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Coinbase Explains Why Crypto Staking Service should not be Classified as Security

Coinbase Explains Why Crypto Staking Service should not be Classified as Security

Crypto Staking Service is not a Security under the US Securities Act, nor under the Howey Test. Trying to superimpose securities law onto a process like staking doesn’t help consumers at all and instead imposes unnecessarily aggressive mandates that will prevent US crypto consumers from accessing basic crypto services which tends to push U.S. crypto Users to offshore and on unregulated platforms.

Paul Grewal, Chief Legal Officer at Coinbase opined recently on CoinBase’s blog that;

At Coinbase, we’ve been committed to providing our users with a secure, compliant platform to access the cryptoeconomy since day one, and our staking products are not securities.

But there are a lot of products in the market called staking and many of them work very differently. Today I’ll focus on core staking services (protocol-based, on-chain staking), like the ones Coinbase offers, which are a vital aspect of crypto and blockchain technologies.

Staking allows anyone, anywhere, to contribute to the security of a blockchain and to be rewarded for their efforts. But while anyone can participate in staking activities, the average crypto user will generally use a service provider like Coinbase to keep the servers running and software up to date. However a crypto owner chooses to stake, they provide a critical service to the crypto ecosystem, allowing proof of stake blockchains to operate seamlessly.

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The reason your crypto earns rewards while staking assets is that you are putting your crypto to work in exchange for a payment from the blockchain itself. Cryptocurrencies that allow staking use a “consensus mechanism” called Proof of Stake, to ensure that all transactions are verified and secured without a bank or payment processor intermediary. If you choose to stake your crypto, it becomes part of that process, but it remains your crypto at all times.

Press Statement from Coinbase Exchange on the recent SEC Legislation on Crypto Staking Service

To put it simply, no. Staking is not a security under the US Securities Act, nor under the Howey test, which the SEC uses to determine whether an investment contract is a security. The Howey test comes from a 1946 Supreme Court case and there is a separate discussion to be had about whether that test makes sense for modern assets like crypto. Regardless, staking fails to meet the four elements of the Howey test: investment of money, common enterprise, reasonable expectation of profits, and efforts of others.

First, staking services do not constitute an investment of money, even under an expanded definition that includes any “specific consideration” that is given up “in return for a separable financial interest.” When a customer asks us to stake some of their crypto, they aren’t giving up one thing to get something else – they own exactly the same thing they did before. Staking customers retain full ownership of their assets at all times, as well as the right to “unstake” those assets consistent with the underlying protocol.

Second, staking services do not meet the “common enterprise” prong of Howey because assets are staked on decentralized networks. Stakers are only connected by blockchain technology and they validate transactions through a community of users, not a common enterprise. The fortunes of users are not tied to those of Coinbase because staking rewards are determined by the protocol—not by anything that Coinbase does. Therefore, this does not meet the case law definition of common enterprise.

Third, staking services fail to meet Howey’s “reasonable expectation of profits” element. To determine this, courts look at whether a customer is attracted to an asset based on the prospects of a return on investment or a desire to use or consume the item purchased. Staking rewards are simply payments for validation services provided to the blockchain, not a return on investment. They are set by the blockchain protocol and are the same whether the customer stakes on their own or through an intermediary like Coinbase. The only difference is that a user who stakes on their own may need to buy a dedicated computer and pay to keep it running, while the customer who stakes through Coinbase, pays us a fee to do those things on their behalf.

Finally, staking services do not pay rewards based on the “efforts of others.” Service providers’ staking services are not entrepreneurial, managerial, or a significant factor in whether customers receive staking rewards or the amount of rewards received. The relevant blockchain protocol governs which validator nodes receive rewards and the amount of rewards paid for each token staked by that node. Service providers simply use publicly-available software and basic computer equipment to perform validation services and do not perform any managerial efforts. These are IT services, not investment services.

Why this matters

The purpose of securities law is to correct for imbalances in information. But there is no imbalance of information in staking, as all participants are connected on the blockchain and are able to validate transactions through a community of users with equal access to the same information. Trying to superimpose securities law onto a process like staking doesn’t help consumers at all. Instead, unnecessarily aggressive mandates will prevent US consumers from accessing basic crypto services in the US and push users to offshore, unregulated platforms.

Blockchain technology can spur significant economic growth in the US and staking is a safe and critical aspect of that technology. Coinbase supports sensible regulation in our industry. But regulation by enforcement that does nothing to help consumers and drives innovation offshore is not the answer. Getting it right on staking matters.

However, Kraken’s settlement with the U.S. Securities and Exchange Commission to end its crypto-staking activities has pushed bitcoin below $22,000 range amid high-selling pressures, the development also caused Coinbase’s shares to drop to its lowest point. Apparently, Coinbase has insisted that it won’t be ending crypto staking services on its platform and that it’s prepared to fight the US securities regulator on this issue. Coinbase is likely to win if they take on SEC on staking, SEC has only defined staking on CEX but kept  mute on staking on DEXs— they are pushing everyone to self custody.

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