Merging into a Security? After Ethereum Migration, SEC Chairman Comments on Staking
On September 15, 2022, the Wall Street Journal reported Securities and Exchange Commission (SEC) Chairman Gary Gensler told reporters after a Congressional hearing that digital assets and the intermediaries dealing in such assets that allow for staking may shift the “efforts of others” analysis under the Howey test. If so, they would be re-categorized as securities.
“From the coin’s perspective […] that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler went on to clarify that he wasn’t referring to any specific digital asset or cryptocurrency, but when an intermediary offers staking services to its customers, it “looks very similar—with some changes of labeling—to lending.”
This characterization of the staking mechanism being scrutinized begs the question: which kind of staking concerns the Chairman?
There are two primary validation models for blockchains: proof-of-work and proof-of-stake.
Under a proof-of-work model, a network of nodes (who work to validate transactions) complete complicated computational problems, fighting for the right to validate transactions and receive newly minted digital assets as rewards.
Under a proof-of-stake model, nodes increase the likelihood of being granted the opportunity to verify transactions and receive the corresponding reward by “staking” the native digital asset to that chain. The staked assets act as a form of collateral and can be destroyed or confiscated if there is impropriety or incompetence (the recourse and process dependent on the specific blockchain in question).
Alternatively, certain service providers have offered the opportunity to customers to “stake” their digital assets in exchange for a particular defined return. When analyzing this form of staking, the SEC has been quite consistent in holding that these “crypto-lending” services constitute securities, fall within their purview, and must register, comply with applicable exemption from registration, or pay the price (in February BlockFi Lending paid the price in the amount of $100 million).
This distinction, between staking as part of the mechanical underpinning of a functioning blockchain and staking as a financial instrument, highlights the need for clarity – clarity of terms, clarity of forms, clarity of roles and of expectations.
As discussed previously, some members of the legislature have taken steps to try and provide the necessary framework for a safe and vibrant decentralized world and marketplace. Since then, both the Senate Agriculture Committee, which oversees the Commodity Futures Trading Commission (CFTC), and the Senate Banking Committee, which oversees the SEC, have held hearings. This degree of attention would be heartening, if not for the fact that these hearings were conducted simultaneously – indicating a jockeying for jurisdiction and authority as opposed to a cohesive and thoughtful approach to how to best protect investors while also staying at the forefront of emerging technologies.
Until there is some form of clarity from the legislature, it is expected that the SEC will continue to pursue regulation-by-enforcement, highlighting the need for entrepreneurs and investors to remain vigilant to stay on the right side of a moving line.