Today, there are barriers to these advancements. Innovators face regulatory minefields while lawmakers must navigate complex consumer protection and security concerns. We’re committed to creating deep partnerships—within and between industry and government—to share knowledge, identify opportunities, and co-create a digital future that’s more transparent, inspiring, secure, and equitable.
Depending on the proof-of-stake network, a staker may (1) stake their own tokens; (2) delegate their right to validate transactions while keeping custody of the tokens; or (3) both delegate this right and transfer custody of the tokens for staking. Validating new transaction blocks earns stakers rewards in the form of created tokens. Delegating is meant to increase member participation by allowing for specialized services, known as staking service providers, to perform the staking function on behalf of individuals. Some have questioned whether such arrangements may resemble securities contracts, but as you’ll read below, it is clear that staking service providers should not be subject to securities laws.
Why the use of a staking service provider and subsequent rewards should not qualify as a security
Determining whether the use of a staking service provider qualifies as an investment contract requires analysis under SEC v. W.J. Howey Co. Per the Howey test, investment contracts involve (1) an investment of money (2) in a common enterprise (3) with the expectation of profit (4) based solely on the efforts of others. If one were to apply the four criteria of the Howey test to staking service providers, it becomes clear that some of these requirements will not be met, which ultimately suggests that staking services should not qualify as investment contracts subject to the securities laws.
Factor 1: “An investment of money”
The first question in need of answering is whether the staking of tokens constitutes an investment. Of course, central to that issue is whether or not the potential investor has assumed a risk of loss. The answer to that question is: it depends.
In networks that allow individuals to delegate staking rights to third-party services, the delegatory relationship does not create a risk of loss because the individual never relinquishes custody of the asset, i.e. the token. In fact, the only “risk” to this person is missing out on potential rewards.
In networks that require stakers to transfer custody of their tokens to a third-party in order to participate in the validation process, the stakers’ assets may be at risk. This is because the staked tokens are subject to the risk that the third party never returns custody of the assets.
Factor 2: “In a common enterprise”
Both common sense and the Securities Exchange Commission (SEC) have answered the question of common enterprise. A common enterprise is defined as an operation in which everyone’s profits are intertwined and interdependent on the work of other participants. In its Framework for “Investment Contract” Analysis of Digital Assets, the SEC clarified that delegating validation and sharing rewards guarantees that the staking service arrangement will satisfy this element.
Factor 3: “With the expectation of profit”
If analyzed before a court, the Howey test would require examination of the expectations or motivations of members who engage in staking in order to decide if these endeavors are made “with the expectation of profit.” While some third parties will advertise their services as profit-making mechanisms, most staking as a service arrangements will not fall under this category. Rather, they are more likely efforts to maintain the value of the member’s investment and secure the overall network. To illustrate this, it’s perhaps best to use an example:
Let’s say a non-staking network participant owns 100 tokens and thus 10% of tokens in a 1,000-token network. As other members participate in staking, 1,000 newly created tokens enter circulation via staking rewards. Non-participating members therefore experience a decrease in their interest in the overall network, from 10% to 5%. On the other hand, if all members participate in the staking and validation process, the network is maximally protected from attacks and other concerns like double spending, and every network participant’s interest in the overall network remains constant. In sum, failing to participate in the staking process can result in losses due to inflation. While this analysis depends on the specific function of a network, there is clearly an argument that expectation of profits is not the primary purpose of staking.
Factor 4: “Based solely on the efforts of others”
The issue concerning the “efforts of others” is where things get interesting. Here, the relevant question is whether the staking participant retains significant control over her assets. In many networks, this is usually the case; the staker can delegate staking rights while retaining custody of her assets. Moreover, individuals may revoke this delegatory authority. This means that an individual participating in staking via delegation to a staking service provider is able to exert control by their delegatory rights to other providers while receiving a substantially equivalent service.
The next consideration is what constitutes “essential managerial efforts” per the expansion of Howey. Generally, a staking service provider may only perform a particular function (validating transactions) in a specific way (according to a network’s protocol). Unlike a stock broker, they do not have the authority to manipulate or control the member’s assets, even if temporarily granted custody. In that sense, the efforts of a staking service provider are more operational than managerial. What’s more, the success of the entire network is dependent on cooperation across a decentralized network, meaning the success or failure of the broader network is independent of a discrete staking service provider’s actions.
Classifying staking service provider arrangements as investment contracts does not advance the intent of the securities laws
Staking service arrangements not only fail to meet the four criteria identified by Howey, but their application to securities regulation also fails to advance the intent of the securities laws. Congress passed the Securities Act of 1934 to create the SEC and instill in it the authority to monitor public companies. Crucial to this mission is the need for investors to have access to full and accurate information, so that they may make informed decisions. In an open proof-of-work network, there is no shortage of transparency or material information asymmetries created by a staking service arrangement. Thus, consumers can already make fully informed decisions regarding their choice of provider.
The Blockchain Association applauds the introduction of the bipartisan Digital Commodity Exchange Act and the Securities Clarity Act, led by Republicans Rep. Tom Emmer and Rep. Mike Conaway and Democrat Rep. Darren Soto. These bills address two fundamental questions regarding the regulation of digital assets: “When do the securities laws apply to digital assets?” and “How will digital assets be regulated when the securities laws don’t apply?”
Securities Clarity Act
In order to clarify when the securities laws apply, Rep. Tom Emmer and others have introduced the Securities Clarity Act. The introduction of this bill is timely given the recent SEC cases against two companies, Telegram and Kik Interactive. The SEC’s arguments in these cases conflated pre-sale investment contracts and tokens. The Securities Clarity Act attempts to resolve this ruling by maintaining that these tokens, which the bill considers to be “investment contract assets,” are not securities.
The test that is used to decide whether something is an investment contract was created in the 1946 Supreme Court case SEC v. W. J. Howey Co. According to Howey and subsequent cases, an investment contract is a “transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” If a transaction or scheme fits this definition of an investment contract, it is a security. However, courts have not endorsed the claim that an asset delivered pursuant to an investment contract is also considered a security merely as a result of it being transferred as part of the investment contract.
The Securities Clarity Act seeks to “clarify and codify that an asset sold pursuant to an investment contract, whether tangible or intangible (including an asset in digital form), that is not otherwise a security under the Act, does not become a security as a result of being sold or otherwise transferred pursuant to an investment contract.” As such, “investment contract assets” are not subject to the securities laws.
Digital Commodity Exchange Act
When securities laws do not apply to a digital asset, other regulatory mechanisms must be implemented to ensure that digital asset markets are safe and fair. Rep. Mike Conaway and others are looking to fill this regulatory gap with the Digital Commodity Exchange Act (DCEA).
Currently, there is no comprehensive federal regulation of digital commodity markets in the United States. To access the digital commodity marketplace, consumers rely on specialized trading platforms, often referred to as “exchanges,” to match buyers and sellers of assets. These exchanges perform functions similar to traditional commodity exchanges and private trading venues, yet they are not treated the same by regulators.
Unlike those legacy players, digital commodity exchanges often operate as money services businesses, which individual states and territories regulate. Because they fall under state and territory regulations, digital commodity exchanges must navigate a labyrinthine patchwork of 53 regulatory frameworks in order to operate across the United States. These state money transmission regulations are not designed to regulate trading venues and do not police exchanges’ trading practices.
The DCEA would address this complexity by creating a national framework with state law preemption for the regulation of digital commodity exchanges. The national framework is “opt-in,” meaning that digital commodity exchanges could continue to operate under the current system if they so choose, and state regulatory systems will remain intact. If the digital commodity exchanges do opt-in to the national framework, however, the bill designates the Commodity Futures Trading Commission (CFTC) as the primary regulator responsible for enforcing the framework.
The existing federal commodity market regulatory framework is well suited to regulate digital commodity markets. Commodity markets have developed robust methods of customer protection (core principles, segregation of assets, the bankruptcy regime) which should be extended to digital commodities. Moreover, a principles-based approach to regulation is appropriate for the quickly developing digital commodity markets, as a prescriptive approach could quickly become outdated.
The introduction of both the Securities Clarity Act and the DCEA are promising developments for the crypto ecosystem in that these two pieces of legislation demonstrate that crypto might finally get the time and attention it deserves on the Hill. And while each bill may need changes as they work through the process, both pieces of legislation legitimize the efforts of industry within the political sphere. Members of industry can find comfort in the fact that crypto is no longer viewed by Washington as simply “a plaything for nerds.” Instead, politicians, lawmakers, and regulators alike are beginning to see the industry for what it truly is: the future.
Today, the Blockchain Association responded to a Federal Deposit Insurance Corporation (FDIC) request for information (RFI). In its response, the Association argues that creating a voluntary certification model for third-party providers of innovative services, including cryptocurrency-related services, would promote innovation, transparency, and inclusivity within the U.S. banking system.
Banks of all sizes regularly partner with third-parties to provide services to their customers, but compared to their larger counterparts, small financial institutions like community banks have long struggled to bear regulatory costs while remaining competitive, a situation that has increased concentration within the banking system over the last several decades. At the same time, consumers’ demand for ever-more-convenient banking options, from online and mobile services to instant payments, has driven smaller financial institutions to invest heavily in new services and technologies or risk losing customers.
Partnerships with third-party service providers, in particular fintech companies, offer community banks a cost-effective way to remain competitive and reach new customers by enabling them to offer new services without having to develop them in-house. Today, however, FDIC-regulated banks are individually responsible for evaluating their third-party partnerships on an on-going basis, even if hundreds of peer banks subject to the same regulations partner with the same third-party service provider.
Centralizing the evaluation of third-party fintechs for bank partnerships would make this process more efficient and secure. Banks could pool their resources into one certification and compliance evaluation process, easing the individual compliance burden that smaller institutions face. Moreover, compared to thousands of banks evaluating third-party relationships individually, a single certification organization would be better equipped to evaluate and monitor the risks associated with the technically complex products and services that fintechs offer. This will be especially important when it comes to partnerships with distributed ledger and cryptocurrency service providers, which emerged relatively recently and offer technologically advanced services.
“Digital securities” are distributed ledger-based representations of value that have the underlying characteristics of traditional securities and are subject to regulation under U.S. securities laws. Transactions involving such digital securities must comply with the securities laws and regulations, just like any security in the United States. As we have written before, digital securities have the potential to create more inclusive and efficient financial markets, yet regulations not designed to address distributed ledger-based systems are impeding the use and adoption of digital securities. In particular, certain regulators have refused to apply rules governing the custody of traditional securities to distributed ledger-based securities, and therefore no broker-dealers have been granted authorization to custody digital securities, stagnating the potential of the industry.
Since digital securities emerged, a surge of broker-dealers have submitted applications to receive clearance to provide services involving digital securities. However, these applications have been held up for years because of issues related to custodial requirements under Rule 15c3–3 in the Securities Exchange Act of 1934 (the “Exchange Act”). In fact, many applicants were asked to withdraw their applications until the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) could sort out the application of custodial requirements to digital securities. According to the SEC, the purpose of Rule 15c3–3 is to “safeguard customer securities and funds held by a broker-dealer, to prevent investor loss or harm in the event of a broker-dealer’s failure, and to enhance the Commission’s ability to monitor and prevent unsound business practices.” In short, the Rule intends to separate broker-dealers’ assets from their customers’ so that customers’ assets are safe and recoverable to them should the broker-dealer fail.
Cryptographic assets based on blockchains, such as digital securities, are controlled through the use of “private keys,” which are essentially “passwords” that grant holders control over assets stored on distributed ledgers. These private keys can themselves be stored in a variety of ways, from being written on a piece of paper to being stored electronically.
Regulators are concerned that the use of private keys by broker-dealers to control digital securities may create unique risks and have therefore declined to grant broker-dealers the ability to custody digital securities. More specifically, regulators are concerned that broker-dealers facilitating digital securities transactions may be unable to comply with the “exclusive control” and “transaction reversibility” requirements of Rule 15c3–3.
Indeed, the SEC and FINRA have stated that “the fact that a broker-dealer (or its third party custodian) maintains the private key may not be sufficient evidence by itself that the broker-dealer has exclusive control of the digital asset security (e.g., it may not be able to demonstrate that no other party has a copy of the private key and could transfer the digital asset security without the broker-dealer’s consent). In addition, the fact that the broker-dealer (or custodian) holds the private key may not be sufficient to allow it to reverse or cancel mistaken or unauthorized transactions. These risks could cause securities customers to suffer losses, with corresponding liabilities for the broker-dealer, imperiling the firm, its customers, and other creditors.”
While these concerns may be relevant to some cryptographic assets, digital securities based on blockchains (such as those built using smart contracts on Ethereum) can and have been designed to minimize the risk of theft and unauthorized use. It is here the regulators confuse “reversible” and “remediable”. Simply because a blockchain provides an inalterable ledger doesn’t mean that transfers cannot be traced, values cancelled and reinitiated. Unlike “permissionless” cryptographic assets like Bitcoin, digital securities must be distributed by an issuer, which can be given control over the issued digital securities. For example, in the event of theft or mistaken transactions, the issuer could essentially “cancel” the stolen securities and reissue the securities to their rightful owner. Moreover, because every transaction involving digital securities is recorded on a blockchain, issuers could quickly and easily identify mistaken or fraudulent transactions and remedy them. Finally, in the event an investor loses a private key, and therefore, in effect, the security, the issuer could replace them, resulting in no harm to the investor.
Furthermore, the potential of third parties or bad actors obtaining a private key is not unique to digital securities. Unauthorized access is a risk at every level of the existing financial system. The ability to secure private keys in a more robust way than traditional passwords may actually mitigate these risks.
The application of distributed ledger technology to securities has created novel regulatory issues. However, there are a growing number of solutions to these problems that, if implemented, could spur greater use of digital securities. It is critical that regulators like the SEC allow current rules to be applied to these novel technologies so that they do not inadvertently harm customer interests or capital formation more broadly. If issues regarding digital securities can be worked through thoughtfully, securities markets could be improved in terms of speed, efficiency, and profitability.