Need Validator Information? Your Proof of Stake Blockchain Has It

Evan Weiss
Jun 27, 2019 · 9 min read
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This year we have seen a rise in the utilization of Proof of Stake (“PoS”) as a consensus mechanism. Whether it’s Tezos’ continued maturation, the launches of Cosmos and Algorand, or Facebook announcing their plans to launch a PoS based blockchain, these variants of staking are gaining real traction. As these networks begin to gain attention and adoption, it is not without the enhanced scrutiny from regulators. On the forefront of the emerging staking economy is one key consideration: due to the open source nature of PoS networks, many securities-related legal concerns are mitigated when token holders engage with staking as a service (“StaaS”) providers.

Proof of Stake Networks and Staking

PoS networks replace miners with validators. These validators are required to “stake”/lockup in-kind tokens in a protocol smart contract in order to be given the opportunity to validate the transactions in the given blockchain. By staking these tokens, the validator is signaling to the network that they are going to be a good actor. If the validator includes the correct transactions, they are compensated with an in-kind reward (i.e. “inflation or staking reward”). However, if the validator acts negligently (i.e. their validator node is not online) or maliciously (i.e. double spend attack) it risks (i) losing the opportunity to earn rewards, or (ii) the staked tokens (“Slashing”).

There are many different iterations of PoS. In this post, we will be focusing on PoS networks where token holders have the ability to receive rewards (unlike in EOS where token holders only have the ability to vote for validators).

Staking as a Service

The process of running a validator node requires a deep understanding of each applicable PoS network along with experience running technical infrastructure (i.e. DevOps). Viktor Bunin of Bison Trails recently published a great article on the challenges of running PoS infrastructure. However, PoS networks have transitioned the security of the network from miners (i.e. individuals who have the technical expertise and purchase specialized hardware) to token holders (most of whom do not have the knowledge or domain expertise required to run blockchain infrastructure). If token holders fail to stake their tokens in these PoS networks, it is likely that the underlying value and utilization of those assets will diminish in value and ultimately may become worthless. This is because the network has a higher likelihood of being unsecure and subject to malicious attacks (double spending) that compromise immutability and fungibility. It is extremely important that token holders participate in the security of PoS networks to help thwart these risks. Understanding security is of the utmost importance; the developers of these PoS networks created technology that makes it easy for token holders to participate in the staking process. This process is called delegation. Token holders have the ability to transfer their rights to validate transactions (what we call “Validation Rights”) to another entity who does so on the token holder's behalf. The majority of token holders currently delegate to a StaaS provider, which is a company that specializes in running blockchain infrastructure. StaaS are service providers who work with token holders to receive delegations, validate transactions, and earn rewards. The rewards earned (minus a service fee for the StaaS) are then distributed back to the token holder. Token holders are incentivized to participate in securing the network because those who do not participate will have their holdings deflated opposed to other token holders who chose to participate will receive a greater share of the network inflation (ie. rewards).

Securities Laws

Before we dive into how securities concerns might be implicated in certain PoS networks, it is important to understand why securities laws were enacted and what they stand to protect against. The Securities Acts (of 1933 and 1934) were passed in reaction to the Stock Market Crash of 1929 and the ensuing Great Depression. As stated on the SEC’s website: “[t]he laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.” The SEC did not want the responsibility of approving which companies were good or bad investments, so instead, they developed a regulatory framework that requires companies to disclose all sorts of material information to stockholders. The underlying premise of such a disclosure regime is that if investors have full and accurate information, they can make fully informed investment decisions about which companies to invest in. Through disclosure requirements, regulators hope to remove any information asymmetries between the promoter/managers of the company and the owners/investors.

Staking and the Howey Test

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Individuals who are familiar with PoS have a deep understanding of why StaaS companies are service providers and why they play an instrumental role in the growth and adoption of PoS networks. However, on its face, the relationship between a StaaS provider and a token holder could potentially be seen as a securities transaction. When applying the highly discussed Howey Test, a delegation agreement or relationship could be seen as an “investment contract”. Below is an example of arguments the SEC could make for why this relationship might be viewed as an investment contract:

  1. Investment of Money — The Supreme Court has held that for this prong to be met, the investor must risk financial loss. In a network with Slashing or where the Staas provider is required to take custody of the digital assets, there is the potential that a holders assets could be lost (although it is much harder to make this argument with a network like Tezos where most delegators are not subject to Slashing).
  2. Common Enterprise — StaaS providers usually pool Validation Rights of their delegators to validate transactions. Additionally, most StaaS providers take a percentage of the reward earned as a fee for providing their services. Taking these two facts together it is very likely that a court would hold that a common enterprise exists.
  3. Expectation of Profits — The third prong of the test requires that the investor expect a profit from interacting with the promoter. The SEC could make the argument that delegating and earning rewards is seen as a profit opportunity. This argument is bolstered when a StaaS provider utilizes marketing that focuses on the opportunity to earn “yield” or “interest” through staking. (NOTE — at POSA, we believe that the main objective when participating in staking is to help secure the applicable network and to protect against being deflated; i.e. why we use the terms inflation rewards and inflation rate).
  4. Managerial Efforts — The final prong of the Howey Test asks “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” The SEC could argue that in a delegation relationship, the token holder is just passively relying on the StaaS provider to run the necessary infrastructure to earn the rewards.

The above is an extremely one-sided analysis of why a delegation could be viewed as an investment contract. At POSA, we have done extensive legal research as to why a delegation does not constitute an investment contract (which we will be sharing more details about in the futre). For purposes of this post, we instead want to focus on how the open source nature of these networks mitigates any securities concerns regulators may have.

Open Source Blockchains (are full of valuable information)

PoS networks are built on open source software. The power of open source networks is that it allows anyone with internet access the ability to inspect, contribute or audit the networks code. Additionally, the open source nature of these networks allows material information concerning the network to be openly verifiable. For Bitcoin and other major protocols, this means data around transactions amounts, active addresses, mining hash rates, and other key metrics.

PoS networks also include critical information related to validators and their role in the network. This information includes the number of assets delegated, block creation success rates, node up-time, reward payout accuracy, and voting history. This staking specific data is material to a token holder who is evaluating which StaaS provider he or she should delegate to. Additionally, there is a strong argument that this type of quality, staking specific information, is much more relevant for a delegator than the information contained in a registration statement usually required by the SEC. SEC registration statements provide public investors with financial and managerial information about the issuer of the securities, details about the terms of the securities offering, the proposed use of investor proceeds, and an analysis of the risks and material trends that would affect the enterprise.

Delegators are not equity holders or owners of the StaaS provider they engage with. Having access to a StaaS providers financials would not be material or useful to a token holder when they are determining which StaaS provider to engage with. For example, this would be similar to the SEC requiring Amazon (assuming Amazon wasn’t already a public company) to provide financial and managerial information prior to customers being allowed to use AWS. The costs of going through registration will be passed down to the consumer which will increase prices while not offering any meaningful protections.

As PoS networks mature, there are a few different tools/companies that provide material information related to StaaS providers to token holders. We take a look at each category below:

Block Explorers

Block explorers are web browsers which contain a history of the entire blockchain in a searchable format. Block explorers curate information regarding transactions on the network so it’s easy for anyone to have a view of exactly what is happening on a specific network. Additionally, PoS networks’ block explorers contain information specific to validators including their assets under delegation, the number of delegators, percentage of self delegation (i.e amount of bond the validator itself has posted), missed blocks, up-time, and fee). For semi-sophisticated token holders, block explorers are a great place to find material information regarding potential validators.

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Cosmos Mintscan Block Explorer

Staking Marketplaces

As PoS networks have grown there has been a rise in the number of StaaS providers that token holders have the option to choose from. This has made it more difficult for token holders to discern exactly who would be the best provider for them. However, there are a few companies that are creating marketplaces that help connect token holders to validators. Union Marketplace, Staker, and Vest are a few companies that are helping curate material validator information from the networks and displaying it in a way that is easily digestible for token holders. The Marketplaces are also taking information not stored on the network and providing it to token holders, including information regarding the StaaS providers management teams. As new token holders begin to participate in the security of networks they will likely utilize these marketplaces. The marketplaces will give token holders the ability to compare key validator metrics including their fees, past performance, return on delegation, and payout schedules. The ability to compare validators based on key performance metrics makes it more likely that token holders will have the necessary information to make informed and educated delegation decisions.

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MyTezosBaker
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Staker

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It’s important for regulators to understand how much material information is contained in open source blockchains. This information is available to anyone and cannot be corrupted or altered by any one party (see Enron). As the staking space evolves, it’s going to be necessary that this information is curated in ways that make it easy for delegators to be informed when choosing a StaaS provider.

Proof of Stake Alliance (POSA)

The Proof of Stake Alliance (POSA) was formed to promote…

Evan Weiss

Written by

Founder Proof of Stake Alliance; Former M&A/Emerging Companies Attorney @ Holland & Knight LLP

Proof of Stake Alliance (POSA)

The Proof of Stake Alliance (POSA) was formed to promote the greater education of Proof of Stake technology through collaboration and dialogue among stakeholders.

Evan Weiss

Written by

Founder Proof of Stake Alliance; Former M&A/Emerging Companies Attorney @ Holland & Knight LLP

Proof of Stake Alliance (POSA)

The Proof of Stake Alliance (POSA) was formed to promote the greater education of Proof of Stake technology through collaboration and dialogue among stakeholders.

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