Original Article Link: Statement on Certain Protocol Staking Activities

Original Article Author: U.S. SEC

Original Article Translation: Felix, PANews

The U.S. Securities and Exchange Commission (SEC) today issued a policy statement regarding PoS network staking activities, explicitly stating that three types of staking activities do not constitute securities issuance, including self-staking, third-party non-custodial staking, and compliant custodial staking. This statement aims to provide regulatory clarity to staking participants, supporting compliant participation in network consensus mechanisms. The following is the full statement:

Introduction

To clarify the applicability of federal securities laws to crypto assets, the Division of Corporate Finance has issued its views on certain activities called "staking" in networks that utilize a Proof-of-Stake ("PoS") consensus mechanism. Specifically, this statement addresses the equity staking of crypto assets inherently linked to the operation of public, permissionless networks, where these crypto assets are used to participate in and/or are awarded for participating in the consensus mechanisms of such networks or are used to maintain and/or are awarded for maintaining the technical operation and security of such networks. In this statement, we refer to these crypto assets as "Covered Crypto Assets" and the equity staking on PoS networks as "Protocol Staking."

Protocol Staking

Networks rely on cryptographic and economic mechanisms to reduce reliance on designated trusted intermediaries to validate network transactions and provide settlement assurances to users. Each network's operation is governed by an underlying software protocol, which is composed of computer code that programmatically enforces certain network rules, technical requirements, and reward allocations. Each protocol includes a "consensus mechanism," which is a method by which disparate computers (referred to as "nodes") comprising a distributed network reach agreement on the "state" of the network (i.e., an authoritative record of network address ownership balances, transactions, smart contract code, and other data). Public, permissionless networks allow users to participate in the operation of the network, including validating new transactions according to the network's consensus mechanism.

Proof of Stake (PoS) is a consensus mechanism used to prove that the network operators (referred to as "validator operators") contributing to the network have made honest contributions, which could be slashed in case of dishonest behavior in some instances. In a PoS network, validator operators must stake the network's Covered Crypto Assets to be programmatically selected by the network's underlying software protocol to validate new data blocks and update the network state. Once selected, the validator operator acts as a "validator." As a reward for providing validation services, validators receive two types of "rewards": (1) newly minted (or created) Covered Crypto Assets programmatically allocated to validators by the network's underlying software protocol; and (2) a certain percentage of transaction fees paid by parties seeking to have transactions added to the network, paid in the form of Covered Crypto Assets.

In a PoS network, node operators must stake or "stake" compliant cryptocurrency assets to qualify for validation and rewards, usually implemented through a smart contract. A smart contract is an automatically executed program that can perform the necessary operations for a transaction on the network. During the staking period, the compliant cryptocurrency assets are "locked" and cannot be transferred for the duration specified in the protocol. Validators do not own or control the staked cryptocurrency assets, meaning that during the staking period, ownership and control of the assets do not change.

The underlying software protocol of each PoS network contains rules for running and maintaining the PoS network, including how validators are selected from node operators. Some protocols randomly select validators, while others use specific criteria to choose validators, such as based on the amount of cryptocurrency assets staked by the node operator. The protocol may also include rules designed to prevent harmful activities to the network's security and integrity, such as validating invalid blocks or double-spending (when a validator attempts to add the same transaction multiple times to the network).

The protocol's staking rewards provide economic incentives for participants to use their compliant cryptocurrency assets to secure the PoS network and ensure its continued operation. Increasing the amount of compliant cryptocurrency assets staked can enhance the security of the PoS network and reduce the risk of an attacker controlling a significant portion of compliant cryptocurrency assets. If improperly controlled, an attacker could manipulate the PoS network by influencing transaction validation or altering transaction records.

Users holding compliant cryptocurrency assets can earn rewards by acting as node operators and staking their own cryptocurrency assets. In self-staking (or solo staking), users always have ownership and control of their cryptocurrency assets and private keys.

Additionally, users holding compliant cryptocurrency assets can participate in the validation process of the PoS network through third-party non-custodial staking without running their own nodes. Users delegate their validation rights to third-party node operators. When using a third party node operator, users receive a portion of the rewards, while the service provider also earns a portion of the rewards for their transaction validation services. When engaging in non-custodial staking directly through a third party, users retain ownership and control of their cryptocurrency assets and private keys.

In addition to self-staking and direct non-custodial staking through a third party, the third form of protocol staking is known as "custodial" staking. In this form, a third party (the "custodian") holds the owner's cryptocurrency assets and stakes such assets on behalf of the owner. When the owner deposits the cryptocurrency assets with the custodian, the deposited assets are held in a digital "wallet" controlled by the custodian. The custodian stakes the cryptocurrency assets on behalf of the owner to receive a agreed-upon share of rewards, which can be in the form of a custodian-operated node or a third-party node operator selected by the custodian. Throughout the staking process, the deposited cryptocurrency assets are always under the custodian's control, while the owner retains ownership of their cryptocurrency assets. Additionally, the deposited assets: (1) may not be used for the custodian's operations or general business purposes; (2) may not be lent, pledged, or rehypothecated for any reason; and (3) must be held in a way that does not expose the custodian to third-party claims. Thus, the custodian may not engage in leveraging, trading, speculation, or similar activities using the deposited cryptocurrency assets.

Department's View on Protocol Staking Activities

The Department believes that the "Protocol Staking Activities" associated with protocol staking do not involve the issuance and sale of securities as defined by Section 2(a)(1) of the Securities Act of 1933 ("Securities Act") or Section 3(a)(10) of the Securities Exchange Act of 1934 ("Exchange Act"). Therefore, the Department believes that parties participating in protocol staking activities are not required to register transactions related to these protocol staking activities with the Commission under the Securities Act, nor are they subject to the registration exemption provisions of the Securities Act.

Protocol Staking Activities Covered by This Statement

The Department's view applies to the following protocol staking activities and transactions:

· Staking compliant digital assets on a PoS network;

· Activities engaged in by third parties (including but not limited to third-party node operators, validators, custodians, delegates, and nominators ("service providers")) related to the protocol staking process, including their roles in reward earning and distribution;

· And providing ancillary services (as defined below).

This statement only discusses protocol staking activities related to the following types:

· Self-staking (or solo staking), where node operators use their own resources to stake the cryptographic assets they own and control. Node operators can be individuals or a group operating a node together and staking their cryptographic assets.

· Non-custodial staking through a third party, where node operators obtain validation rights from the cryptographic asset owner per the protocol's terms. Reward payments can flow directly from the PoS network to the cryptographic asset owner or indirectly through the node operator to the owner.

· Custodial staking, where a custodian stakes on behalf of the cryptographic asset owner, for example, a cryptographic asset exchange platform may, with customer consent and delegation on a PoS network, stake such cryptographic assets on behalf of the customer. The custodian can use its own nodes for staking or choose third-party node operators.

Discussion on Protocol Staking Activities

Sections 2(a)(1) of the Securities Act and 3(a)(10) of the Exchange Act define the term "security" by listing various financial instruments, including "stocks," "notes," and "bonds." As cryptographic assets do not fall under any of the explicitly enumerated financial instruments in the said definitions, we analyze certain cryptographic asset transactions involving protocol staking based on the "investment contract" test set forth in the U.S. SEC v. W.J. Howey Co. case. The "Howey test" allows for an analysis of arrangements or instruments not explicitly listed in the statutory terms based on their "economic realities."

When assessing the economic reality of a transaction, the key is whether there is an investment of money in a common enterprise with the expectation of profits solely from the efforts of others. Since the Howey case, federal courts have interpreted that the requirement of "efforts of others" in the Howey case is satisfied when "the efforts made by those other than the investor are undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise." Federal courts have also noted that ministerial and administrative activities do not fulfill the requirement of managerial or entrepreneurial efforts under the Howey test.

Self-Custody Staking

A node operator's self-custody staking is not based on the expectation of reasonable profits derived from the entrepreneurial or managerial efforts of others. Instead, node operators contribute their own resources and stake their own crypto assets to secure a PoS network, validate new blocks, and thereby facilitate the network's operation, making them eligible to receive rewards based on the underlying software protocol of the PoS network. To earn rewards, a node operator's activities must comply with protocol rules. By staking their own crypto assets and participating in protocol staking, node operators are merely engaging in ministerial or administrative activities to secure the PoS network and facilitate its operation. The expected rewards for node operators stem not from any third-party managerial or operational efforts on which the PoS network's success relies. Instead, the economic incentives expected by the protocol are entirely derived from this ministerial or administrative act of protocol staking. Therefore, the rewards are a compensation paid to node operators in exchange for the service they provide to the network, rather than profits derived from others' entrepreneurial or managerial efforts.

Third-Party Custodied Staking

Similarly, when the owner of crypto assets delegates their validation rights to a node operator, the owner does not expect to benefit from the entrepreneurial or managerial efforts of others. The service provided by the node operator to the owner of the crypto assets is inherently ministerial or administrative, rather than entrepreneurial or managerial, for the same reasons discussed above regarding self-custody staking. Whether node operators stake their own crypto assets or obtain validation rights from other crypto asset holders does not change the nature of protocol staking in the Howey analysis. In either case, protocol staking is a ministerial or administrative activity, and the expected economic incentives come solely from such activity, not from the success of the PoS network or any other third party. Additionally, node operators do not guarantee or otherwise set or fix the amount of rewards to be paid to the crypto asset owner, but they may deduct their fees (whether fixed fees or a certain percentage of that amount) from such rewards.

Compliant Custodial Staking

In Compliance Custodial Staking, the custodian (whether or not a node operator) does not provide entrepreneurial or managerial efforts to the owner of the staked cryptocurrency receiving its services. These arrangements are similar to the above scenario where the cryptocurrency owner delegates their validation rights to a third party but also involve the owner delegating their custody rights over the staked cryptocurrency to a third party. The custodian does not decide when, if, or how much of the owner's cryptocurrency is used for staking. The custodian merely acts as an agent representing the staked cryptocurrency deposited by the owner.

Furthermore, the custodian's custody of the deposited cryptocurrency and, in some cases, the selection of node operators do not satisfy the "efforts of others" prong of the Howey Test, as these activities are inherently ministerial or transactional and do not involve managerial or entrepreneurial efforts. Additionally, the custodian does not guarantee or otherwise establish or fix the amount of rewards to be paid to the cryptocurrency owner, but the custodian may deduct its fees from that amount (whether a fixed fee or a certain percentage of the amount).

Auxiliary Services

Service providers can offer the following services to cryptocurrency owners ("Auxiliary Services") to complement protocol staking. Each of these auxiliary services is inherently administrative or transactional in nature and does not involve entrepreneurial or managerial efforts. They are part of the overall activity of protocol staking, which itself does not possess entrepreneurial or managerial characteristics.

Slashing Coverage: Service providers compensate or indemnify staking clients for losses incurred due to slashing. This protection against node operator errors is akin to safeguards provided by service providers in many traditional business transactions.

Early Unbonding: Service providers allow the return of the cryptocurrency to the owner before the protocol-defined unbonding period ends. This service merely shortens the effective unbonding period of the protocol, providing convenience to the cryptocurrency owner and alleviating the burden of the unbonding period.

Alternative Reward Distribution Schedule and Amount: Service providers deliver rewards at a different pace and amount than the protocol's set schedule, or earlier than the protocol's stipulated time or less frequently than the protocol mandates, provided that the reward amount is not fixed, guaranteed, or higher than the protocol-awarded amount. Similar to early unbonding, this is merely an optional convenience to cryptocurrency owners in reward allocation and distribution management.

For cryptocurrency aggregation, service providers offer to aggregate the cryptocurrency to meet the minimum requirements for protocol staking on behalf of the cryptocurrency owner. This service is part of the validation process and is inherently administrative or transactional. Aggregating the owner's cryptocurrency to assist in staking is likewise administrative or transactional in nature.

Whether provided individually or as a suite of services, a service provider offering any or all such services does not have a custodial or managerial nature.

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