Now that it’s harder to make a quick buck with ICOs, a new investment opportunity has sprung up: crypto staking.

Some cryptocurrencies and exchanges now invite you to leave some crypto in a locked wallet. Then at the end of every month, they promise to automatically deposit rewards in your wallet. 

The best part is, they say, you don’t have to do anything! All you have to do is leave the crypto there and you’ll make regular returns each month. 

Now before you dive in head first, hold on a second!

I took a closer look to see if these staking offers could be considered security offerings. And as it turns out, some forms of crypto staking are definitely securities. 

That said, not all are. So it pays to know the difference. 

To make sure that you don’t get caught off guard once the SEC starts looking into staking investments, read on to learn when staking is and is not a security.

What is Crypto Staking?

In the crypto space, staking refers to two different activities. So it’s crucial that we first start by differentiating between them. The first relates to crypto that is staked in order to facilitate Proof of Stake consensus chains and the other is Investment Staking.

I will go through each of these and run them through the Howey Test. This is the SEC’s standard means of determining if an investment offer is a securities offering

Now, crypto has innovations all the time, so there may be other types of staking that aren’t covered here. My aim is to break down the fundamentals of staking in the context of how the SEC would view them from a securities perspective. This way you can apply these principles to any variation that you encounter.

Proof of Stake (PoS) Consensus

The original form of staking comes from the Proof of Stake (PoS) method of consensus. This form of consensus was conceived in 2012 in an attempt to find a more energy-efficient method of maintaining a blockchain network. 

With Proof of Stake, blockchain transactions are validated through a simpler algorithm. And rewards are paid out based on the amount of money staked in a locked wallet. 

Not only does this save computing energy, but the staked funds help to align incentives between the node operators (also known as validators) and users of the network. This also enhances the security of a network by making it extremely costly for someone to attempt a 51% attack. 

Put simply, by staking money, a node operator establishes himself as a ‘good’ actor whose interests are aligned with the community. The node operator then provides a service to the network and receives a reward based on both his service and the amount of money he staked.

This is typical practice even outside of crypto. I’ve seen it many times in my work with technology companies in the healthcare market. 

For example, when a service provider wins a big contract with a US hospital, the service provider must put money in escrow at the start of the contract to ensure its performance. This is not an investment, just a feature of the service agreement.

So, let’s put the Proof of Stake system through the Howey test:

Is it an investment of money? Yes. 

Is there an expectation of profit? Yes, you’re expecting to earn a portion of the transaction fees based on how much you’ve staked.

Do the returns come wholly from the efforts of others? No. You need to perform a service to earn rewards. Moreover, this service has expenses. You need to run powerful computers that cost money and consume energy. 

Is the investment in a common enterprise? Yes, all other stakers are doing the same thing and the profits are pooled before being distributed to them. 

As you can see, Proof of Stake arrangements match three of the four prongs of the Howey Test. However, since the person who staked the funds is also providing a service, this means that the returns are not entirely based on the efforts of others. 

As a result, staking crypto in conjunction with Proof of Stake node operations should not be considered an investment contract. And thus should not require registration with the SEC. 

Staking as an Investment

Now, let’s discuss the second main form of staking: investment staking.

Since the start of crypto winter, projects have been eager to find a way to support declining crypto prices.

Investment staking rewards emerged as a popular strategy to encourage coin holders to save their tokens and thus take them out of circulation. It’s basic supply and demand. Lower supply, higher value.

To earn these staking rewards all a user needs to do is transfer his or her crypto to a locked wallet and let it sit there. At the end of the designated lock up period, the depositor will receive a fixed amount of crypto rewards. 

This kind of staking has been touted as a great passive income opportunity because no work is involved. Everything is managed by the project and paid for from the block rewards.

For a non-crypto example, this is essentially the equivalent of a Certificate of Deposit (CD) that is offered by your local bank or a short-term bond note. In a traditional CD, when a depositor locks up cash in a bank, at the end of the lock up period, the bank will pay back the principal with a return on investment. 

Already it should be clear that this kind of agreement is an investment contract. But to understand why, let’s run it through the Howey test. 

Is it an investment of money? Yes. 

Is there an expectation of profit? Yes, it’s stated loud and clear ahead of time how much interest you are expected to earn.  

Do the returns come wholly from the efforts of others? Yes, the funds and rewards are entirely managed by the blockchain. The depositor has no control over what’s happening with the funds or the underlying investment.

Is the investment in a common enterprise? Yes, all other stakers are doing the same thing and the profits are pooled before being distributed to them. 

In summary, this type of staking arrangement should be considered an investment contract.

I won’t call out any specific projects here, but just do a quick search for “staking investment”. You’ll see that many projects and exchanges are offering these investment opportunities. 

Essentially, if the returns that are promised are unrelated to mining, node operation, validating or providing any other service to the network then be aware that the staking opportunity you’re looking at is likely a security offering. 

And so far as these investments are available to US citizens and residents, the projects that offer them should be legally required to register with or file for an exemption from the SEC. 

(Given the latest court ruling for Telegram, I would not rely on geofencing alone to be sufficient proof of excluding US citizens.)

What does this mean for Crypto Law Insiders?

For crypto holders and investors, know that eventually, the SEC will be knocking on the doors of these projects that are offering securities to US investors. 

As an investor, you are technically not at fault. So you won’t suffer any civil penalties for investing in any of these schemes. Nonetheless, as you consider the regulatory risk faced by your investments, be aware that these projects have very high regulatory risk. You could stand to lose everything that you invest with them.

If you’re running a project yourself and you’re thinking about offering staking rewards because you see it as a good way to soak up supply, be careful. This may be a direct violation of US Securities laws, and as we’ve seen over the last 2 years, the SEC doesn’t hesitate to crack down on those who violate its rules.

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