Cryptocurrencies

Should Staking as a Service be Considered an Investment Contract?

By Sanjay Raghavan, VP of web3 at Roofstock (follow Sanjay on Twittter)

There’s been a lot of recent news regarding the $30M settlement between the SEC and Kraken pertaining to Kraken’s “Staking-as-a-service” program. Kraken has since discontinued its staking-as-a-service offering for US customers. Let’s take a deep dive!

PROOF OF STAKE

Ethereum 2.0 and several other cryptocurrencies use a consensus mechanism called “Proof of Stake.” Under this mechanism, instead of many miners simultaneously trying to solve a cryptographic puzzle (which is the case with proof-of-work), a “validator” is chosen to create the next block on the blockchain. To ensure the security of the blockchain, validators have to “stake” tokens as a guarantee that they are acting in good faith.

Since validators are computers built to complex specs for performing this function, it requires significant technical know-how to set up these computers. As a result, many holders of tokens are limited in the ability to use their tokens for staking to earn staking rewards. Staking-as-a-service provides an elegant solution to this problem.

WHAT IS STAKING-AS-A-SERVICE?

Staking-as-a-service is a way for an intermediary to offer validation service by service pooling and staking tokens from several individuals. This allows individuals to earn staked rewards from validation, less a service fee taken by the intermediary for its services. The more tokens an individual stakes, the higher their pro-rata share of rewards from the staking-as-a-service provider.

WHAT IS THE HOWEY TEST?

The SEC v. W.J. Howey Co case essentially involved the applicability of Section 2(1) of the Securities Act through the examination of an offering of units of a citrus grove development coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. 

The Supreme Court ruled that the offering was more than merely the sale of fee simple land and a management contract. In the way the scheme was designed, it was ruled that the investment had the following four characteristics:

  1. An investment of money
  2. In a common enterprise
  3. With the expectation of profits
  4. Primarily through the efforts of others

EXAMINING KRAKEN’S STAKING-AS-A-SERVICE (FROM A COMMONSENSE PERSPECTIVE)

The two pre-requisites for an individual to stake crypto involves:

  1. having the minimum amount of crypto needed to participate in a staking program
  2. having the technical knowledge to set up the computer systems as validators on the applicable blockchain

So why was the Kraken staking-as-a-service program deemed to be an issuance of an unregistered security? Is the activity of staking-as-a-service itself an investment contract, or was it the way Kraken sold this service that made it an investment contract? 

Kraken (through its affiliates) was offering a staking-as-a-service program whereby investors could transfer their crypto to Kraken for staking, in exchange for an “advertised” annual return of up to 21%. 

You can look at the SEC complaint in its entirety here: https://www.sec.gov/litigation/complaints/2023/comp-pr2023-25.pdf. The key aspects involve (a) touting specific investment returns, (b) returns determined by Kraken and not the underlying blockchain protocols, (c) creating a bespoke payout structure (that depends entirely on Kraken), (d) not making staking investments subject to bonding and unbonding periods and so on.

The SEC alleges that this scheme meets the prongs of the Howey Test:

  1. Investment of Money: Under the securities framework, an investment of money does not need to take place in fiat currency. 
  2. Common Enterprise: Investor tokens are transferred and pooled in wallets for the purposes of the Kraken Staking Program, and the fortunes of investors and Defendants also are tied together in this common enterprise. This arrangement would appear to satisfy both horizontal and vertical commonality.
  3. Expectation of Profits from the efforts of others: Investors in the Kraken Staking Program reasonably expect to profit from Defendants’ efforts.

When I look at the SEC complaint, I am reminded of Gary Plastic v. Merrill Lynch. Merrill Lynch was involved in the sale of Bank CDs, which by themselves were not considered to be securities. The case however analyzes whether the manner of the sale of these CDs constituted an investment contract. 

The finding was that the sale of CDs, although conventionally not securities themselves, when coupled with features like the issuer’s ability to negotiate special deals with banks, monitoring issuing banks, and providing a liquid secondary market etc., resulted in the creation of an investment contract. 

Applying this context to Kraken’s Staking-as-a-service program, one can draw inferences that investors in the staking program relied on similar entrepreneurial efforts by Kraken and their expertise to get a better deal for investors, provide access to instant unstaking liquidity and so on. 

Meanwhile Coinbase’s staking program makes the argument that “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.”

This arrangement appears to make the Coinbase staking program look as though the customer is hiring Coinbase as a vendor to perform a service, as opposed to the Kraken program that seemed to lean more heavily on its entrepreneurial efforts to derive a better outcome for its customers.

In summary, though we may not have robust regulations on crypto currencies yet, we do have the benefit of about 70 years of case law on the topic of securities. While oranges may not be securities themselves, a scheme involving the sale of a fractionalized orange grove with attached management contract renders it an investment contract. Similarly, while CDs themselves may not be securities, an arrangement to bundle them with access to negotiated deals, secondary liquidity, and other aspects that rely on the entrepreneurial efforts of a centralized party could make it an investment contract. 

Do we need more regulatory clarity? Absolutely. Does the cookie-cutter ban on Kraken create uncertainty for other companies offering staking programs? You bet. Should there be more discussions on these topics between the industry and the regulators? Yes, indeed.

Where does it leave us until then? While we await more regulatory clarity, we can certainly start with a commonsense approach to understanding existing securities regulations and start looking at offerings in the context of existing case laws.

About the author:

Sanjay is the VP of Web3 Initiatives of Roofstock onChain where he leads the real estate investing platform’s blockchain initiative. After being accepted into Cypher Accelerator, the first-of-its-kind Wharton-backed program for blockchain startups, Sanjay continues to build connections between real estate investing and blockchain. Sanjay is also an Advisor at Pudgy Penguins NFTs. With over 20 years of finance and product experience, Sanjay has an extensive background consulting, developing, and founding several financial companies. Prior to Sanjay’s current role at Roofstock, he was the Co-creator and GM of Roofstock One, an innovative, transparent rental investment platform that allows accredited investors to get targeted exposure to the economics of curated SFR properties. Before joining Roofstock, Sanjay served as a Product Manager at Renew Financial and Director of Carolina Financial Group LLC. He also co-founded LCAP Advisors which provides Wall Street caliber portfolio analysis and risk assessment solutions to small banks and credit unions for their on-balance sheet loans. Sanjay has a Masters in Business Administration from The Wharton School. 

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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