Event: “Legal Analysis of Staking and Securities”

Watch a panel with industry-leading staking and securities experts on the current legal and regulatory considerations surrounding staking and liquid staking in the United States.

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Transcript

The following transcript of this live event has been edited for clarity.

Evan Thomas

Afternoon, welcome to this Liquid Collective panel on the legal analysis of staking and securities. I'm Evan Thomas. I'm the General Counsel for Alluvial, which is a software development company supporting the Liquid Collective protocol.

We have a fantastic panel of seasoned legal experts joining us today. Before I introduce them, I just want to say, from a logistical perspective, if any audience members have questions, they're free to put them in the livestream chat, and if we have time permitting at the end we can see if we can take some of those questions. So with that, I'd like to introduce our panel. Again, we're very privileged to have them with us today, and so I just ask each of them to introduce themselves briefly. I guess we'll start with Jake, if you could introduce yourself, please.

Jake Chervinsky

Absolutely. And thank you Evan for having me and all of us for this. I'm Jake Chervinsky. I am Chief Legal Officer at Variant, which is an early stage venture capital firm in the crypto industry.

Evan Thomas

Terrific. And then, Mike, if you could introduce yourself.

Mike Selig

Hey, I'm Mike Selig. I'm a Partner at Willkie Farr & Gallagher, working in the firm's crypto group. I help crypto projects and ecosystem participants navigate the complex and sometimes hostile federal regulatory landscape for crypto. Before joining Willkie, I spent some time working at the Commodity Futures Trading Commission.

Evan Thomas

Terrific. And Scott?

Scott Bennett

Hi, I’m Scott Bennett. I'm a Corporate Partner at Cravath Swaine & Moore LLP. A lot of my work is in the capital market space, and a lot of it involves digital asset companies, helping them fundraise, helping them try to go public, working through regulatory issues, and everything else across the ecosystem.

Evan Thomas

And thank you. And Tiffany?

Tiffany J. Smith

Hi, I am Tiffany Smith. I'm a Partner at WilmerHale in the securities department. I'm also a Co-Chair of our blockchain and crypto working group, and the majority of my practice focuses on helping crypto, web3, and technology companies understand the federal securities landscape.

Evan Thomas

Thank you, Tiffany. Thanks to all for taking the time to join us and speak to us today. As we get underway, I want to ensure that all of those in the audience have a common understanding of some of the technical and legal subject matter they'll be getting into. So, to give folks that familiarity, perhaps Jake, if you could start us off and just briefly explain what we mean by staking.

Jake Chervinsky

Yeah, absolutely. Happy to do that. And I'll start with a little bit of Blockchain 101, and I'll try to keep it pretty high level. But, in short, staking has everything to do with providing security for a blockchain. And essentially, a blockchain is simply a database that people can use to add transactions or other types of information, that is available to everyone around the world. The magic about a blockchain is that it is not a database that depends on a single third party that has to be trusted and relied upon in order to maintain the database. Instead, it is a distributed database managed by many different people all around the world. And this begs the question, how do we make sure that all of these different people who are maintaining that database are following the rules and acting honestly? And what we need in order to do that is to have something called a consensus mechanism.

This is something that incentivizes those people to, again, act honestly and validate transactions correctly, and continue adding blocks to the blockchain according to the rules of the blockchain. And the first consensus mechanism that was created—and really you know, the great invention of Bitcoin—was the proof of work consensus mechanism, which uses sort of a carrot and stick approach in order to make sure that miners, who are the people who add blocks to the blockchain, are following the rules.

On the one hand, it says, the miners will have to put up something of value. They will have to risk some financial loss in order to participate in this network. And what they put up basically is computing power. The way that proof of work functions is that miners are spending a lot of energy to run computers that are solving very difficult math problems in order to add transactions to the blockchain.

And the reward for them, if they do this correctly, is mining rewards. They essentially get paid in bitcoin, the native asset of the Bitcoin blockchain, which is the incentive for them to follow the rules. But there's also a threat, which is that if they don't follow those rules, they will not be rewarded, and they will have spent and lost all of that money that they put into the computing power that they used.

Now, then, the issue with proof of work, or at least one that many people have flagged, is that it is extraordinarily energy intensive. In some ways, it is very wasteful and environmentally impactful. And so a new consensus mechanism was devised called proof of stake, which uses essentially the same carrot and stick approach to incentivize people to follow the rules and act honestly when maintaining a blockchain. But what it says, is, instead of having an extrinsic resource like energy that you were putting toward the blockchain, instead you take that native asset—so, for example, ether in the context of the Ethereum blockchain—and then you stake it. You put it at risk, the value of that asset, in order to earn the right to act as a validator.

Validators are the ones who maintain the blockchain in a proof of stake blockchain. And, again, if they act honestly and follow the rules, they will be rewarded with staking rewards, which is more of that native asset of the blockchain. So, that's the way in which they profit, by following the rules, but if they don't follow the rules, they can be slashed, meaning they will lose whatever the value is that they have put up initially as their stake. And so, again, staking is a reference to a security model that allows many, hundreds or thousands of validators around the world to cooperate in order to maintain the security of a blockchain without simply saying all users of the blockchain must trust them in order to act honestly.

Evan Thomas

Thanks for that, Jake. And, so, my understanding, I mean, there's a variety of ways of participating in staking, and so maybe we can go through what those are. Tiffany, we sometimes hear the term ‘solo staking’ or ‘home staking’ or ‘native staking,’ which may very well all mean the same thing. Perhaps you could shed light on what that's referring to.

Tiffany J. Smith

Sure. Happy to. So, going back to Jake's amazing explanation of staking, you have the process by which transactions are approved. It's the validation process. And so when you're talking about solo staking the person that's putting up the stake in meeting the—whatever the requirements are of a network and for the stake—they perform that on their own. So, thinking about the requirement to be a staker or a validator, on the Ethereum network that is 32 ETH. That person, or sometimes the company, would put that ETH up as their stake and perform all of the necessary functions to earn staking rewards. And as we talk about other examples of how staking works, that's the thing to keep in mind with respect to solo staking, is it’s an actual person doing the functions, putting up the stake, in order to earn the reward on the network.

Evan Thomas

Right. And then, you know, we also hear a reference to staking as a service. And maybe, Scott, you can explain that, and contrast it with what Tiffany just described.

Scott Bennett

Certainly. So, if you think about what you need to do to solo stake, to what Tiffany was just talking about, if you're talking about Ethereum, you need 32 ETH. Well, that's like a hundred thousand dollars worth of ETH, in today's prices. That's fairly significant for an individual. You also need to go through some IT steps. You might need to have your own servers, or you contract with someone else—Amazon Web Services, something else—for processing power. You download software so that you can run a validator. There's a whole series of things you need to do. And you need to have your ETH or your other proof of stake digital asset, that you are actually holding and custodying, so that you can solo stake. Many people can't do all that.So that's where other service providers come in to provide staking as a service services.

There's probably two big buckets, at least the way that I think about it. One is if you are already on a custodial digital asset platform. So, you're holding digital assets in Coinbase and Kraken, or whatever, they already have custody. You're not holding your private keys. And so you can't really solo stake with those assets. So, those companies provide staking as a service on your behalf. There's not really another option to have staking now (we will get to the SEC enforcement issues, and some of the US limitations on staking as a service because of the uncertainty as a legal matter that we're dealing with right now).

But that's sort of one version of staking as a service, where you either opt in or it's a system where everybody's opted in, unless you opt out, if they provide it. And they will stake on your behalf; take the digital assets that you own, plus other people on the platform that have the same, stakable proof of stake assets, put them together into the relevant amounts—32 in the case of ETH for a validator. Then, those crypto assets are staked as a service, by the Coinbase, the Kraken, or whatever it may be. Then, the rewards that come back are allocated back pro rata to the person who had their crypto assets on the platform and use that staking as a service, typically with a deduction for some portion of fees, 20%, 25%, whatever it may be, that the company keeps as in effect the fee for providing that.

That's sort of one model. Another model would be, not necessarily custodial in the way that I just described, but a non-custodial staking as a service, where there is somebody out there who is, maybe, 'You actually hold your crypto, you have a wallet, you have the private keys,' et cetera. But you're using a service provider who is aggregating different people's digital assets to create the 32 ETH (in the case of ETH), to run the validator, to run the software, to go through the effort of actually providing those. And so you go there, but ultimately you still have your wallet, you have your private keys.

So, that's kind of a couple of ways to think about it. And then, I think one of the next topics, but I think somebody else is going to touch on it, is the liquid staking, and some of the other interesting nuances in the market.

Evan Thomas

Yes. Thanks for that, Scott. And I'm picking up on that. Mike, maybe you could talk a bit about liquid staking protocols, which are, you know, attracting increasing attention.

Mike Selig

Yeah, absolutely. Liquid staking is almost kind of like the automated vending machine version of a staking as a service model. What you're doing in the context of liquid staking is depositing assets into a smart contract. So everything's happening onchain. The smart contract is actually managing the process of allocating the ETH to various validators.

So, Scott mentioned you need 32 ETH on the Ethereum blockchain to run a node, rather than have a common custodian in the context of a StAAS model. So with staking as a service, you would all have to be using the same custodian, all the users would've to be using the same custodian in order to reach that 32 ETH. And, in order to then have a technical service provider run the validation services using that ETH, and set the withdrawal address back to that contract, or to that wallet, in this case, you have an onchain smart contract where assets are being directed, and then the contract is allocating in 32 ETH increments to each validator.

When the user deposits those assets into the smart contract, they receive a liquid staking token, which is essentially a receipt or a document of title that evidences the fact that the user has deposited assets into a contract for the purposes of staking those assets. And then is receiving this document of title evidencing legal and beneficial ownership of that ETH. And, you know, it can get interesting with things like restaking. Where, if you think about setting the withdrawal address to an EigenLayer pod, that allows you to kind of stake the asset a second time. All this document of title or receipt is evidencing in the context of restaking, now that you've staked it twice, is that the withdrawal address for that contract, or for that staking action, is now an EigenLayer contract. And you have this document of title that evidences all of that. So it almost is like a chain of custody, chain of title instrument, that you can then transfer to a third party to demonstrate that you own this ETH, and that they can go now to the smart contract and withdraw that ETH.

And then it's subject to slashing, for example, the risk of loss, both at, maybe, if it's restaking, at the contract level on the Ethereum blockchain, and then as well at the EigenLayer level. But it's really just an instrument. It's not the same as ETH—you can't pay your transaction fees on the network with the instrument. It's really just very much akin to what you would receive, you know, if you drop off your dry cleaning at the dry cleaners and they give you a receipt saying, ‘you can come and pick this up,’ or you drop your grain off at a silo, anad they give you a warehouse receipt saying you can pick that up. These are really just title instruments, but they can be used in in decentralized finance to service the underlying to a futures contract, or to function in a lending arrangement where you're using it as collateral.

So it [the LST] really just allows more flexibility, but you still are subject to the same mechanics of the staking network. So if you're staking on Ethereum, you still have to go through the withdrawal queue to actually pull your ETH out of the network. You still are subject to slashing, and all of the unbonding requirements of the network itself.

Evan Thomas

Thanks, Mike. Moving then from what is staking itself, now, sort of turning more to the legal issues. I think one question to start with for you, Jake, I mean, just the fact that these assets, leaving aside how they're staked and what issues that might raise, does the nature of the ability to stake a proof of stake asset itself raise any legal considerations under securities laws? Does it transform that asset into a security in some fashion?

Jake Chervinsky

It shouldn't transform the asset into a security, although this has become unfortunately a somewhat controversial issue. I think more for political reasons than for legal reasons. But, let me give you a bit of a sense of legal argument, and then I'm sure, you know, others can weigh in, in more detail.

But the main question when we're looking at any digital asset, and wondering whether or not it will be treated as a security under the 1933 or 1934 acts, is the investment contract analysis and Howey test. And surely everyone on this call, and everyone who works in this industry, is well familiar, unfortunately too familiar, with the Howey test, which says that there is an investment contract in the presence of an investment of money in a common enterprise with a reasonable expectation of profit derived from the managerial or entrepreneurial efforts of a third party.

And I think everyone agrees broadly that in the context of proof of work, there is no investment contract, miners are not engaged in an investment contract, and the presence of proof of work as a consensus mechanism does not convert the native asset of the blockchain into an investment contract. And even the SEC, as hostile as they have been to our industry, has admitted that Bitcoin itself is not a security. And there's really nothing about the distinction between proof of work and proof of stake as consensus mechanisms that changes the analysis under the Howey test.

Let me give you at least two reasons why both a proof of work and a proof of stake consensus mechanism should fail the Howey test. The first relates to the presence of a common enterprise. And without getting super deep into the weeds of the various different tests for a common enterprise in different circuits around the country, the test for common enterprise we typically look at is called horizontal commonality, which exists when there is pooling of assets among those who were involved in the enterprise and pro rata distribution of profits, or sharing of losses, as a result of participation. And that is simply not how a staking arrangement works.

There is no pooling of funds in a typical staking system. Each staker, as we've been discussing, stakes their own assets and always has control over those assets, does not commingle them in any way with any other users or any other stakers in the system. So there is no pooling in the sense that applies in the presence of a common enterprise.

In addition, there is no pro rata distribution of profits or sharing of losses. Each staker in the system will have their own unique result based on how they act in the protocol. First of all, not each staker will receive the same profits. They are, as we've been discussing, randomly selected, or selected according to the consensus mechanism to validate the next block. So at any given moment, on a defined timescale, some stakers may validate many blocks, some may validate no blocks, and they will have a different amount of profit as a result.

They also don't share pro rata in losses. The way that stakers lose their capital in some way in staking is if they don't follow the rules, and then they are slashed. And not everyone gets slashed equally. In fact, the entire point of slashing is to incentivize each staker individually to follow the rules. So, in my opinion, there is no common enterprise under the horizontal commonality test in a staking system.

The other element of the Howey test that's worth talking about a little bit is the fourth prong, the requirement of a dependence on the managerial or entrepreneurial efforts of a specific third party or promoter. And we all think about this in the context of sufficient decentralization. In other words, the Howey test only applies when there is some party that has an information asymmetry and thus should be forced to make disclosures under the securities laws, to make sure that the investing public has the same access to information as they do, given their privileged role in the ecosystem. And that simply is not present in the context of a proof of stake blockchain.

All of the stakers, generally speaking, are unaffiliated and dispersed participants. They coordinate only in the sense that they are following the same consensus mechanism. But there's nothing that these stakers know, that they have privileged access to, you know, some information or some privileged role in the ecosystem that it would make any sense to require them to make some disclosures. The beauty of a public blockchain is that all of this is public, and transparent, and can be seen by the public.

And to the extent that there is some reliance on other people, it is reliance on a broad and dispersed group of individuals simply to perform a task of validating transactions, not in the sense that they trigger the Howey test. So, in my opinion, there's really no distinction between proof of work and proof of stake in determining that this type of arrangement does not trigger the securities laws.

Evan Thomas

Thanks for that, Jake. You touched on the Howey test. I just want to make sure that for the benefit of folks in the audience who may not be as deep in some of these legal issues, maybe Tiffany, ask you, if there's anything you can elaborate on, on Jake's explanation of the Howey test, and then how it bears on the issues. And then, also, whether there's any other aspects of securities laws that are potentially relevant with staking, for example, the Investment Company Act. If you could just give an overview, high-level, of the legal considerations that bear on these issues.

Tiffany J. Smith

Sure. So, first off, I think Jake's explanation of the Howey test was correct: investment of money in a common enterprise, based solely on the efforts of others. And it's managerial, not ministerial. Another thing worth pointing out is that, you know, we look at this test to determine whether or not an asset, or sometimes a scheme, meets the definition of security. And there's many other definitions of security. There's note, there's stock, et cetera, right? And so we're in this position because we're trying to, we're looking at the definition of security in the investment contract tests articulated by Howey, as the most common test used in the crypto industry, as articulated by the SEC.

And so, as Jake explained, when you’re thinking about the investment contract test and whether or not a scheme is a security, you think both about the actual asset being offered as well as how it's being offered. And so, as Jake articulated, ETH, you know, there's great arguments that ETH is not a security. And despite what we're hearing out of the SEC, some of the officials there, I agree with that. But let's look past that, and think about, you know, putting that aside for a second, whether ETH, or any other crypto asset for that matter, could be offered as an investment contract with respect to staking.

And then you start thinking about the way it's offered and whether or not the staking as a service type of offering meets the definition of Howey. Is there an investment of money? Is there a common enterprise? Are you reliant on the managerial efforts of others? And in at least one SEC enforcement action, which would settle so it wasn't litigated. So the SEC wasn’t able to articulate the facts as it wanted to. So, at least in one action, you have the SEC deemed that an offering of a staking as a service product was an investment contract. There's also a number of actions at the state level, in the form of CS and other types of investigations going on. So, that's still an open question.

The issue that's worth flagging is that there's no standard way to offer a staking as a service program. So even though you might have an SEC enforcement action, it doesn't really give you clarity as to how you structure a program, right? It tells you in that particular way that program was structured, the SEC thought that it met the different definition of investment contract. But that doesn't encapsulate every variation of a staking as a service type of offering.

The last thing I want to point out, about just securities law generally in the Howey test, is another test, that is relevant when you're thinking about staking and really crypto in general, is this Gary Plastic case. And it's important to keep that in mind because it's another articulation of an instance where you can take something that's not a security, but offer it and package in a way that meets the definition of security. So in that particular case, they had bank CDs, where everyone knows that bank CDs, certificate deposit, actually in the definition of security it’s not in by itself a security, but it was offered and packaged in a way that triggered the definition of security.

You also asked about the ‘40 Act, and this comes up in the instances where you have staking as a service offering where it's a custodial offering. Scott did a great job of articulating the custodial versus non-custodial offerings. And in those instances, you have what's called an investment. You have a test that's the 40% test, where you look and see whether or not a company has assets on its balance sheet that are securities of more than 40%, especially if you're dealing with assets that the SEC has articulated that it believes are securities, and any of the three lawsuits against the major crypto platforms.

And then the last thing you wanted me to touch on was whether or not there's any considerations on the Commodity Exchange Act. I'll just touch on this briefly, because this is Mike's area, so I always defer to Mike about CFTC things. But, with respect to the liquid staking receipts that Mike described, there's questions as to whether or not those receipt tokens are swaps under the CEA. So that's another regime to keep in mind, as if you didn't have enough going on with the securities boss.

Evan Thomas

Thanks for that, Tiffany. Actually, why don't we pick up on that thread? We'll definitely want to come back to staking as a service, and talk about some of the cases you referenced, Tiffany. But, Mike, maybe you could talk a bit about liquid staking protocols and how the investment contract test, the Howey test, and other areas of this securities, commodity futures laws, may bear on those protocols, and how they might be considered under these legal regimes.

Mike Selig

Yeah, so the important threshold consideration is always ‘what is the asset that's being staked,’ right? Let's assume it's not a security, let's assume it's a commodity. You're dealing with a different set of considerations from the world, where if it's a security, the receipt instrument is likely to be a security as well. And so, you know, there's not really a whole lot of analysis to be done there, in the case when you're dealing with a commodity. So, you know, if this current SEC, maybe they don't think it’s a security, maybe they do, it's really hard to say these days.

But let's assume it's a commodity. When you're taking a commodity and putting it in some sort of vehicle—so, it could be a smart contract if it's a digital asset, it could be on a boat, it could be in a warehouse facility—you oftentimes receive these documents of title, bills of lading, or warehouse receipts. They're really just these title instruments. And so in the digital world, you really have this construct that's useful for ensuring that you're able to move assets, put them into smart contracts, stake them, restake them, do all sorts of things with the asset, and still be able to come back and take those assets out to unwind those transactions. And that's really what these instruments serve, as these liquid staking tokens, liquid restaking tokens, et cetera.

So when you're thinking about how we analysis on that, you're first considering whether there's an investment of money, right? Are you making any sort of investment in a common enterprise, in any sort of business? Do you have a business relationship with anyone? Well, really, the nice thing about these liquid staking protocols is that they're designed to essentially operate onchain, to have relationships with validators that are really verifiable onchain, so that assets are being allocated on a round-robin basis, essentially, to different validators. All of this happens based on programming.

So really, you might have some sort of contract, right? But do you have an investment in a business and an enterprise, likely not, because you're essentially maintaining that ownership, the legal and beneficial ownership, of everything you're putting in, the same way that if you go to a warehouse, or you put assets on a ship for transport, or you go to any sort of vendor, provider, and give them something, and they give you a receipt saying you can come pick it up, they're not taking ownership of that. You're not making an investment in their business. So the first prong of Howey, where you're making an investment, you're looking for an investment of money, arguably is not met in these cases with liquid staking tokens.

Then when you take it to the next element of a common enterprise, you know, Jake went into detail on those elements of horizontal versus vertical. But really, collapsing that all down to a single construct, you're not putting anything into any business or any enterprise. You're using a service provider. And so really, when I drop off my dry cleaning, the same same analogy applies here. I'm not investing the dry cleaning with the dry cleaner. I'm coming to pick it up later. When you're looking at the last two prongs, which often get collapsed down into one, you know an investment or a expectation of profits based on the efforts of others, really you're expecting profits, if any, arguably, you're not necessarily expecting to engage in this activity to expect profits, but really to to participate in the network, to stabilize and secure the network, and participate in validation of transactions.

But, arguably, if you're looking for some sort of profits from that activity, it's based on the network itself, right? So that a liquid staking provider, or staking as a service provider, or really any staking provider, they're not going out and engaging in real, material activities. They're engaging in administrative activities, right? Like, as Scott had mentioned earlier, there are certain things that are more like IT services, technical services like setting up the node software, configuring the node, running MEV software, doing all of these things that are really just administrative in nature. They're like the IT department of your law firm, of your business, right? They're not the profit center of the business itself. That's all stuff that someone could do on their own.

We mentioned staking as a service models with a common custodian. People can use a common custodian and stake on their own as solo stakers. They don't necessarily need to even have a provider. So what we like to think of these, we like to consider these as more administrative services when we're at least engaging with regulators and trying to explain this sort of thing. And similarly, when you're talking about the efforts of others, which these all kind of get collapsed, the efforts are, again, of the entire network of the validators of this enterprise itself, around the technology, not really around any sort of provider. So that's kind of the Howey considerations.

I know we touched briefly on some of the swap issues earlier on as well. It's kind of a similar analysis, when you're thinking about the swap definition under the Commodity Exchange Act and the CFTC regulations. These aren't synthetic instruments. They're really title documents that can be passed around and transferred for commercial reasons. Like you can think of a world where there's a cyber risk to one of your wallets, and you want to move the assets without unstaking them. That's really a commercial decision. You might need to use them as a collateral for a transaction, and you don't want to unstake your assets. So there are many commercial reasons, and in the commodities world and the physical world, we use these types of instruments all the time. You know, it's uncommon for somebody to take grain out of a silo when they want to use it in a futures contract as an underlying. To make delivery, you typically would pass delivery of a document of title.

And so when you're thinking about the prongs of the swap definition, what you know, it's not not an option, it's not an event contract. When you're thinking about this third prong of synthetic ownership of financial instrument, that is going to provide price exposure to something, but not provide ownership, you really do have ownership of these the underlying asset here. It's really just the title instrument.

And, additionally, there's kind of these exclusions, exemptions, that the CFTC has, promulgated through regulation that pertain to commercial instruments. And this is really an exemption that's not often relied upon, but really fits here, because these instruments are intended to serve commercial purposes, not really to be investment instruments. And so that's how I like to kind of analyze through these issues.

Evan Thomas

Thanks, Mike. I'm going to move to staking services, but I just wanted to press on one point that Jake referred to, the pooling of assets and pro rata distributions, as bearing onto the consideration of a common enterprise. And you know, one of the things in the descriptions of both the staking protocols, and I guess you do have, it seems, the pooling of assets for staking. So, just curious, is there anything you, and how would you address analysis of that? I mean, if there is this actual pooling of assets in these protocols or these services, how does that not bear, how does that not implicate, the common enterprise element of the Howey test?

Mike Selig

Yeah, I mean, so the 32 ETH construct is kind of an arbitrary number that the Ethereum team or developers kind of settled upon. But really, the notion when you're moving assets into the contract and they're being allocated on a programmatic basis of 32 increments, the pooling itself that's occurring here, it's not pooling in the investment sense. The assets are being moved into a contract that's facilitating the staking of the assets. In commodities world, you deal with fungible bulk, assets that are held in a grain warehouse, or in a silo, or in any sort of commodity warehouse. You kind of have to think similarly in terms of these smart contracts because really what's happening, if you think about your commodities.

Let's say you own a bunch of grain, you can store it in your own facility, right? I have a small apartment in New York City. It's not going to store a ton of grain, and it's going to be expensive and burdensome, right? So I can use a service provider, and get it in my own storage locker. All of the administrative headache and burden of that is that now pushed onto the provide. Or, I can have an even more efficient scenario where it's going to be cheaper for me and just easier to manage, where it gets stored in fungible bulk. Because it's a commodity with other people's stuff, right? I still own the percentage that I've put in. It's still my stuff. It's just a fungible bulk commodity. And so there's no reason for it to be in a separate facility for myself, or in my own apartment, or something like that. And so it's really an efficiency thing, and it goes back to these administrative services that we're talking about, right?

Everything's done for administrative reasons and, you know, not to add edge or add a more, you know, speculative element to it. It's just more efficient, right? And going back to a staking as a service model, if I were to use a common custodian, that, again, it's just the custody element of the whole thing. It's not changing the staking relationship and how the staking is performed. You know, the contract is allocating in an efficient way, and people are able to move assets in an efficient way, to have them maintain in a fungible, but at the end of the day, it's all going through the pipes of the Ethereum blockchain, and through smart contracts, nothing's being pooled for an investment purpose. It's being pooled for efficiency and for administrative reasons.

Evan Thomas

Thanks for that, Mike. With our last 10 minutes or so, I'd like to talk about a case decision and a case rather just last week between the Securities and Exchange Commission and Coinbase, where Coinbase staking services were at issue. And Scott, perhaps you could just take us through what the issues were in that case, and the gist of the judge's decision as it relates to Coinbase staking services.

Scott Bennett

Yeah, certainly. To start, it might be helpful to just give a little bit of context of where that case is. So that was a motion for judgment on the pleadings, so, a bunch of lawyer mumbo jumbo, but, effectively what that means is it's at an early stage in the case. There's been a complaint by the SEC saying, ‘Coinbase, you violated a bunch of securities laws, one of which is staking, there's others in the case.’ And then Coinbase responds, with their answer, ‘no, we didn't for all of these reasons.’ And then Coinbase moves for judgment on the basis of those pleadings to have a portion of the SEC's complaint, all or a portion, thrown out of court. That's effectively where we are, prediscovery, it's not an actual trial.

And so the judge, when looking at that, makes the determination, looking only at the pleadings and basically assuming the facts as alleged by the SEC are true, not the person seeking the judgment, you assume the other person's facts are true. Then can the judge conclude, as a matter of law, that there has not plausibly been alleged a violation?

And so that's the posture. So it's not a final determination. But in that posture, Coinbase ought to have, the SEC alleged in their complaint that Coinbase’s staking as a service platform violated the securities laws as an unregistered offering of Howey investment contract securities. Staking as a service on Coinbase is available broadly to their users. If they were to actually register it, it would, you know, need an S1 with the SEC that would look sort of bizarre and wouldn't really provide, you know, all that much information that would be useful to folks, for reasons discussed earlier. But that's effectively the allegation. You have an investment contract, and it's not, the ETH that's being staked isn't the investment contract, it’s the bundle of things around the staking as a service.

So in Howey, the investment contract there related to orange groves. But it wasn't actually the orange groves. It was the orange groves combined with management services, and so on, and so forth. And so when you're talking about staking as a service, whether or not you have a Howey investment contract, again, it's sort of this broader context to add it all together. Do you have an investment contract, in that the SEC has to allege all of the elements of Howey. Because if a person claiming not to have an investment contract security can defeat one element of Howey, you win. And so in connection with that, Coinbase was arguing, you know, multiple things, but there was particularly a focus on ‘no risk of loss.’ Because you don't, the underlying crypto has continued to be held and owned by the users, and the owners of the ETH, or the other proof of stake digital assets that were on.

There were five different ones that they provide the service for, and Coinbase agreed to indemnify, make whole, anybody, if there was slashing penalty, et cetera. There'd never been a slashing penalty on Coinbase. So you combine all those things together in one argument, there's no risk of loss, the risk of law, sort of no investment of money and no risk of loss is a challenging one, just based on the case law and the way this often gets argued. Because if there's any potential risk of loss, the SEC will often say that, yes, clearly there's an investment of money and there's some case law to support that, although there's case law goes in different ways. So winning on the ‘no investment of money’ is difficult, not impossible, but difficult.

And then a lot of the meat of argument was going to the efforts of others. Is Coinbase, in providing the staking as a service platform and what they're doing, essential managerial and entrepreneurial efforts, or is it really administrative, clerical, ministerial? And so this goes back to the question of are we talking here about an investment manager? Think about the management team, the board of directors that are running a business and making important decisions about how to move a business forward, versus ministerial services. I think a lot of the folks that are on this call, and myself included, we were involved in an amicus brief in the Coinbase matter that we filed on behalf of the DeFi Education Fund, where we very much argued that this is ministerial IT services, in terms of what really Coinbase is doing. Validators are publicly available open source software, you know, they can be run on Amazon Web Services, they can be run kind of easily in the same across different solo stakers, Coinbase staking, et cetera.

Where the judge really, ultimately did not grant Coinbase the decision, there was a few things. One, the judge focused on some of the statements that Coinbase had made around the fact that ‘staking on your own is complicated, confusing, and costly’ was the quote. Also, that there have been various statements about how much money people have made through staking, profits people have received through staking. So the judge was definitely focused in quite a bit on the amount of public statements that make it look like there's a profit making opportunity here.

And then the other thing that the judge was focused on is something more than ministerial efforts, that there's a lot of hard work that needs to be put into maintaining server runtime at, you know, a hundred percent, to get the most rewards. And some of that, to be honest, I was struggling to conclude was all that compelling, because the reality is slashing penalties are quite rare, or require something that's really an attack on the network. And just maintaining a server uptime, a lot of people use external cloud-based services anyway, and they're not doing anything with respect to that. And that's how a lot of staking as a service works anyway. And there is really no concept of, in the proof of stake world, ‘we are going to just blast the most computing power at this problem, to somehow create greater rewards’. That's just not how proof of stake works. And that's why we pivoted, in a lot of cases, from proof of work into proof of stake, because you don't want people doing that, because of the energy drain issues.

So there are statements in the decision from the judge talking quite a bit about the efforts involved in maintaining server uptime in doing all these things to make sure that you're optimizing and maximizing the return for staking. And I think there's real holes in that logic. But, going back to the original point I made about the case, that the procedural posture is to, as a factual matter, take what the SEC said in its complaint on its face and say, should we dismiss it, if we assume what's in there factually is true. So, hopefully as things move forward, there'll be a better opportunity through discovery, further arguments, et cetera, to refute those facts.

Evan Thomas

Thanks so much, Scott. We're coming up to near the end of our scheduled time, but I do want to ensure that everyone gets a chance to weigh in on this case. Maybe Tiffany, really just any thoughts on the case itself, you know, its implications for staking more broadly, or any sort of thoughts on the judge's reasoning that you'd offer, and then we'll go to Mike and Jake for their perspectives as well.

Tiffany J. Smith

Yeah, I mean, I think, the point that Scott began and ended with, the fact of where this case is, is probably the most important one, right? Because even if we were in a world in which the staking claim was dismissed, the SEC ultimately probably would still appeal it, right? That's likely going to happen with Ripple. So I think. in this world, unfortunately, we're just in flux. And even though this may be in some respects a minor setback, because it wasn't dismissed, I'm hopeful that when the parties get into discovery, some better facts come out. And in particular, it's important to know that these were the SEC's allegations of the facts. And we've seen other instances where it's not clear that the SEC's articulation or understanding of what was going on is always accurate. So I think we shouldn't get too worked up about this case, and just look forward for the discovery of the next phase of the trial.

Evan Thomas

Terrific. Mike, over to you for any comments?

Mike Selig

Yeah, I mean, I agree with everything that's been said. You know, I think there's definitely a dynamic here where a large amount of stake is performed by staking as a service providers, at, the majority probably of retail staking aside, from, you know, there are a number of solo stakers, but a lot of the staking on many of these networks is being done by these types of staking as a service providers. So I do think there's, you know, we've a number of us that have expressed frustration at the hostility that the SEC has kind of had towards the asset class. This, to me, is another kind of politically charged way to kind of undermine the use of these networks, undermine the ability of these networks, to really decentralize, which ultimately is kind of, you know, somewhat, if you look back to like the Hinman speech and some of the prior administration's views, you know, a lot of the goal is to make these networks more decentralized, more like Bitcoin. And this to me is, is kind of a way to kind of attack that and undermine the decentralization of these networks.

And so, you know, I just think there's a political motive here. And, you know, the reasoning behind saying certain administrative, ministerial technical services are, for some reason, kind of more of an investment contract than just the idea of holding your assets with the custodian is really mind-boggling to me because they're running very similar technology. It's very important that they custody assets in a certain way to maintain the security of those assets. And then to make the argument that just because you're earning rewards, if it's configured in a certain way, that's better for the network, better for the decentralization, undermines the idea that it could be a security. It's just really an odd way to approach regulation of the asset class.

Evan Thomas

Thanks. Jake, the last word to you?

Jake Chervinsky

Excellent. Well, I don't have much to add. I think that Scott, Tiffany, and Mike really nailed this one. So the only thing I'll do is to zoom out a bit and remind everyone that ultimately we have to interpret laws and regulations based on the underlying policy concerns that they're intended to address. And when you look at staking, whether it's native staking onchain or it's a staking as a service provider, we just don't see the type of principle agent relationship or the type of information asymmetry that would justify applying the securities laws. And I think the same is true for a lot of other federal regulatory frameworks. Like, you know, those that the CFTC enforce that we've been discussing today, they just don't seem to apply in this type of context. That's not to say that this is an unregulated space. There are many other laws and regulations that do ensure consumer protection and investor protection in this type of environment, but the securities and commodities laws just aren't the right fit for this type of technology. So I'll, I'll leave it there.

Evan Thomas

Absolutely. Thanks for ending on that note. And with that, thank you, first to our audience for joining us, and for being willing to to learn from our esteemed experts on this panel. And again, by thanking our panelists for taking the time to share their knowledge and their expertise with all of us today. Thanks so much.