The Breakdown - A Legal Argument for Why Staking Doesn’t Make ETH a Security

Episode Date: October 9, 2022

This episode is sponsored by Nexo.io, Circle and FTX US.   On this week’s “Long Reads Sunday,” NLW reads “Ethereum's New ‘Staking’ Model Does Not Make ETH A Security.” The piece was authored by: Rodrigo Seira, crypto counsel at Paradigm Amy Aixi Zhang, policy counsel at Paradigm Jake Chervinsky, head of policy at the Blockchain Association, adviser at Variant Fund and board member at DeFi Education Fund   - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Eleanor Pahl and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “The Now” by Aaron Sprinkle and “The Life We Had” by Moments. Image credit: Jason marz/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FTCS, and produced and distributed by CoinDes. What's going on, guys? It is Sunday, October 9th, and that means it's time for Long Reads Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit. com slash breakdown pod. Also a disclosure as always. In addition to them being a sponsor of the show,

I also work with FTX. All right, folks, well, today for Long Read Sunday, we are diving into one of the long-term thornyest issues in crypto, and that is whether tokens constitute securities. This is a conversation that has never really gone too far out of view when it comes to crypto and regulation. It certainly has had spiking moments of relevance, such as during the ICO boom in 2017 and early 2018, but even to this day remains one of the most contentious questions. The answer to it has implications for which body should oversee cryptocurrencies and what the rules around them should be. It's something that legislation that has been proposed such as the Responsible Financial Innovation Act comes at explicitly. In that act, for

example, there is a new definition of ancillary assets which are sort of security-like commodities that to some extent change over time. The conversation around whether tokens are securities has come more into view recently, based both on the Gary Gensler-led SEC's push for broader power to oversee crypto, as well as in discussions around the Ethereum merge. One of the narratives on crypto-Twitter, or more specifically, if we're being honest, Bitcoin Twitter, was that the shift from proof-of-work to proof-of-stake might actually make Ethereum more security-like. This interpretation, while sometimes proffered in a political way on Bitcoin or Crypto-Twitter, has also seen some validation in SEC enforcement actions. Today, we are reading a piece that argues the opposite.

The piece is written by Rodrigo Sierra, Crypto Council at Paradigm, Amy Axi-Zhang, the Policy Council paradigm, and Jake Trevinsky, the head of policy at the blockchain association. It's called Ethereum's new staking model does not make ETH a security. One. Introduction. In the wake of Ethereum's transition to a proof-of-stake consensus mechanism, the merge, various commentators have suggested that Ethereum's new staking model could result in its native token ether or ETH being deemed a security under U.S. securities law. Some have taken the extreme position that the token in any proof-of-stake system is likely to via security. However, these arguments stretch the interpretation of the Howey test beyond recognition

and fail to recognize that the fundamental purpose of securities laws is to address information asymmetries that are not present in this context. As explained below, Ethereum's adoption of a proof-of-state consensus mechanism does not make ETH or even staked ETH and investment contract, and such a finding would result in a nonsensical application of securities laws. 2. Securities Laws Primer. U.S. securities laws require issuers to register any offers or sales of securities with the SEC unless an exemption is available. Registration entails mandatory disclosure that ensures material information is shared with investors

to allow for informed decision-making, prevent information asymmetries, and avoid agency problems. The Securities Act of 1933 enumerates the types of instruments that constitute a security, which include an investment contract. As defined by the Supreme Court's seminal opinion in Howey, an investment contract entails, one, an investment of money, two, in a common enterprise, three, with the reasonable expectation of profits, four, derived solely from the efforts of others. In order to meet this definition, a contract, scheme, or transaction must satisfy each of the four prongs. In decisions interpreting investment contract, the court has rejected a literal construction of the statute, adopting instead a flexible interpretation that focuses on the, quote, economic realities of the relationship between the promoter and investors. In various instances, the court has applied the economic reality concept to limit the scope of investment contracts and the application of securities laws if the underlying economic relationship between the parties is not one of investor and promoter.

Three, application of Howie to proof-of-stake Ethereum. Ethereum's adoption of a proof-of-state consensus mechanism has led various commentators to suggest that ETH, or more specifically the act of staking-Eath could meet the definition of an investment contract under Howie. The argument takes the following structure. Staking-Eath as a validator meets the Howie test because the validator is, one, investing money by locking up 32-Eath to stake, two, in a common enterprise comprised of the various parties participating in the validation process, three, with the expectation of receiving profits in the form of staking rewards, four, that are derived from the efforts of other validators or other parties participating in the validation process. Putting aside whether a

validator depositing ETH into a smart contract would qualify as an investment of money, the argument that Ethereum's adoption of proof-of-stake results in ETH being deemed an investment contract fundamentally misinterprets the second and fourth prongs of Howie, and the failure of either prong is fatal. The conclusion would also result in an absurd and unnecessary application of securities laws because there is no issuer or promoter with privileged access to information who could or should be forced to make disclosures. 3A. Proof-of-Stake does not entail a common enterprise. 3A1. Legal standard. As the Supreme Court stated in Howey, an essential component of an investment

contract is a common enterprise. While some courts have held that a common enterprise exists only when there is, quote, horizontal commonality, others have found vertical commonality sufficient to meet this prong of Howey. As explained below, staking Eth entails neither horizontal nor vertical commonality, and thus fails to meet the common enterprise prong of Howey. 3A2. There is no horizontal commonality among validators. Horizontal commonality is present when each individual investor's fortunes are tied to the fortunes of the other investors by the, quote, pooling of assets, usually combined with the pro rata distribution of profits. Pooling, in turn, requires an issuer or promoter to co-mingle investors' funds

and then use them towards a common enterprise. In other words, courts have stressed that horizontal commonality requires the expected profits of an investor to be tied to other investors, quote, by entrepreneurial efforts of a promoter. Horizontal commonality, therefore, requires investors to give up any individualized claims to profits in return for a participatory and pro-rata interest in the ensuing profits distributed by the promoter. Some have mistakenly argued that staking eth implies horizontal commonality because validators deposit eth into a single smart contract address, which allegedly entails a pooling of assets, or alternatively, that horizontal commonality is found because there is a perceived cooperation amongst validators. As shown below,

these arguments are conclusory and misunderstand the mechanics of staking in Ethereum. To become validator on the Ethereum network, one is required to deposit 32Eth into a smart contract address known as the deposit contract. However, the deposit of ETH to the deposit contract is not pooling, since that ETH is never under the discretionary control of a promoter who can use it to drive value to a common enterprise. Instead, the purpose of staked ETH is to create an incentive mechanism that secures the network. It ensures that validators have some skin in the game so that they can be penalized or slashed for behaving dishonestly. Further, while each validator's ETH is deposited in the deposit contract, it is not commingled and remains distinguishable.

Each validator will have the ability to withdraw its staked ETH once that functionality is implemented in a later network upgrade. Individual validators also do not have participatory rights to any pro-rata distribution of profits generated by an enterprise. As explained further below, rewards vary for different validators and are determined primarily based on each validator's individual efforts. Their fortunes do not rise and fall together based on the entrepreneurial efforts of any promoter. Therefore, in analyzing the economic realities of a staking transaction, a court should find an absence of horizontal commonality. 3A3. There is no vertical commonality among validators. Some courts have held that the common enterprise prong of Howey can also be

satisfied through vertical commonality, which focuses, quote, on the relationship between the promoter and the body of investors. However, staking ETH does not entail vertical commonality simply because there is no promoter. In general, the Ethereum network does not rely on any key party for its success or operation. It is, quote, sufficiently decentralized. To ensure decentralization, Ethereum's consensus mechanism allows validators to operate self-sufficiently without reliance on any third party. Validators come to the network freely and voluntarily, but they can choose to stop participating at their discretion. Validators can perform their role in the network without depending on anyone else. If they perform their role properly

based on the rules of the network, they will receive a reward based on those rules and not on the efforts of a promoter. Focusing specifically on the economic realities of the, of a staking transaction, it is clear that there is no promoter on which validators rely. Since vertical commonality requires that the fortunes of investors are, quote, tied to the fortunes of the promoter, the absence of a promoter ends the inquiry. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on NXO Pro. The new Spot and Futures trading platform uses aggregated liquidity of over 3,000 order

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with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDX U.S. is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTCX app today and use referral code breakdown to support the show. 3B. Staking, ETH does not satisfy the efforts of others' prong of Howie. 3B1. Legal Standard. According to the Supreme Court's original formulation in Howie, one of the requirements for an investment contract is that investors expect profits, quote, solely from the efforts of the promoter of a third party. This standard has been watered down by the appellate courts, which have read out solely and focused instead on whether the efforts of promoters are, quote, undeniably significant and, quote, essential managerial efforts, which affect

the failure or success of the enterprise. According to the SEC's guidance, these efforts are typically characterized by, quote, expertise and decision making that impact the success of the business or enterprise through the application of skill and judgment. Inversely, courts have focused on whether the investor had the, quote, ability to control the profitability of his own investment. The greater the degree to which an investor relies on their own efforts for their profit, the weaker the justification to characterize the underlying transaction as an investment contract under Howie. In these cases, applying securities laws or disclosure requirements is unnecessary because there is no separation of ownership and control. Courts have further outlined several factors,

known as shot in factors, to test an investor's, quote, ability to control. Listed in order of importance, these include one, the investor's access to information, information, two, the investor's contractual powers, three, the investor's contribution of time and effort, four, the adequacy of financing, five, the nature of the business risks, and six, the level of speculation. Three B two, application to proof-of-stake Ethereum. Some have argued that Ethereum's transition from proof-of-work to proof-of-stake was also a transition from a competitive to a more cooperative mechanism, since the validation process in proof-of-stake requires multiple parties. According to this view, when staking ETH, each validator is reasonably expecting to derive

staking rewards by relying on the efforts of other validators. This argument has been supported by the low-level implementation detail that, under Ethereum's unique proof-of-stake protocol, validators are sorted into committees. However, there are multiple other proof-of-stake protocols that do not segregate validators into committees. More significantly, this argument misunderstands the mechanics of validator rewards in Ethereum's proof-of-stake implementation, and dilutes Howey's original standard requiring reliance, quote, solely on the efforts of others to an unprecedented degree. As we explain below, Ethereum's validators cooperate no more than minors in the premarge proof-of-work network and do not expect rewards from significant managerial efforts of others,

but instead expect rewards primarily from their own efforts and funds. To understand why this is the case, it is helpful to have a base level of understanding of the rewards validators can earn in Ethereum's proof-of-stake network. 3B21. Validator rewards in Ethereum's proof-of-stake network. There are many factors that enter into the calculation of rewards for validators. Under Ethereum's proof-of-stake implementation, validators receive rewards every epic, 6.4 minutes, that are calculated as multiples of a base reward. The base reward is itself determined by the number of active validators on the network, the total active stake, and dynamically adjusted to incentivize a validator set of desired size.

The total amount of stake in the network is arguably the most impactful factor dictating rewards earned for validating transactions. validators can earn a multiple of the base reward for attesting or accurately voting on one, the correct source, two, the correct target, three, the correct head, collectively the accuracy rewards of a block, and four for having their attestation or their vote included in a block, the inclusion reward. The inclusion reward is also split between the attestors and the validators that are chosen at random to produce a block. According to researchers, assuming a fixed base reward over time, the profits of a single validator are predominantly determined by the balance of

ETH the validator has deposited in the network, which is capped at 32 ETH. A testing with a higher balance results in larger rewards and penalties and vice versa. On a finite time scale, a significant portion of validation rewards will also be determined by the random opportunities a validator receives to propose a block. 3B22. Validators expect to earn staking rewards from their own actions, not from the efforts of others. Analizing the economic realities of staking Eath, a court should find that it does not meet the efforts of others' prong of Howie. Staking rewards are primarily determined by a validators' individual efforts and not dependent on any managerial efforts of a third party. As explained above, a validator's rewards are largely determined by the amount of ETH they have staked, and the

random opportunities they received to propose a block, both of which are idiosyncratic to the individual staker and do not depend on any third party. In other words, validators retain the ability to control the profitability of their investment. Applying the shot and test, a validator's control is evidenced first by a lack of information asymmetries, rewards are distributed based on open source protocol and transactions recorded on a public blockchain. The rewards are also determined based on the validator's contribution of time and effort, as validators must maximize their uptime and remain connected to the network to avoid being slashed. While a validator is sometimes incentivized to have other validators join the network,

e.g. when it would result in an increase to the base reward, and depends on the action of other validators to maximize rewards, e.g. the requirements for an attestation to be propagated. A validator is never relying on entrepreneurial or managerial efforts requiring skill and judgment as required by Howie. Four, conclusion. As shown above, analyzing the economic realities of staking ETH on Ethereum's proof-of-stake network, a court should find that staking fails to satisfy the Howey test because there is no common enterprise, and validators are never relying on the efforts of others. While not the focus

of this paper, there are also questions about whether depositing Eth to stake would qualify as an investment of money. And again, failure to meet any of the four Howey prongs would entail that the transaction is not an investment contract and therefore not a securities transaction. But beyond the legal analysis, applying the stringent requirements mandated by U.S. securities laws to staking would result in an ill-fitted and absurd application of the law. As we have noted, a raison deter of securities regulation is to ameliorate information asymmetries that exist between promoters and investors through disclosure. Deeming the staking of ETH to be an investment contract would therefore entail imposing disclosure obligations on an issuer or promoter.

As we stated above, no identifiable issuer or promoter exists when staking Eith. But if we accept the premise that validators play the role of a promoter, voter or issuer, the clear unreasonableness of attending registration, reporting, and disclosure requirements becomes clear. Would securities laws mandate validators to provide each other with disclosure? What material information would validators be required to disclose? How would this help alleviate any information asymmetries and how would it serve the public interest? The impracticality of answering these questions illustrates the flawed logic of applying securities laws to validators in the first place. They don't pose the risks that disclosures are meant to address.

All right, guys, back to NLW now. And that was obviously a little wonkier than our normal LRS. But I thought it was really important because, believe it or not, that's kind of the most retail-focused explanation of some of these concepts that I've ever seen. Now, not being a lawyer, and I assume that most of you aren't lawyers as well, there's obviously a huge amount of interpretation in here. And that's exactly what the legal system is for. I think what's frustrating about the discourse that we've long had around these issues is that we speak in binaries. SEC Chair Gensler's favorite statement is if it walks like a duck and it quacks like a duck, then it's a duck. But obviously that belies all the nuance here. And I think it's pretty clear that to

the extent one's objective is actual investor protections and consumer disclosures, then digging in on what makes these things different, even if they share commonalities with other types of financial instruments in the past, is going to end up yielding a much better, smarter regulatory regime. Luckily, as I've shared before, I think a lot of that's going on. But I'm I hope the folks who are trying to actually have those nuanced conversations and bring them into the legal framework are successful in doing so. For now, I want to say thanks again to the authors, Rodrigo, Amy, and Jake for a great piece. Thanks to my sponsors, nexus.io, Circle and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.

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