Securitization of Proof of Stake, the path to regulated validators?
The recent Merge of Ethereum made many headlines as it was a significant change from Proof of Work to Proof of Stake. The move to Proof of Stake was motivated by several issues, the reduction of the environmental impact as Proof of Stake does not require heavy computing power to secure the network, speeding up the network, and an ambitious plan to scale the network through sharding.
This is all technical stuff, and both Proof of Work and Proof of Stake are well understood, so what is the big deal?
Proof of Stake requires the network operators, called validators, to stake (lock up) tokens, which provides security by reducing the number of available tokens, and a mechanism to punish validators if they are an offline or double sign. As a working model, Proof of Stake is well understood and underpins many successful blockchains.
The very public change of Ethereum to Proof of Stake prompted Gary Gensler of SEC to generally talk about Proof of Stake and ask the question of whether they were investment contracts.
Delegated Proof of Stake is a common sub-set of Proof of Stake where token holders delegate their tokens to validators in return for a share of the rewards. Ethereum has adopted the Delegated Proof of Stake model. The validator's role as an agent rather than a principal in sharing a return with the delegators approaches a line which could see the act of delegating in expectation of a reward as security. The mechanisms are very close to a savings platform where I lend my capital for a return; the borrower, in the case of a savings platform, then lends out the capital to others for a fee (interest). The only difference in delegated Proof of Stake is that the tokens are not transferred but are held in the wallets of the delegators. We took the decision in Tgrade not to have delegations and proposed an alternative mechanism where token holders lent their tokens to the validators under a bilateral loan agreement, thus setting the validator as a principal and thus removing the potential ambiguity of the function of the token.
Liquid Staking has emerged in Proof of Stake chains as a way for token holders to earn a yield by locking up funds and still being able to use the funds and earn a further yield, such as through a lending protocol. Unlike delegation, there is no lockup window, meaning that the token holders can access their tokens without having to wait. The returns are commonly slightly lower than delegating. The interaction a token holder has is through a Liquid Staking protocol rather than directly with a validator. The risk to the network is not in the use of the native token as collateral but in the success of the Liquid Staking protocols, which accrue a large amount of tokens and thus have a high proportion of voting power. How is Liquid Staking classified? Under the Howey Test, it could be seen as a security? The presence of liquid staking on a protocol is beneficial to the liquidity and makes the token attractive to investors; however, it does question the underlying premise of the native token as a pure utility and nudges it towards securitization.
Miner Extractable Value (MEV) includes a range of activities from questionable front-running and sandwiching orders to arbitrage opportunities. There are “ethical” MEV operators that avoid the darker activities and offer returns to the validators and investors in return for a share of the activities. On its own, it is not a case to declare the native token a security; however, it is an economic activity very close to the operating of a network, and while an MEV platform may make a case for “ethical” operations, it is a very subjective area. It is much harder for MEV operators to operate in Tgrade, especially if businesses and organizations work within Trusted Circles and manage the permissions around Digital Assets.
In Europe, the MiCA legislation has been finalized and will come into force in 2023/4. Under MiCA, utility tokens are not classified as securities, nor are there questions around the roles of token holders, and their relationship between validators or the protocols that offer yields on the network’s native tokens. The EU has created the necessary regulatory certainty and while this may be reviewed in the future, this will not happen before 2023/4 at the earliest, and this ensures that businesses have the space to develop with certainty.
In the US, there is much more uncertainty as Common enterprise forms part of the decision made in the Howey Test. Common enterprise is where there is more than one investor who expects to earn profits from the efforts of the promotor. We see in delegators, liquid staking protocols, and MEV a relationship where token holders expect a profit from the activities of the promoters (validators, protocols, etc.), and this begins to look like Common Enterprise. This uncertainty as to how the native or utility tokens will be classified creates regulatory risk.
There is a danger of a two-tier system where the EU and US take different approaches to the classification of native or utility tokens. There is a way to mitigate the US risks around Common Enterprise by ensuring that there are no delegations or MEV. The Liquid Staking or staking pools can be considered differently as the protocols or pools are intermediaries; Tgrade mitigates the influence of pools by requiring validators to earn Engagement Points and has a Sigmoid reward curve to prevent the concentration of power in validators.