Does Proof-of-Stake Violate Securities Law? Part I

Disclaimer: The following post is not intended as legal advice and should not be relied upon when making investment decisions, designing protocols, or other activities which this post touches. It is intended to foster discussion only. Consult with a qualified legal advisor before acting on any subject touched by this post.

In late July of this year, the Securities and Exchange Commission (SEC) affirmed that cryptographically-secured digital assets (often called “cryptocurrencies”) are potentially subject to US securities law. This is especially concerning to the industry, as these assets’ primary value stems from the fact that they are out of the control of individual entities; protocol developers have few ways of monetizing their work outside a crowdfunding model, and lack the expertise and resources necessary to navigate the complex regime surrounding securities.

At the 2017 Cryptoeconomics and Security Conference (CESC), a number of participants raised an interesting question: do protocols relying on Proof-of-Stake (PoS) violate US securities law?

This series will explore the relationship between securities law and consensus algorithms, with a special focus on Proof-of-Stake. Part I will describe some of the essential concepts of securities law; Part II will discuss the application of those concepts.

Background

Proof-of-Stake is a new consensus model designed to mitigate some of the concerns raised by the canonical Proof-of-Work (PoW) system used by Bitcoin. In PoW, miners may create blocks only after finding a solution to a complex cryptographic puzzle. The effort required to solve this puzzle signals that the miner is behaving honestly, and controls spam on the network. However, PoW has a few notable problems:

1. Mining is extremely wasteful, burning over $1 million of electricity per day with no value added (other than the security of the network). And “Proof of Useful Work” — such as contributions to a distributed supercomputer — would reduce the felt cost of mining and thus undermine security.

2. The costs of mining create incentives for miners not to process transactions. Congestion drives up transaction fees, which are necessary to pay resource costs.

3. Miners lack certain economic incentives to maintain the network. After amassing a certain threshold of hashing power, it may become more profitable for a miner to attack the network than to support it (the “51%” attack). Realistically, a 51% attack is unlikely because such collusion would quickly drive the value of the token to zero. However, malicious entities outside the network (e.g. a wealthy individual or government intent on destroying the currency) can procure the necessary computing power independent of the system. Additionally, miners may take computing power offline in response to changes in electricity or asset prices.

PoS aims to resolve these problems by assigning the right to propose a block randomly, with the probability of being selected dependent on how much a participant “stakes” (i.e., puts up as collateral to guarantee honest performance). This has a number of attendant advantages:

1. Because a cryptographic puzzle is no longer necessary, PoS consumes only a fraction of the electricity that PoW would. This reduces waste and friction, as well as the incentives toward network congestion.

2. Because nodes may be called to propose a block at unpredictable times, and may — in some implementations — be punished (“slashed”) for failing to propose a valid block, they have an incentive to remain online as much as possible.

3. An attack on the network requires expending significant real resources. A 51% attack on PoS requires purchasing the majority of the (staked) assets on the network. Aside from the direct expense involved in such an accumulation of assets, achievement of that threshold guarantees that the harm of the attack will fall primarily on the attacker. Furthermore, if such an attack is detected, the honest nodes can easily sanction the offender (for example, by slashing the offender or forking the protocol).

Separating Securities From Underlying Assets

Part of the issue is whether the asset in question is the PoS token itself, or the bond. (Most debts or other financial commitments can be traded or assigned to others, after all.) A person who says “I promise to pay X dollars if I don’t perform Y” is creating a security — the promise — although the underlying asset — dollars — are not securities.

Put another way, if there were a smart contract that issued StakeCoins that granted voting rights, could be traded, and could be redeemed at some later date for value greater than the purchase price, those tokens would resemble a debt-equity hybrid and would almost certainly be regarded as securities.

The Complication

The conceptual difficulty arises from the fact that the stakes in a PoS protocol are not tradeable, and do not result in distinct assets. Under US securities law, it is unlawful to sell, or offer for sale, a security which has not been registered with the SEC. The act of staking locks up the asset, preventing anyone from transferring, spending, or controlling it. The questions we have to resolve are twofold:

1. Does staking violate securities law?

2. May tokens capable of staking be traded without registration?

Notably, tokens created from block rewards are granted, not sold, so even if the tokens were securities, the act of staking would not seem to implicate unlawful activity under US securities law. Indeed, stakes cannot be traded in any way. Sale of tokens on exchanges, however, might — it depends on how the analysis for the other elements shakes out. The essential question is whether the mere capability of staking makes a token a security, even when the token is unstaked.

To determine whether an asset is a security, the SEC uses the so-called “Howeytest,” which provides that an asset is a security if it has all of the following characteristics:

1. Investment of money

2. In a common enterprise

3. With the reasonable expectation of profit

4. Based on the entrepreneurial efforts of others

Here’s the basic argument in favor of treating PoS tokens as securities:

Any asset produced in connection with an ICO, or otherwise placed at risk, will necessarily involve an investment of money. Because there is always an opportunity cost to staking (tying up capital, if not risking their being slashed), block rewards and transaction fees are necessary to incentivize staking, thereby generating an expectation of profit. Delegated-PoS models, wherein holders can assign their stakes to others, raise additional concerns about the reliance on entrepreneurial efforts of others. Even in a non-delegated system, however, a holder’s returns will be statistically proportional to the holdings.

Part II will examine each of these elements in detail.