Unraveling the Legal Conundrum: Liquid Staked Tokens – Security or Commodity?

Arpeet Biswas, Member @BlockEdge Solutions

Introduction

Each Blockchain network has a unique method of verifying transactions known as a "Consensus Algorithm". This Algorithm incentivizes nodes on that network, to contribute their resources to validate transactions and ensure the accuracy and security of the network. This system of incentivization encourages collaboration among nodes and helps to maintain the integrity of the Blockchain Network. Generally, the most common type of consensus mechanisms is "Proof of Work" and "Proof of Stake".

What is Staking?

Staking refers to a process or mechanism whereby network participants (node operators/validators) stake their crypto assets to validate network transactions or supply liquidity to others in the network and receive a portion of the network’s reward as compensation for their contributions. Validators in blockchain networks stake their crypto assets as collateral, which can be destroyed or "slashed" if the validator engages in misconduct. For instance, if a validator in the Ethereum blockchain makes an erroneous attestation by voting for the wrong source, target, or head block, or fails to make an attestation at the appropriate time, the validator will incur a slashing penalty equal to the number of network rewards they would have earned if they had executed the attestation accurately. This mechanism provides a powerful disincentive for malicious actors to compromise the network and incentivizes validators to uphold the network's integrity. In contrast to the energy-intensive and costly hardware requirements for proof-of-work mining, proof-of-stake validation can be accomplished with far less demanding hardware. Validators can typically operate the necessary software (a node-software client) on a basic laptop, with only a minimum amount of the blockchain network’s native crypto-assets required to stake.

The Concept of Liquid Staking

Imagine being able to transform your frozen crypto assets into a fluid or dynamic resource that you can access at any time. That’s exactly what the revolutionary concept of 'Liquid Staking' aims to accomplish. In previous instances, the conventional staking mechanism had been burdened by challenges such as ‘lack of liquidity, inability to transfer, and inaccessibility to staked crypto-assets’ .

'Liquid Stakers' usually engage in the staking of crypto assets using a decentralized protocol for liquid staking (ex. Lido, Frax Ether, Rocket Pool, etc.) or through Staking-as-a-service providers (Kraken, Coinbase). As a result of their participation, they receive 'Receipt Tokens' that serve as proof of their lawful and beneficial ownership of the staked crypto assets.

Analysis of 'Liquid Staked Token' under the U.S. Securities Act of 1933 and the U.S. Securities Exchange Act of 1934

The Howey Test is a widely recognized legal evaluation utilized by Federal and State courts to determine whether a crypto asset satisfies the lawful classification of security . The term "security" as defined by the Securities Exchange Act of 1934 (the "Exchange Act") encompasses a range of specified financial instruments, such as stocks, notes, transferable shares, warrants, or rights to purchase securities. It also includes a residual classification known as "investment contracts".

The U.S. Supreme Court in SEC vs. Howey Co. held that, held that an investment contract is a contract, transaction, or scheme when there is an (i) investment of money in a (ii) common enterprise with a (iii) reasonable expectation of profits to be (iv) derived from the efforts of others .

Argument: "Why Liquid Staking May Not Meet the Criteria for an Investment Contract and Security Under the Howey Test"

1. Investment of Money : In order to meet the criteria for Investment of Money, an individual must transfer their assets to the enterprise in a way that exposes them to potential financial loss or a return for an investment. When Liquid Stakers allocate their crypto assets to a Protocol or Provider Model for staking, they don't invest their money. This is because Liquid Stakers still own their crypto assets and get Receipt Tokens in exchange. Moreover, any fees the protocol or service provider collects are payment for their services, not an investment. The Receipt Token serves as proof that the Liquid Staker still owns their staked crypto assets, and functions as a Digital Warehouse facility for the safekeeping of those staked crypto assets. As a result, it establishes a relationship of bailor and bailee between the Liquidity Staker and the Protocol or Provider Model, where the latter is responsible for the secure storage and management of the staked crypto assets. With Liquid staking arrangements, neither the Protocol Model, the Provider Model nor any third party has the authority to completely assign or rehypothecate (use as collateral for financing) the staked crypto assets of Liquid Stakers. Such an action would indicate an investment arrangement, which is not the case with Liquid staking. A Liquid Staker may face the risk of losing their crypto assets in the event of slashing, although liquid staking arrangements often come with slashing coverage . This means that in the event of slashing, the Liquid Staker may still be able to receive full payment upon redemption of their Receipt Tokens. As a result, Liquid Stakers may not subject themselves “to a risk of financial loss” that is required to establish an investment of money.

2. Common Enterprise: To fulfill the criteria of a ‘Common Enterprise’ there should be the success or failure of an investment which is dependent on the success or failure of other people involved in the same investment. In other words, the investors' fortunes are tied together with others involved in the same enterprise.

3. Expectation of Profits: The Expectation of Profits involves two distinct concepts: (i) whether a transaction involves any expectation of profit and (ii) whether expected profits are the product of the efforts of a person other than the investor. The staking services do not meet the requirement of "expectation of profit" because the rewards that users get are just payments for the validation services they provide by staking their assets. The main purpose of staking is to validate a network or protocol, and the rewards are given as consideration for this service, rather than as a profit or return on investment.

4. Efforts of Others: To satisfy the "efforts of others" element of the Howey test, it is necessary that the buyer anticipates earning profits largely from the managerial efforts of others. These efforts must be crucial and significant to the extent that they can affect the failure or success of the enterprise. If a seller only agrees to provide additional support to the buyer, then the buyer's profits will likely depend on their own skills and efforts, rather than the skills and efforts of the seller. Liquid Stakers cannot reasonably expect their staked crypto assets to increase in value or provide returns primarily due to the protocol or service provider's managerial efforts since the provider does not make managerial decisions related to the use or spending of the staked crypto assets. The protocol or service provider is only responsible for providing a Receipt Token and assigning the underlying crypto asset to a validator. They do not make any managerial decisions related to the usage or spending of the staked crypto assets.

Analysis of 'Liquid Staked Token' under the Commodity Exchange Act of 1936

The term "commodity" means all agricultural products and all other goods and articles except onions and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in. The CFTC and federal courts have classified specific "digital assets," such as bitcoin, ether, litecoin, and tether, as commodities according to statute, regardless of the existence of futures contracts for a particular type of crypto asset or the possibility of trading such contracts in the future. Receipt Tokens represent ownership of staked crypto assets, which the CFTC and lawmakers from both political parties have acknowledged as commodities falling under the jurisdiction of the CFTC.

We have observed that the ‘Receipt Tokens’ obtained from staked crypto-assets could fit the description of a commodity, as they have an inherent value that can be traded in contracts for future delivery, both currently and in the future.