ETHDenver 2023—Alison Mangiero, Executive Director of the Proof of Stake Alliance, caught up with Mike Selig, Counsel at Willkie Farr & Gallagher LLP.
The Proof of Stake Alliance recently published two white papers representing first research and analysis into key legal questions surrounding the taxation and regulation of liquid staking and LSTs in the US, which Mike conducted key legal counsel on with Willkie Farr & Gallagher. The two discuss LSTs, the POSA white papers on the regulation and taxation of liquid staking in the US, fostering industry growth, and more. Liquid staking tokens, or LSTs, are a key feature of liquid staking protocols like Liquid Collective. LSTs offer a unique way to stake with increased flexibility.
Hi everyone. I'm Alison Mangiero, the Executive Director of the Proof of Stake Alliance, and I am super excited to be here at ETHDenver with Mike Selig to talk a little bit about liquid staking and some of the work that we've done recently.
Absolutely. So, the liquid staking papers that we worked on really look at this digital commodity, right? We're looking at a new class of assets that are commodities—many of them, you know, although the current SEC chair views many to be securities...
I was just going to say, are you sure?
You know, Bitcoin, Ether, and many other digital assets are regulated by the Commodity Futures Trading Commission (CFTC) when they trade on futures markets as futures contracts, or in the swap markets as swaps. And so the CFTC has taken this view that there are crypto assets—like Ether—that are commodities and not securities.
So [for the POSA whitepapers research] we really started there, and started thinking about how in the world of physical commodities, you have what's called a warehouse receipt. That's typically what's used to deliver the physical assets, because nobody's lugging around bars of gold or grain—they're putting it in a silo or in a warehouse. You get this receipt, this document of title, that evidences your legal and beneficial ownership of that commodity.
Really, in the digital world, there's no reason that we shouldn't have these same types of primitive instruments that are used to transfer ownership of assets that might be staked. They might be in a protocol, they might be used for various purposes, but people still want to transfer those without pulling them out of being staked—or whatever purpose they're being used for.
So really, the liquid staking white papers started there. We started thinking about what the regulatory implications are of having a receipt for a liquid staking asset: for a crypto asset that's been put into a protocol to be staked. We thought through the securities issues, the commodity issues, as well as some of the tax issues.
So the TLDR: what exactly is an LST?
A liquid staking token is a receipt that evidences your legal and beneficial ownership of a staked commodity (digital commodity). Let's only focus here on digital commodities, so that the whole analysis as to whether something's a security or commodity—you know, that's an important first step—but when we're talking about assets like ETH and Bitcoin (if you're staking Bitcoin in some way... it may not be possible today) you're really looking at a digital commodity to start out. If that asset has been staked, and you get a receipt through a liquid staking protocol, that really is just facilitating that staking on behalf of the staker and giving you that receipt.
The whole concept here is really to add on a new technology layer giving you a receipt that allows you to transfer ownership, as opposed to just staking directly, where you don't have any receipt. You might be stuck: let's say you want to shift from one wallet to another for security reasons. You're not going to be able to do that without the receipt. So the receipt is really an important tool to help facilitate the growth of this ecosystem.
So, to clarify, when you were talking about the underlying token (meaning the original staked token), we were making an assumption there that that's a commodity, right?
Yeah, that's an important first step. We're not going to be able to turn a security into a non-security by putting a liquid staking wrapper around it. But the liquid staking wrappers are really meant to be very similar to what you get when you deposit grain into a silo. You're getting this receipt, this document of title, that allows you to transfer it.
And our view, in the view that we took in these POSA white papers, is really that the law and regulations should be technology-neutral. We shouldn't be taking a different view with respect to how we interpret case law and regulations in the context of digital commodities, simply because they're more liquid, or because it's easier to transfer in a digital context. Because the reality is, when I trade a futures contract on the CME or ICE, I receive a warehouse receipt if I take delivery. There's no, you know, shipping container that's going to show up at my doorstep with a bunch of pork bellies. I'm going to get a warehouse receipt or some sort of document of title that enables me to take custody of that.
And that's the same thing here. When some participant in the ecosystem chooses to stake their assets and receives a receipt for that, they may just want to hold their receipt. They may want the receipt so they can shift it between wallets. They may choose to use that in the DeFi ecosystem, or they may just want to transfer those assets and not be locked in to having the assets staked within an environment where they can't easily unstake them.
So how do the LSTs differ then—or not—from other staking products, and other situations where people are pooling tokens? What's the differentiator here?
The big differentiator is that a lot of the other staking products on the market today, where people aren't staking directly through self-staking, are really programs where there's some manager that's operating the program. And what we've seen with a lot of the centralized products on the market is that there is some operator of the program that you're depositing your crypto assets with, and that operator tends to offer a product that looks a little bit like an investment fund—where some of the assets might be staked, others may be held back to offer instant liquidity, or the product might have a fixed rate of return.
All of these sorts of features, that are added on top, that aren't crypto-native, these aren't the features that you get from the Ethereum blockchain. Of course, they're generating rewards from staking in the same way, but the rewards are kind of being managed by some operator as opposed to being organically generated by the network and then transferred on to the holder, or the staker.
In the context of a receipt token, it really mirrors the way that you stake with a blockchain network directly. So, you're receiving the rewards in an automated way from the network. Those rewards accrue to your receipt, and there's no management. The assets that are put into the protocol get staked, they're assigned to a validator, and the validator operates a node on your behalf, generates rewards, and those rewards accrue to your receipt. And of course, there's fees that might go to the operators and to the protocol developer, or to the DAO, or whoever else is associated with the protocol. But there's not the same management of a program where you're relying on someone's efforts to generate rewards for your account.
So why then—and, you know, this is a topic that I feel strongly about—is it important to call these tokens LSTs, to use appropriate terminology? When we are talking about these things, whether that's in legal white papers or on crypto-Twitter, what kind of implications does the language have here?
Derivatives are a very different instrument from a receipt or a document of title. Derivatives really provide synthetic exposure. The idea behind a derivative is that you're able to hedge certain risks by agreeing to purchase or sell something in the future, or having an option with respect to the ability to purchase or sell. These types of derivative instruments can be distinguished from a receipt or document of title that really provides actual ownership of something.
So when I want to take delivery of pork bellies and I receive this receipt, it allows me to go to the warehouse, or wherever the pork bellies are being stored, and pick up those pork bellies. When I purchase a futures contract, I'm kind of betting on the future price of something, and it's a synthetic instrument. Futures contracts tend to settle by offset. So when I purchase a futures contract, I sell that same futures contract with somebody else that has an offsetting position, and they net out. I receive my profit, or I pay my loss. And that's that. With a receipt token, there's always that underlying asset that's associated with it that it can be redeemed for.
It's a very different type of asset, and characterizing it as derivatives is problematic just because that's not what they are as a technical matter. But it's also problematic because under the commodity laws, just characterizing something as a derivative can have implications under the derivatives laws. So if you're calling something a swap, for example, and it becomes commonly known in the industry as a swap, the CFTC may be able to regulate that as a swap, whether it's a swap or not. And so that's really the linguistic issue when you're characterizing things as liquid staking derivatives as opposed to liquid staking tokens.
So obviously we've been working on these papers for a while, and the legal analysis for a while, and there are many folks involved in the working group and putting these arguments together. But, it seems like in terms of timing, we ended up releasing them just a couple weeks ago, and the regulatory environment in the U.S. has made these, I think, more important now than ever. So can you speak a little bit to the environment and the value you think these papers have in the current regulatory environment?
It's really important in the context of the current regulatory environment to be thinking about how the laws and regulations can be applied in a technology-neutral way. So we've had commodity markets for generations, since the earliest of times, and these markets have flourished and grown as a result of some of the innovations in contracting in documents and receipts.
Warehouse receipts have allowed for the storage of physical commodities in a warehouse, and the farmer or rancher who has deposited those can transfer ownership of that without having to actually pick up the goods from the warehouse and ship them off. The savings in costs and expenses to that farmer are massive. And it's the same thing really when we're talking about these new digital commodities. The cost in having to unstake something, and pull it out of the deposit contract, and then transfer that asset to someone, it could be massive. It might not even be possible to do, in the context of the current technology, due to withdrawal restrictions and unbonding periods. And so to build these new technological primitives, like digitally native warehouse receipts, like a receipt token, it's very important.
The white papers really take this position that should be taken in many contexts: that there should be technologically-neutral application of the laws and regulations to these new digital commodities. So I think that's really the big takeaway here, that the laws have been applied in a certain way for a very long time, and just because we have these new digital commodities, they shouldn't be applied differently. We shouldn't be looking at these as a new type of derivative or security or financial product. We should be thinking about how these are commercial products that are being used to transfer ownership of digital commodities in a commercial context.
All right. We talked a little bit about the current regulatory environment. Let's talk a little bit about self-regulation, and the role that the best practices and some of the industry principles that we've tried to produce as POSA can play.
A lot of the reason why we produced these legal white papers and open-sourced them is so that people have access to these arguments, and so that people in the industry and in these ecosystems who have questions can think about how they want to conduct themselves. So, maybe talk a little bit about the role of self-regulation as opposed to the regulatory state.
It's really important in this industry where we've had so many catastrophes and calamities—the Mount Goxs of the world, the FTXs of the world, the Terra-Lunas, to start taking responsibility and really think from a first principles basis: how can we self-regulate? How can we impose certain restrictions and requirements on ourselves that are going to allow this technology to grow within a safe environment, where we don't have the frauds and the wash trading and the scammers out there. I mean, there's so many scammers in this space, so much fraud, and it really gives the industry a bad name.
So to start to push back against a lot of these bad actors, and think about, “Okay, what are certain principles we can stand by? How as an industry can we come together to support each other and work together to establish some guidelines and guardrails around what we're trying to do?” Just starting with labeling things correctly, like not going around saying that things are derivatives when they're not, and also not permitting wash trading on your exchange, or permitting fraudulent trading and scams, and not supporting, you know, NFT projects that are trying to rug people.
It's important to have some basic guidelines and principles that can be thought of as a self-regulating constitution, almost, for the industry. Because these are the next generation of digital commodity markets, and they're not supposed to be some new degen commodity market. We're taking some of the best practices and constructs from the physical commodity markets that we've had for centuries and applying them to this new digital asset class. And it's important to have that self-regulation and moderation so that this isn't just regulated into oblivion.
Yeah. So—responsible growth. The industry is obviously growing, as we're seeing here at ETHDenver. Liquid staking ecosystems are continuing to grow, this technology is obviously going to be around for a long time. Any other key considerations that you think will come up, maybe that the white papers didn't address? I know we talked about them being a first step, so what do you think is on the horizon more broadly speaking?
I think that the most critical issue facing this industry right now is distinguishing digital commodities from securities, and really this whole idea that crypto is just this investable asset class—that every product is some sort of speculative instrument, that's tied to some team, that's gonna grow some project, and everyone's just betting on that project, right? I mean, in the words of the current chair of the SEC, 'there's always some team at the middle, and that's what we're looking to move the needle with these assets.' And that's not really the case.
I think that's why liquid staking is such an important use case, and really primitive, to be looking at here. And that's why we had such a great time researching it and really thinking through a lot of these issues. Because we're really seeing the evolution of these digital commodity markets in liquid staking, where we've had these receipt-type instruments for centuries.
There's been warehouse receipts, documents of title, bills of lading, doc warrants, all these types of receipts that have been used within commerce to really allow all sorts of market participants to transfer legal and beneficial ownership of their physical commodities while they're being transported, or stored, or held for some other purpose. And, you know, if you're sending cattle across the country in a ship and you've got a receipt evidencing your ownership of that, and the cattle has offspring, of course the offspring belong to that owner that holds the receipt, and not the person flying the plane or the ship or whatever.
So it's really important that we have these same sorts of digital primitives in our commodity markets today, and, really, pushing this whole digital commodity market into a speculative securities world misses the boat and really misses what's happening here—where you have assets that are being used to secure massive networks that are being used for all sorts of real commercial purposes.
We're seeing tons of massive brands and businesses building on these networks, and it's important that the physical—the digital commodities, rather—that are securing these networks, that are really providing the security for these networks, are treated as digital commodities and not treated as securities. And the digital equivalence of warehouse receipts and documents of title and all of that similarly should be treated as legitimate assets that are representative of some commercial purpose and not a speculative one.
All right. Well, Mike, it's been a pleasure working with you on the papers for months now. Thank you so much for holding the pen and thanks for taking the time to talk today.
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