Does Proof-of-Stake Violate Securities Law? Part II
Part I of this series described the principles of securities law and Proof-of-Stake consensus algorithms. This post will analyze the application of those principles.
Investment of Money
The first requirement for a security is the investment of money, which courts read broadly as “anything of value”. But what investment are we talking about?
An ICO will certainly entail the investment of money, but an ICO is a process for governing the initial allocation of tokens on the network — not how the tokens operate within the network. Purchased tokens need never be staked, and thus would never have any nexus with securities law.
At the staking phase, the investment is the PoS token itself. But note that at this stage, there’s no “offer or sale” of the asset — the asset is already in the system, and it’s not being sold, either by the owner or any other network participant, including a smart contract. Rather, the asset is bonded to guarantee the performance of the staking participant. If the participant is honest, the bond is returned; if the participant is dishonest, it will be destroyed.
Furthermore, not all participants need stake. Intuitively, it seems incorrect to say that the mere capability of staking (and the fact that some individuals do stake) “taints” all tokens on the network.
Evidently, whether staking involves the “investment of money” depends on whether posting a commitment device to ensure performance qualifies as “investment,” and the extent to which the ability to stake qualifies as an investment. Delegated stakes, however, will almost invariably involve an investment of money.
Common Enterprise
The term “common enterprise” indicates a venture in which participants act in concert, with the fortunes of all participants tied together. The question is, what “enterprise” is implicated in a PoS protocol? We have essentially two options, and it’s not immediately clear which of these interpretations should control:
1. There is no common enterprise; the protocol is merely a platform for individuals to use independently of each other.
2. The protocol is the common enterprise. The process of staking allows participants to act in concert to validate transactions, secure the network, and vote on protocol changes that participants expect to increase the protocol’s value.
On the one hand, the use of the token itself can be completely independent. Individuals can use the protocol for a variety of purposes; they may acquire their tokens through exchanges, by selling goods and services for tokens, etc. Indeed, individuals need not stake at all, and many participants will not. After all, staking requires bonding assets for a period of time. Thus, it entails not just a risk that the asset will be forfeit, but an opportunity cost for the inability to use the bond while it is staked. Some proportion of tokens, and some proportion of users, will never be staked.
However, an alternative view is that participants who stake are creating a common enterprise: acting in concert to secure the network. Each devotes a certain amount of capital, in the form of both physical equipment and staked assets, and contributes to the network proportionally.
The counterargument is that participants need not stake together. When a stake is called, that particular stakeholder must propose a valid block in a timely manner, at the risk of being slashed. This means that although honest stakeholders will each be called — and benefit from staking — roughly in proportion to their stakes, their fortunes are not actually tied together. A dishonest participant will be punished as an individual, leaving the rest of the network unscathed. Rather than acting in concert, stakeholders are acting in competition.
Similarly, stakeholders must allocate significant real resources — primarily storage space and high-bandwidth/low-latency Internet connections — to create blocks. That capital will be owned and operated independently; while any benefits will be proportional to the proportion of honest stakes, they will not be the result of other entities’ work. Although delegated-PoS protocols may weaken this capital requirement by allowing participants to stake using other entities’ equipment, participants will organize into distinct “pools” rather than staking with a single entity or with the network as a whole.
Analogously, in a PoW context, physical capital is allocated and work is performed individually, with rewards flowing approximately in proportion to the relative hashing power allocated to the network. Yet no one argues that PoW protocols implicate securities law.
Furthermore, for protocols acting as platforms or network infrastructure (like Ethereum or Tezos), the supposed “common enterprise” would essentially be a marketplace, rather than a particular business within that marketplace. In such cases, it seems ill-fitting to describe the protocol as a common enterprise given that the protocol is not itself generating any kind of economic activity. The real economic activity happens one level down, by individuals acting independently via the platform — not at the platform level itself.
Expectations of Profit
The basic case for rewarding staking is that participants incur an opportunity cost arising from physical capital deployment, loss of use of funds, and risk. The question is whether these rewards are profits.
One argument is that they are: participants gain valuable assets, which are sufficient to overcome the opportunity cost of staking.
The counterargument is that if all participants stake at equal rates, everyone’s wealth will scale by the same proportion, resulting in a general increase in the price level (i.e., inflation). Furthermore, because staking increases the money supply, it will tend to dissipate the holdings of individuals who do not stake. This rising tide does not actually lift any boats: although nominal holdings of each participant are increasing, their actual purchasing power is not. Thus, participants do not actually profit by staking; rather, they are caught in a Red Queen’s Race, running just to stay in the same place.
This property is important for the security of the network. Security is maximized when all individuals stake as much as possible, because this reduces the likelihood that any one actor controls which transactions are included in, or excluded from, the blockchain. A happy consequence of the Red Queen’s Race is that all participants are invested, in multiple senses, in the welfare of the network: every owner has a general interest in the network’s security (to maintain the value of unbonded assets), a direct financial interest (the risk of losing bonded assets), and active participation in creating and validating blocks.
To the extent there are profits, they result from a disproportionate level of staking. (Note that this is a very real possibility due to differences in individuals’ needs for liquidity.) Staking rates are especially likely to be different across consumers in non-delegated PoS protocols due to higher barriers to entry. If staking is only available to individuals wealthy enough to maintain the required equipment, relatively poorer individuals will stake less frequently, effecting a net transfer of purchasing power toward the relatively wealthier stakeholders. Staking will thus be motivated by the prospect of profit, and not merely a desire to avoid wealth dissipation. (One interesting consequence of this is the tension between the “common enterprise” and profitability elements. The higher the barriers to entry for staking, the less common the enterprise and the more profitable staking is. Delegation reduces the barriers to entry for staking, and thus reduces the differences in the rates at which participants stake and the real benefits to staking.)
Moreover, in PoS, any profits which may arise are not inherent to the tokens. As mentioned before, staking requires a series of deliberate actions, and individuals may always choose not to stake. Until they are staked along with physical capital, assets cannot produce any income stream.
Entrepreneurial Efforts of Others
The final element is whether the token’s value arises from the entrepreneurial efforts of others. For a pure PoS system, this will rarely be the case, because staking individuals will be called to propose blocks and will thus be acting on their own rather than relying on others.
Delegated PoS protocols, on the other hand, do implicate the entrepreneurial efforts of others. Individuals may assign their stakes to others, sharing in block rewards for increasing the likelihood that actor will be called. However, these delegated stakes would not require the owner to do any work. It seems fairly clear that delegated stakes satisfy this part of the Howey test.
Perhaps the strongest fact weighing against that determination is that only delegating individuals rely on others; many owners would either not stake, or would maintain their own nodes. Accordingly, reliance on others is not inherent to the token. Furthermore, a particular entity relied upon for that entrepreneurial activity is not a central figure, fixed, or even necessarily known in advance.
Summary
As with all cryptographic token protocols, implementation matters. However, for a general, platform-level token like Ethereum or Tezos, it appears that Proof-of-Stake is unlikely to satisfy all four elements of the Howey test. In particular, staking seems relatively unlikely to qualify as a common enterprise or to entail expectations of profits, and these two elements are in a fundamental tension. Additionally, the fact that all participants need not (and will not) stake seems to strongly cut against a determination that PoS tokens are inherently securities, and the inability to transfer stakes suggests that there is no real nexus with securities law.
Furthermore, pure PoS protocols do not involve entrepreneurial efforts of others, and arguably may not even entail a true investment of money. Delegated PoS protocols, on the other hand are very likely to involve investment of money and rely on entrepreneurial efforts of others.
To qualify as securities, digital assets need to meet all four elements of the Howey test, which seems unlikely. Therefore, it seems that a determination that PoS implicates securities law would depend on a fairly aggressive and unsophisticated interpretation of both securities law and the protocol. Such a determination would not achieve any of the SEC’s consumer protection objectives, and would additionally stifle innovation in the industry, forcing developers to adopt primitive and wasteful consensus algorithms. Any ambiguities in the applicability of the Howey test to PoS should be resolved in favor of innovation.
