By Evan Weiss, Founder of POSA.
I talk with a lot of people in the ecosystem about liquid staking. It’s time to address a common misconception head-on. When tokens are staked via a liquid staking protocol and are pooled together simply to be staked, that pooling does not make participation in the protocol a security.
Staking in this scenario does not represent an investment contract and the persistence of this myth unnecessarily harms those participating in securing proof of stake networks. The recent ruling in the SEC lawsuit vs. Ripple shows the US courts agree that whether or not the sale or issuance of tokens represent investment contracts depends on the facts and circumstances associated with each specific sale or issuance: in other words, it depends on the specific scenarios in which the tokens are offered. There is well established case law specifically relevant to service provider relationships that clearly shows that most liquid staking tokens are not securities as their protocol’s offerings are designed.
Let’s start with some facts. The CFTC determined that ETH is a commodity, like grain and pork bellies. These are staple foods that are warehoused. If you’re not familiar with the concept of bailments, the idea is simple: a bailment is a legal/contractual relationship, where an owner transfers physical possession of property for a time to a bailee, but retains ownership of that property. The bailee safeguards the property for the owner and is required to return it when requested. In certain bailments the bailee/safeguarder issues the owner a warehouse receipt to represent the owner’s ownership. These warehouse receipts can be exchanged to efficiently trade the underlying property which happens today at large exchanges like the Chicago Mercantile Exchange (CME).
Bailments have been a part of law for so long that no one knows their origin. There has always been a need to define the obligations and liabilities of someone contracted to take care of other people’s commodities. The concept of warehouse receipts or electronic documents of title have been around for decades and are commonly used for all types of commodities, including livestock, gold, crops, and more.
Today there is well-established case law about pooling of commodities. Consider a farmer securing their wheat in a commodity warehouse. It’s stored there in one big silo with everyone’s deposited wheat. The farmer sells their wheat using their warehouse receipt. The buyer doesn’t care about getting back the exact grains of wheat that were deposited, because wheat is a fungible commodity, just like ETH. What matters is that the warehouse receipt is a document of title representing ownership of the amount of wheat the farmer sold and that the grain is safeguarded in a safe and secure way by the warehouse owner.
So what does liquid staking have to do with pooling grain and pork bellies?
Warehouse receipts and electronic documents of title are commonly used today. They’re incredibly important for increasing the feasibility, growth, and capital efficiency of commodity markets by removing the need to physically transfer the commodity.
The case law surrounding the pooling of bailments provides a clear example of how liquid staking tokens (LSTs) should be considered as a document of title. LSTs as documents of title are in effect receipt tokens, just like warehouse receipts, that allow the stakers to trade/utilize the ETH being secured by the liquid staking protocol. These types of relationships even cover specific concerns, like how liquid stakers earn network rewards and socialize staking losses.
The liquid staking protocol as a staking facility compares to the storage facilities for commodities like grain, pork bellies, or whiskey. The liquid staking protocol is akin to the warehouse where everyone’s wheat is stored and safeguarded, and the relationship between the staker and the liquid staking protocol is akin to the relationship between a bailee and bailor.
The courts have already considered whether documents of title qualify as investment contracts. The court in Noa v. Key Futures held that certificates of ownership for silver bars pooled together and warehoused by a seller, where a seller advertised that it “would buy the silver back at any time at the spot price quoted by the Wall Street Journal,” were not investment contracts because the future value of the silver did not depend on the efforts of the seller.
Even the SEC has taken a no-action position regarding several offerings of gold and the issuance of warehouse receipts. As early as 1974, the SEC considered how the issuers of the warehouse receipts had arranged for the storage of, and insurance for, gold. They determined that such arrangements and activities did not result in the warehouse receipts being investment contracts.
Relating to multiple arrangements, the SEC found that these warehouse receipts were not securities because the sellers’ efforts did not rise to the level of being those essential efforts in which the purchaser would rely on to realize a profit. Instead they were focusing on safeguarding the assets and ensuring they retained their value for their owners.
However, courts have found warehouse receipts for whiskey to be investment contracts where the purchaser depended on the efforts of others to achieve profits because such persons provided their expertise in the selection of whiskey, casks, and finding a market for the whiskey, along with the administrative efforts of arranging for warehousing and insurance for the whiskey. Given the structure of these offerings, the investors had a dependence “upon the seller or others to select, store and trade the whiskey,” which created an investment contract. These cases show that there is a thin line between the efforts provided by the promoter, especially when it comes to identifying the ability to significantly increase the value of the underlying commodity or controlling secondary markets for resale.
While too-often the industry uses the term ‘pooling’ solely to describe the pooling of assets into a joint venture, as described under securities law, the example of ‘pooling commodities,’ or storing them together under commodities law is much more aligned with how liquid staking tokens work.
Liquid staking protocols may pool an end user’s ETH together with the ETH of other end users in a single blockchain address or smart contract. This is just like how physical commodities may be maintained in a single warehouse as a fungible bulk. Whether it’s gold, silver, wheat, or livestock, this kind of pooling for storage happens in all types of service provider relationships.
The direct parallels between pooling commodities as fungible bulk in a warehouse and pooling ETH as fungible bulk to be staked even cover staking rewards and slashing losses:
- A warehouse receipt or bill of lading for physical commodities allows the holder to transfer legal and beneficial ownership of the commodity while it is maintained in storage or is in transit. The holder of the receipt is entitled to any naturally occurring fruits of its owned commodities, such as offspring of livestock, or any staking rewards generated in the case of liquid staking.
- When storing physical commodities as fungible bulk with a bailee, a huge silo fire could result in all bailors’ grain being lost at the same time. Gold under custody could be robbed from the vault, or all stored milk could be affected by a facility power outage. This is just like how losses could be experienced across a liquid staking protocol’s end users due to a slashing event. The users of these service providers may be simultaneously affected by these losses (sharing losses pro-rata), and these losses could even come as a result of other customers’ actions, but that doesn’t mean that all users of the service provider are engaging in an investment together.
How does this all relate to liquid staking? Let’s look at liquid staking through the commodity lens:
- The CFTC has determined that ETH is a commodity akin to grain or pork bellies.
- The staking protocol is akin to a storage warehouse for digital commodities used by end users for purposes of safekeeping their staked ETH and network rewards.
- End users will deposit this commodity into the staking facility to be staked by validators.
- The protocol will issue an electronic document of title in the form of a LST to an end user as evidence that the end user has ETH staked via the protocol and is entitled to the network rewards generated by their portion of staked ETH, as well as losses due to slashing.
- The staking protocol has no discretion or ability to reappropriate the ETH. ETH must be staked on the beacon chain, making the arrangement very different from lending, which requires underwriting, third parties, and transfer of funds.
- As a result, the LST has characteristics that are consistent with the receipt instruments in Noa v. Key futures and the SEC’s Warehouse Receipt No Action Letters. They should not be considered as securities.
Not every liquid staking offering will fit into this mold cleanly. And, as true with any analysis under Howey, there will be cases where the facts and circumstances differ. As with any investment contract analysis every solution must be examined on a case-by-case basis.
Most liquid staking tokens are not securities
Examining well-established case law to debunk the myth that pooling tokens in liquid staking represents an investment contract
By Evan Weiss, Founder of POSA
8/17/2023
Noa v. Key Futures: Not investment contracts
- Future value of the silver did not depend on the efforts of the representatives
- Future value of silver depended on the market rate for silver as quoted in the Wall Street Journal
- Participants didn’t get their value from the relationship by relying on the representative’s ability to select the best asset
SEC v. Glen-Arden Commodities, Inc.: Investment contracts
- Representatives of the issuer of the warehouse receipts “would utilize [their] expertise in selecting the type and quality of Scotch whisky and casks to be purchased,” providing participants with value by selecting the best assets likely to appreciate in value
- Made themselves available to warehouse receipt holders to obtain information about the market
- Traded whiskey on the owners’ behalf
Direct staking designs
- Allow users to stake directly, retain legal and beneficial ownership of their staked tokens, and stake in any amount
- Act akin to technical service providers, with network rewards generated organically from the Ethereum blockchain
- Selling price of the ETH (or LST) is dictated by the markets
- Do not actively manage or create secondary trading venues
Actively managed staking designs
- Enhanced yield generation mechanisms
- Fractional reserves held for arbitrary deployment and/or increased liquidity for users
- Varying levels of discretion held by the custodian or service provider
- Offer guaranteed returns or instant rewards
Just as there is room for technical service providers in staking, some teams may choose to build liquid staking solutions that are more akin to financial intermediaries.
So, what makes a liquid staking protocol aligned with a traditional service provider relationship, with the LST akin to a document of title in terms of case law? Here are some of the defining features that differentiate most liquid staking tokens from securities.
- No discretion on the part of a liquid staking protocol to use the end stakers’ ETH
- ETH locked into the Ethereum deposit contract
- Protocol does not have the ability to transfer, exchange, or otherwise exercise control over the ETH maintained within the staking facility
- The ETH is just used for staking
No ability to transfer, exchange, or utilize the staked tokens
No centralized control: you can exchange or redeem an LST through many different venues
- LST can be traded or exchanged on many different venues
- Decentralized community operating the protocol may assist in integrating those venues
- LST holder is responsible for making any sales
- Liquid staking protocol doesn’t offer secondary trading opportunities, just the ability to redeem LST for ETH
- This is even better than in Noa v. Key Futures (not an investment contract) where the warehouse was offering to buy silver on their balance sheet at rates dictated by the market
No offer of secondary trading
- The technical service action of selecting validators that meet performance requirements is distinct from a financial services offering
- Using a service provider to earn network-determined staking rewards is different than paying a representative to choose a whiskey likely to appreciate in value for you to buy, or to provide the financial service of choosing different investment schemes to deploy staking pool reserves into
Not selecting value or appreciation
- In the case of slashing, all LSTs associated with the liquid staking protocol are equally impacted
- Functions like a commodity warehouse, where an outage, fire, or burglary would have an equal chance of affecting any participant
Losses are shared
Simply storing and securing commodities or tokens together does not automatically make a relationship an investment contract. Based on standing case law on the pooling of commodities, the service of liquid staking should most often be considered that of a service provider safeguarding assets.
In my five years working on staking legal issues I have yet to see case law or a contractual structure that better represents the relationship between a staker and service provider than that of liquid staking as a document of title. Now that participation in liquid staking is broadening, it’s time for the industry as a whole to accurately represent liquid staking to the world according to existing legal precedent.
When regulators issue blanket statements that all staking services fit into a given model of case law, it’s harmful to consumers. We need tailored evaluation for each offering based on its design, just as the courts have shown in the SEC v. Ripple case. Our collective goal should be to work with regulators and lawmakers to craft a framework for technical staking services without necessitating securities registration. Having clear and appropriate rules will allow staking providers the ability to offer safe services to users, protecting consumers while ensuring one of the fastest parts of the industry continues to flourish.
In the absence of proper regulatory clarity, the PoS ecosystem must step up to the plate and self-regulate. We can foster responsible growth by designing liquid staking protocols that don’t actively manage participant’s funds, precisely defining the relationship between stakers and liquid staking solutions, and getting everyone to stop inaccurately portraying LSTs as investment contracts or liquid staking derivatives. This will allow for the ecosystem to continue to grow responsibly while we advocate for the clear, nuanced rules of the road we need.
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