Some have claimed that since Ethereum switched from proof-of work to proof-of stake, ETH or even staking ETH is a form of security.
They don’t hold up under scrutiny.
Staking ETH, when properly understood, is a service that ensures transactions are handled correctly and securely on the Ethereum Network, not an investment subjected to securities laws. Even if third-parties like exchanges or node operators facilitate staking ETH, this is still the case. Stakers are more likely to expect profit from staking and the market price of ETH than they are by the technical and administrative services offered by third-parties.
What is the legal framework? “investment contract”
The definition of securities will determine whether or not a particular instrument or activity falls under the Securities Law. “security.”
A security under US federal securities laws includes a variety of instruments. “investment contract.” The meaning of the term has been refined by various court rulings, but it is still an acronym. “investment contract” A contract, scheme, or transaction that involves an investment in money.
The US Supreme Court took this meaning from its decision in the Howey Case, which concerned orange groves. The court concluded that if a third party sold orange groves along with a contract to manage the grove and share its profits, this was an investment contract subject to securities laws — purchasers were not merely buying land, but were instead investing money to earn profits based on the third party’s efforts in growing and selling oranges.
Howey has clarified the decisions since Howey “efforts of others” It must be “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Administrative or “ministerial” You should not make an investment contract.
The concept of “investment contract” Remember that Ethereum’s move to proof-ofstake did not make ETH an investment contract. As holding ETH alone does not entitle you to staking incentives, the switch to proof-ofstake has not created an investment contract.
The argument that staking ETH constitutes an investment contract is more subtle, but it does not hold up to scrutiny.
Staking ETH, in a technical sense, means sending ETH to an Ethereum deposit contract, and associating it with a validator. A validator is a piece of software that processes transactions over the Ethereum network. Slashing is the penalty that the Ethereum network imposes on staked ETH if the validator fails to follow Ethereum’s validation rules due to hardware or software problems. The ETH staked by a validator is essentially a financial assurance that it will work as expected.
The case where the ETH staker operates the validator themselves — sometimes referred to as solo staking — is the simplest case to analyze. Since there aren’t any “others” There can’t be an investment contract without exerting effort.
A liquid stake protocol, or exchange is used to stake through a provider.
Certain ETH stakeholders may want to use validators operated by third parties.
More complex situations — like node operators, liquid staking protocols or a centralized exchange’s staking services — require further analysis of whether this relationship creates an investment contract.
Click here to read our latest opinion: Ether is the Schrödinger’s cat of crypto
Typically, staking ETH with a node operators does not require the staked ETH be transferred to them. The staker instead associates ETH to a node operator validator and uses the staker’s address as the address of withdrawal for staked ETH. Staking rewards, as well as the original ETH itself, can only be withdrawn from an address that is controlled by you. It ensures that the staker is always in control of his ETH and has full ownership.
Similarly, with liquid staking protocols, the protocol — that is, a smart contract deployed on Ethereum — programmatically associates staked ETH with validators run by node operators willing to operate validators on behalf of stakers. The protocol allows ETH to be staked and the staker is given a token which can then be redeemed in exchange for their ETH, as well as accrued rewards.
This is also facilitated programmatically by the protocol, not a third-party. It is important to note that neither the node operator nor any third party acquires ownership or control over staked ETH.
The exchange can stake the ETH for users of centralized exchanges that offer staking service. Exchanges stake users’ ETH with validators that are operated either by them or a third-party. Even though custodial trades have the ETH of their customers, they are clear in their terms that staked ETH is theirs. It is the exchange’s responsibility to arrange for ETH staked by validators to receive rewards and to account for those rewards.
There is a question in each of these scenarios as to whether there exists an “investment of money” We are a “common enterprise.” Stakers retain legal ownership of their staked ETH, and — except in the case of custodial staking services — do not even transfer their ETH to another party. It is in stark contrast to an investment plan where funds or assets are sent from one person to another. “promoter” Who has substantial discretion in how these investments are used to generate profits.
Even if ETH staking involves a joint enterprise, such as node operators and exchanges, the stakers’ expectations of profit are not primarily tied to third-party effort.
The Ethereum network generates rewards for validators who propose new blocks or attest them. These rewards also include execution-layer payments, which are essentially payment from validators to users for prioritizing transactions.
In order to determine the timing of and reward amount, factors include: total number validators; Ethereum users’ willingness and ability to pay extra for transactions prioritization. Stakers may see their profits affected by market prices of ETH as rewards are paid in ETH.
It means stakers should expect their profits to be based more on the network dynamics and market dynamics than they are reliant on exchanges or node operators who facilitate staking.
The activities of node operators and exchanges, however, are still not included. “entrepreneurial” The following are some examples of how to use “managerial,” As explained by the case law. These third parties may provide technical or other services to allow stakers earn rewards. However, they typically use the same hardware infrastructure and open-source software, and adhere to similar security and operation best practices. The third-parties do not possess proprietary software or expertise to allow users of their services to earn higher rewards. The reward rates of validators that are operated by node operators vary very little, usually by less than one tenth percent.
Recent SEC Cases: Lessons to be learned
The above does not mean that stakes cannot be part of an investment plan that falls under securities laws.
Kraken reached a settlement with the US Securities and Exchange Commission in February 2023 over allegations that Kraken’s US staking services were against federal securities laws. In late March 2024 a US District Court judge refused to dismiss the SEC’s claims regarding Coinbase’s Staking Services.
The SEC claimed that in the case of Kraken that exchanges retained control over the rates at which users received staking rewards, rounded out payments to users, and kept a large pool of tokens that were not staked so users could bypass the lock-up period applicable to tokens they had staked. The Coinbase ruling refers to the allegations that Coinbase had a liquidity pool at one time, similar to Kraken. These alleged features, it is important to note, are unique to the way these exchanges offered staking. The alleged features are not of ETH itself or staking as a whole.
It is important to note that neither case has a legal conclusion concluding these (or other) staking service offerings are securities in the US. Kraken paid the fines without denying or admitting the SEC allegations, and also agreed that its US staking operations would be discontinued. Coinbase’s decision only confirms the SEC allegations as plausible enough to proceed through litigation.
Staking is a service that provides technical assistance, and not security.
Staker’s profit expectations are not dependent on the actions of third parties, even when they work together with node operators or exchanges. They come directly from market and network conditions. These third parties act more as administrative or technical services providers rather than managers or promoters of investment schemes.
It is important to note that the fact that ETH may be staked doesn’t mean it constitutes a security. Also, staking ETH in order to receive staking reward does not automatically result in a public securities offering.
Evan Thomas serves as General Counsel of Alluvial. Alluvial develops and supports the Liquid Collective Liquid Staking Protocol. He worked previously as the Head of Legal at Canada’s largest fintech consumer company Wealthsimple. Evan was at Wealthsimple when they launched Canada’s very first regulated stake product. Before Wealthsimple, Evan was a litigator at Osler, Hoskin & Harcourt LLP for nearly 15 years. Evan served as hearing counsel for 3iQ Corp., a company that won regulatory approval in 2019 to launch Canada’s very first bitcoin-based fund.
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