ETH Staking is a technical service, not a securities issuance, with profits mainly coming from network and market conditions, rather than third-party efforts.

Author: EVAN THOMAS

Translated by: Plain Blockchain

Since Ethereum transitioned from proof of work to proof of stake, some have argued that this makes Ether (ETH) or at least ETH staking a security.

These arguments do not hold up under scrutiny.

The correct understanding is that ETH staking is a technical service designed to ensure transactions on the Ethereum network are processed correctly and securely, rather than as an investment subject to securities laws. This holds true even if third parties (such as node operators or trading platforms) facilitate ETH staking. The stakers' profit expectations come from staking rewards and the ETH market, rather than from administrative and technical services provided by third parties.

1. Legal Framework: Defining "Investment Contract"

Whether an instrument or activity is subject to securities laws depends on the definition of "securities."

Under U.S. federal securities laws, the definition of securities includes various instruments, including "investment contracts." Rulings from various courts have refined the meaning of this term, but "investment contract" generally refers to an arrangement involving (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits, (4) primarily from the efforts of others.

This concept originated from the U.S. Supreme Court's ruling in the Howey case, which involved an orange grove and its profits. The court concluded that if a third party sells an orange grove and includes a contract to manage the grove and share its profits, it constitutes an investment contract subject to securities laws — the purchaser is not just buying land, but investing funds to earn profits based on the efforts of the third party in cultivating and selling oranges.

Subsequent rulings since the Howey case clarified that the "efforts of others" must be "undeniably significant managerial efforts that affect the success or failure of the enterprise." Administrative or "ministerial" efforts do not form an investment contract.

Considering the concept of "investment contract," Ethereum's transition from proof of work (POW) to proof of stake (POS) clearly did not turn ETH itself into an investment contract. Simply holding ETH does not automatically confer the right to staking rewards, so the transition to proof of stake did not create an investment contract.

A more nuanced argument is that staking ETH constitutes an investment contract, but this argument also does not hold up under scrutiny.

Technically, staking ETH means sending ETH to an Ethereum deposit contract and associating it with a specific validator; in other words, it is a software instance designed specifically to process transactions on the Ethereum network. If hardware or software failures lead to a validator violating Ethereum transaction validation rules, the network will impose penalties on the staked ETH associated with that validator (referred to as slashing). In essence, staking ETH serves as a financial guarantee for validators to perform operations as expected.

In the case of independent staking, where ETH stakers operate on their own, this is the simplest analysis. Since there is no "others" involved in the effort, there is no investment contract.

Staking through a staking pool or a centralized exchange's staking service

Some ETH stakers may prefer to have others operate validators on their behalf.

More complex situations — such as staking services provided by node operators, staking pools, or centralized trading platforms — require further analysis to determine whether this relationship constitutes an investment contract.

In most cases, staking with node operators does not mean transferring the staked ETH to the node operator. Instead, stakers associate their ETH with validators operated by the node operator and designate their own address for withdrawing the staked ETH and any rewards. All staking rewards and the original ETH can only be withdrawn to an address controlled by the staker, not the node operator. This ensures that stakers always maintain legal ownership and control of their ETH; there is no transfer of funds or value to others, except in the case of custodial staking services.

Similarly, staking through a staking pool, which is a smart contract deployed on Ethereum, associates the staked ETH with nodes operated by the staking pool on behalf of the stakers. When staking through this pool, stakers receive a transferable token that can be used to redeem their staked ETH and any accumulated rewards.

Again, this is programmatically implemented by the protocol, not by a third party. Importantly, neither the node operators nor any other third party gains ownership or control over the staked ETH or staking rewards.

Users of centralized trading platforms' staking services can also have the platform stake on their behalf. The platform arranges for the users' ETH to be staked with validators operated by the platform or a third party. While the custodial trading platforms do hold the users' ETH, their terms of service typically explicitly state that the staked ETH belongs to the users. The platform's role is to arrange for the ETH to be staked with validators and calculate rewards.

In all these cases, the presence of "investment of money" and "common enterprise" is debatable. Stakers retain legal ownership of their staked ETH, and except in custodial staking services, they do not even transfer their ETH to others. This contrasts sharply with investment schemes where investors transfer funds or other assets to "promoters" who have significant discretion over how these investments are used to earn profits.

Even if we assume that ETH staking does indeed involve a common enterprise, in cases involving node operators or trading platforms, stakers' profit expectations are not primarily tied to the efforts of third parties.

Staking rewards include consensus layer rewards generated by the Ethereum network itself when validators propose or confirm new blocks. They also include execution layer rewards, essentially fees paid by users to validators for prioritizing their transactions.

The timing and amount of these rewards depend on factors such as the total number of validators, the fees Ethereum users are willing to pay for transaction prioritization, and the state of the Ethereum network. Since the rewards are received in ETH, stakers' profits may also be influenced by the market price of ETH in their currency.

This means that stakers must anticipate profits based on network and market dynamics, rather than relying on node operators or trading platforms facilitating staking efforts.

Furthermore, the activities of node operators or trading platforms are not "entrepreneurial" or "managerial," as interpreted in case law. While node operators or trading platforms may provide technical and other services to enable stakers to earn rewards, these third parties typically use similar hardware infrastructure, run* open-source software, and follow similar best practices* to secure and operate their systems. They do not have proprietary methods or specialized knowledge that would enable their users to earn more rewards than others providing similar services. In fact, the reward rates for validators operated by different node operators are often very close to each other, rarely differing by more than a thousandth.

2. Lessons from Recent SEC Cases

The above does not mean that staking can never be part of a broader investment scheme subject to securities laws.

In February 2023, Kraken settled with the U.S. Securities and Exchange Commission over allegations that its staking services in the U.S. violated federal securities laws. More recently, at the end of March 2024, a U.S. district court judge denied a motion to dismiss the SEC's lawsuit against Coinbase's staking services.

In the case against Kraken, the SEC alleged that the exchange retained discretion over the rate at which users received staking rewards, smoothed out payments to users, and maintained an unverified token pool, allowing users to effectively bypass lock-up periods applicable to their staked tokens. Similarly, in the case of Coinbase, it was mentioned that Coinbase had maintained a liquidity pool similar to Kraken's. The key is that these alleged features are specific to how these exchanges provided staking services. They are not inherent properties of ETH or staking in general.

Importantly, these cases are not definitive legal determinations about whether these (or any other) staking services constitute securities offerings under U.S. securities laws. Kraken settled the charges without admitting or denying the SEC's allegations and agreed to cease its staking services in the U.S. Coinbase's decision only determined whether the SEC's allegations were sufficiently reasonable to proceed with the litigation.

3. Conclusion: Staking as a Technical Service, Not Securities Issuance

Even if stakers collaborate with third parties such as node operators and trading platforms for ETH staking, stakers' profit expectations still stem from network and market conditions independent of the efforts of these third parties. The economic reality is that these third parties are more akin to administrative or technical service providers, rather than promoters or managers of an investment scheme.

The fact that ETH can be staked does not mean it is a security, and earning staking rewards through staked ETH does not necessarily result in a securities issuance.

Source: Blockworks

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