Introduction/Casper
[1]The much awaited “Casper” upgrade is not yet implemented by Ethereum. Briefly Casper, it is in my view is a software to manage an investment scheme which comes under the Australia’s Corporations Act 2001 (Cth), that requires licensing and approval for the promoters. But first what is Casper ? For the sake of not repeating what others have already done, Casper is described in ( https://blockgeeks.com/guides/ethereum-casper/ ) as follows:
“Casper has implemented a process by which they can punish all malicious elements. This is how POS under Casper would work:
The validators stake a portion of their Ethers as stake.
After that, they will start validating the blocks. Meaning, when they discover a block which they think can be added to the chain, they will validate it by placing a bet on it.
If the block gets appended, then the validators will get a reward proportionate to their bets.
However, if a validator acts in a malicious manner and tries to do a “nothing at stake”, they will immediately be reprimanded, and all of their stake is going to get slashed.
Casper is not one specific project. It is an amalgamation of two research projects which is currently being undertaken by the Ethereum dev team. The two projects are:
Casper the Friendly Finality Gadget (FFG)
Casper the Friendly GHOST: Correct-by-Construction (CBC)”
[2]This is how another explains this recently when Casper codes were updated in May 2018. (https://www.coindesk.com/first-version-ethereums-casper-upgrade-published/)
Vitalik Buterin, who created ethereum, addressed the Casper upgrade at a conference in Toronto last week, calling it “hopefully one of the more joyous experiences in ethereum in a fairly short time.”
Once implemented, Casper FFG will alter ethereum’s software so that updating the blockchain involves a combination of proof-of-work — the electricity-intensive “mining” familiar from bitcoin — and proof-of-stake. The latter employs validators to update the ledger through a voting system within which users, sometimes called stakers, put down deposits of ether, which they risk losing if they attempt to cheat.
In its initial stages, Casper will retain ethereum’s current proof-of-work protocol to do most of the heavy lifting, using proof of stake to validate “checkpoints” periodically. Because the network can only handle so many validating nodes, the minimum deposit will start off at 1,500 ether, or $1.1 million at the current exchange rate.
The plan is eventually to move to a fully proof-of-stake system and to lower the minimum stake, but there is no definite timeline for that transition at present.
[3]Yet another to morph this complex idea in a simple way as described by V Buterin in https://www.coindesk.com/ethereum-casper-proof-stake-rewrite-rules-blockchain/
What separates Casper (and other more recent versions) from traditional PoS, is that it punishes participants who don’t play by the rules.
Buterin described it with a rough analogy: imagine 100 people sitting around a circular table. One person has a bundle of papers, each with a different transaction history. The first participant picks up a pen and signs one, then passes it onto the next person, who makes a similar choice.
Each participant only gets $1 if they sign the transaction history that most of the participants sign in the end.
“And if you sign one page and later sign a different page, your house burns down,” Buterin added, arguing that this is probably a good incentive to sign the right piece of paper.
[4]So the basic features of Casper is that Validators have to deposit ethers (ETH is the symbol for ether used for services on the Ethereum network) as a stake in the system to keep them honest. They are the ones that are going to sign the transactions and those that sign the wrong or questionable transactions will get their “houses burn down” as put by Buterin, the creator of Ethereum. It is like, instead of having licensed bankers looking after your financial records and able to sue them when they steal from you, you are asking strangers, automated programs called “pools” or even your mum and dad with “stakes” in the system to bet the transactions (for services) are valid of not before appending them to the block. Welcome to the brave new world of decentralised.
[5] At the Toronto Developer Community conference (“DevCon”) in May 2018, we have more definite answers to what and how Casper will account as seen in the colour slides below (courtesy of David Lim).
[5A] The significant finding here is the relationship between what is being staked and the return. According to Buterin, this is “Validator returns are proportional to the inverse square root of total deposits” In lay man terms this means the more deposits the less the return as seen below. This is only an example and not the actual figures to illustrate an inverse relationship between total deposit and returns.
[6] For example we can have a case where we started with 9 Validators with 1,500 ETH (min each*) and tenth with 2500 so total is 16,000 ETH. The inverse square root of 16,000 is 1/126.5 = 0.007 or 0.7% return on their ETH. These people will be making 0.7% return on their stake. The one with 2500 will be the lead signer and the rest will follow. Now assume in the second period two validators come on board with 4,500 ETH each making total deposit to be 25,000 ETH. The inverse square root of 25,000 is 1/158.1 = 0.006 or 0.6%. This means every Validator will be making 0.6% in the second period which is lesser. Note there is no distinction between those with more ETH, everyone get the same rate which is different with banks where they reward you more for more deposits.
- *Deposit is now 32 ETH — https://www.trustnodes.com/2018/06/16/casper-sharding-merger-confirmed-constantinople-back-table Casper and sharding are merged.
[7]In fact, Vitalik Buterin, ethereum’s inventor, estimates an initial ten million ETH will be staked, “Currently, an expected value is 10 million ETH staking at 5% interest, which is 500,000 ETH per year (~0.22 ETH per block).” (https://www.trustnodes.com/2018/04/20/ethereums-inflation-reduced-80-within-months-hybrid-caspers-specification-launches). In the same article, the author also remarked as follows:
“That means ethereum, and nodes, will basically get a decentralized savings account. Like the penny dividends in stocks, or the near 0% interest rate on your savings, ethereum will also automatically increase the amount of eth you have at a very competitive rate of 5%.”
[8]Obviously this can be achieved by participating in a stake pool which is like a “savings bank” in a smart contract.
Managed Investment Schemes
[8]Now no doubt the above scheme of taking deposit and paying an interest prima facie will raise some financial issues. For example, by receiving interest is this a deposit taking instrument or generally is this an Managed Investment Scheme as defined in section 9 of the Corporations Act 2001 (Cth) herein “Act” ? ASIC the Corporation regulator in Australia had considered this in general terms as:
“Managed investment schemes are also known as ‘managed funds’, ‘pooled investments’ or ‘collective investments’. Generally in a managed investment scheme:
people are brought together to contribute money to get an interest in the scheme (‘interests’ in a scheme are a type of ‘financial product’ and are regulated by the Corporations Act 2001 (Corporations Act))
money is pooled together with other investors (often many hundreds or thousands of investors) or used in a common enterprise
a ‘responsible entity’ operates the scheme. Investors do not have day to day control over the operation of the scheme. “
(https://asic.gov.au/regulatory-resources/funds-management/)
[9] With this in mind, this article will now consider whether Casper could fall under the definition of a managed investment scheme by which it has to be regulated to protect the innocent and not so savvy investors. To narrow down the definition, ASIC had excluded investments that are not managed investments schemes include: regulated superannuation funds, approved deposit funds, debentures issued by a body corporate, barter schemes, franchises, direct purchases of shares or other equities, schemes operated by an Australian bank in the ordinary course of banking business (eg term deposit) or retirement village schemes. It is clear Casper does not fall into any of these categories.
[10] In brief, Casper provides a mechanism where ETH can be deposited and interest (calculated by a formula above as decided by Buterin) are earned by ‘validating’ transactions on the Ethereum network. To validate this, let us go through the 3 elements under Section 9 of the Act:
A. The first element in par (a) of Section 9 — the definition requires that:
(a) “people contribute money or money’s worth as consideration to acquire rights (interests) to benefits produced by the scheme (whether the rights are actual, prospective or contingent and whether they are enforceable or not);”
[11] In Casper, holders of ETH (a well known crypto-currency) contribute to a staking contract under Casper’s protocol which is locked up for the duration where they are used as collateral to validate transactions. If the stakers/Validators signed on the wrong transaction, then their stake will be burned. This means they will lose their deposits and of course there is no interest at all. The first issue is whether ETH is “money” in the ordinary sense. ETH or Ether is the unit of currency in Ethereum. It is a token that can be exchanged for services on the decentralised platform. Bitcoin is a digital form of money and payment system as Bitcoin is not used for its services, its utility is merely to “transfer” from A to B, whereas Ether is a means of buying services within Ethereum. Ethereum network is programmable using Solidity to do a number of things like issuing more Tokens (ERC 20 format) in exchange for Ether like the one seen in https://token.depositoffer.com. I also noted that in the case of Burton v Arcus (2006) 32 WAR 366 at para 51, their Lordships had made it clear that at para 51 and I quote “51 It is settled that the broad words of the definition of “managed investment scheme” should not be read down.” In the same Judgment at paragraph 56 & 57, it says
“56 This element was described in par 19.6 of the explanatory memorandum to the Managed Investments Bill 1997 as “incorporating a purposive element in the definition”. In other words, the money or money’s worth must be contributed for the purpose of acquiring the relevant rights to benefits.
57 The word “contribute” means, in this context, to pay or supply. It is implicit in the first element in par (a) of the definition, in the context of the definition as a whole and the provisions of Ch 5C, that the people will pay or supply the money or money’s worth to or as directed by the promoter or operator of the scheme.”
(https://jade.io/article/10795)
[12] I am also fortified to note that “Money” is defined as “money includes a payment order” under definition in the Corporations Act 2001 and as it is not disputed that ETH is used for paying for services on the Ethereum network, then as per its usage it must also be “money”. With that in mind, by staking ETH, the stakers or Validators are contributing them as ‘money’ to acquire rights to benefits or as directed by the promoter or operator of the scheme. There is no issue about earning interest as Buterin had already advanced that. Repeating the above, Buterin said it is expected the value of contribution is 10 million ETH receiving 5% of ETH per annum. In Section 9 of Act, “interest” in a managed investment scheme was defined in terms which corresponded to those in par (a) of the definition of “managed investment scheme”. In particular, “interest” was defined to mean “a right to benefits produced by the scheme (whether the right is actual, prospective or contingent and whether it is enforceable or not)”.
B. The second element in par (a) of the definition of “managed investment scheme” has three aspects as summarized below:
(a) the contributions or some of them “are to be pooled, or used in a common enterprise”;
(b) the purpose of the pooling, or use in a common enterprise, must be “to produce financial benefits, or benefits consisting of rights or interests in property”; and
(c ) those benefits must be produced “for the people … who hold interests in the scheme” (whether as contributors or as people who have acquired interests)
[13] The Federal Court has said that knowing where resources are located and that the resources are available to the members fulfills the pooling condition. At paragraph 90, the learned Lordships explained :
In our view there is no justification for limiting the meaning of the word “pooled” by requiring that it involve a fund. In common experience many things other than money are pooled, including motor vehicles, typists and skills or talents. In such cases, there is no identifiable fund. Further, in its second sense the word “pool” does not necessarily involve a “physical concept”. The purpose for which particular resources arepooled may be fulfilled simply by knowing where resources are located and that they are available. Two other definitions were advanced by his Honour, namely “any aggregation of the interests or property of different persons made to further a joint undertaking or end by subjecting them to the same control and common liability” and a “common fund or combination of interests for the common adventure in buying or selling”. These definitions seem to be designed to meet specific situations and not to provide an exhaustive definition of the term “pool”
(Brookfield Multiplex Ltd. v Int’ Litig. Funding Partners Pte. Ltd [2009] FCAFC 147) (see https://jade.io/article/118716).
[14] In Casper, stakers or Validators can either run their own stake operation or pooled together with others (say when they do not meet the 1500 ETH or just recently change this to 32 ETH) into a pool which will optimize for staking/validation operation. Be that as it may, each staker or Validator by themselves individually with 1500 ETH/32 ETH as minimum will not be able to run Casper. This is because the benefit of a decentralized system such as Ethereum is to have many independent nodes doing validation by Validators as they do now with miners. This means there must be a pool of funds collectively even though those Valdiators act individually to protect their own stake.
[15]Even if I am wrong, in the alternative “used in a common enterprise” is also satisfied as it is not disputed that all stakers are there to validate (being the “common enterprise”) and to validate they need to offer their deposits minimum 1,500 ETH/32 ETH. For this effort of validating, they will be rewarded or receive a benefit which depends on the total stake deposits. As mentioned the larger the stake deposits the lower the return the Validators will received. The High Court in their Judgment in Australian Softwood Forests Pty Ltd v Attorney-General (NSW); Ex Rel Corporate Affairs Commission [1981] HCA 49; 148 CLR 121 considered this “common enterprise” and held that at para 133;
“An enterprise may be described as common if it consists of two or more closely connected operations on the footing that one part is to be carried out by A and the other by B, each deriving a separate profit from what he does, even though there is no pooling or sharing of receipts of profits. It will be enough that the two operations constituting the enterprise contribute to the overall purpose that unites them. There is then an enterprise common to both participants and, accordingly, a common enterprise. ”
[16] As to par ( c) above, to produce financial benefits, or benefits consisting of rights or interests in property, for the people (the members) who hold interests in the scheme, we again say that the promise of interest in the form of payout of ETH is not in dispute and is the root of this Casper protocol; otherwise there is no reason why Validators would stake their ETH for nothing. While one would argue that ETH is not “property” (real or personal) because it exists digitally as a computed figure in the user’s wallet as recorded on the blockchain, the fact that this figure exist at all clearly represents a benefit which can be used on the Ethereum network, as long as it is greater than zero. We also noted that under Section 229(2)(c ) of the Act, a financial benefit does not have to involve money as read below.
229(2)(c ) giving a financial benefit that does not involve paying money (for example by conferring a financial advantage).
[17] However, this “financial benefit” is only for Chapter 2E (Related party transactions) of the Act for members of a public company only and may not be applicable to unregistered managed investment schemes. In any event, Casper will still be paying out ETH at 5 percent per annum and ETH can be used for paying for services on the Ethereum network is not in dispute. Given that ETH is liquid and convertible to fiat currency on a number of domestic and global digital currency exchanges, we say this limb is likely to be satisfied.
C. The last element to complete this managed investment scheme is the members do not have day-to-day control over the operation of the scheme (whether or not they have the right to be consulted or to give directions)
[18] In the judgment of Burton v Arcus (2006) 32 WAR 366 at [81]-[83], his Lordship said that day to day control means control-in-fact and “does not, of course, require that there be activities in relation to the scheme on each and every day or even on most days during the term of the scheme.” In Casper, the scheme requires the Validators to stake their ETH in return for validating transactions, which is a day to day affair. The ETH stake is to ensure Validators will act in good faith or lose everything. However this ‘validation’ process had nothing to do with the overall scheme of Casper which is operated by codes written by the Ethereum folks. In short, the Casper’s codes run the scheme of things by managing the members’ processes of validation to ensure the block-chain records those transactions and checking for malicious acts. The codes determine how much Validators or stakers will be paid in terms of interest rate by a formula and obviously the same codes will burn all the ETH belonging to a Validator who had wilfully acted in bad faith. Validators also do not have no control over the membership side of the scheme and all validators are bound by the code. Unlike miners in the Proof of Work Scheme, Validators seem to have less control and are only tasked with validation in return for promise of ETH. We say this limb is likely to be satisfied since Validators cannot be said to have day-to-day control over the operation of the scheme which is programmed or coded once implemented.
[19] We say based on the above, it is likely to be unlawful under Australia’s Corporations Act as an unregistered managed investment scheme.
Now Casper 2.0 (Hybrid Version) -19 June 2018
At the time of writing, Justin Drake of Ethereum’s Sharding research team said through Reddit:
“We are considering changing the Ethereum 2.0 roadmap to skip Casper FFG with 1500 ETH deposits. Instead Casper and sharding validators would be unified from the get-go in the beacon chain, and deposits would be 32 ETH.”
[20] This will essentially change the system’s dependence on the central PoW chain to the beacon-chain itself. (https://bitcoinexchangeguide.com/ethereum-casper-v2-updates-proof-of-work-sharding-plasma-ffg-upgrades/)
Concluding remarks
[21] It is by no coincidence that there are similarities between Australia’s managed investment scheme, United Kingdom’s collective investment scheme, Hong Kong’s collective investment scheme and United State’s Howey Test for an investment contract. The following elements (1) an investment/contribution/arrangement (2) pooling of funds/common enterprise (3) profit/financial reward/benefit/return (4) management by someone other than the investor but obviously decided by different case precedents. As our conclusion is likely that Casper will fall under the definition of a managed investment scheme but unregistered, it may be of some insight to also consider the repercussion of implementing Casper for members based in Australia. While members are not the promoter, it may still be against the law to operate an unregistered managed investment scheme in this jurisdiction by simply running a node (updating Casper or taking a pool of ETH for instance) and to make or accept an offer in relation to an interest in an unregistered managed investment scheme in this jurisdiction (See Section 601ED(5) and Section 1020A of the Corporations Act). This may result in criminal penalties, compensation orders, injunctions and/or winding up of the scheme. Section 601EE(1) of the Act provides that member or in this case “Validators” may apply to the Court to have the scheme wound up. By Section 601EE(2) of the Act, it says “The Court may make any orders it considers appropriate for the winding up of the scheme.”
[22] Casper will be implemented by coders from the Ethereum Foundation which is based in Switzerland outside of Australia. However, once the codes are released onto the Ethereum network, it is up to individuals in Australia and indeed anywhere in the world who would want to be part of this Scheme by depositing their ETH as stake by updating their softwares. As the entire scheme is operated by machines in a decentralized platform, this makes the task of winding up an unlawful scheme impossible as it means shutting down machines/nodes of the Validators anywhere in the world. Of course the Court can shut down machines/nodes in Australia but that would mean higher interest rates will be offered as the deposit stakes get smaller; attracting more to stake in other jurisdictions. Be that as it may, the real benefit of Casper is that its code regulates itself and the Validators, making regulation redundant I would say….unless the entire crypto-currencies is a ponzi scheme (as suggested by some banker) as there is nothing to back all these ‘currencies’ which only truly exist in a ledger (block-chain) run by those Validator’s machines/nodes.