To future-proof staking, we must redefine it. This endeavor requires industry-wide collaboration to establish consensus among all providers globally. Adopting the term “validator staking” to describe pure staking service where stakers earn rewards solely for validating transactions and securing respective blockchains would be suitable for companies operating validators to verify transactions and create new blocks, independent of any decentralized apps (Dapps).

In this volatile and uncertain regulatory landscape, staking companies cannot afford to operate in a grey zone. Transparency, security, and good governance are indispensable — all transactions and rewards must be verifiable on-chain, providing token holders with the confidence that their assets are being used exclusively on validators and not for unidentified purposes. 

While the forthcoming regulations in Europe and Hong Kong promise much-needed clarity to the broader ecosystem, staking’s legitimacy remains in question. By proactively adhering to best practices, validator staking companies can better safeguard their future, foster trust among regulators, partners, and users, and thus ensure the longevity of the industry.

Chen Zhuling

About the author

Chen Zhuling is a serial entrepreneur in the blockchain space. An engineer by training from Nanyang Technological University and the Massachusetts Institute of Technology, Zhuling started his career as a strategy consultant at Roland Berger before going on to create the Aelf public blockchain in 2017, as well as institutional-facing staking and access node provider RockX in 2021. Since a landmark Series A funding round less than a year after it was founded, RockX has gone to hold nearly USD 1 billion in staked assets.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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