Proof of Stake and regulatory uncertainty
I wrote a post in September 2022 about the regulatory uncertainty in the US around Proof of Stake and whether Proof of Stake tokens could be considered securities. The argument that staking tokens were securities centered around Common Enterprise in the context of delegated Proof of Stake, Liquid Staking and MEV and the Howey’s test.
In light of recent activity around Kraken’s staking service and the SECs decision, it has again bought the whole issue of staking into the foreground again and the role of the tokens, and the validators. As I also wrote about in my previous blog there are other activities that also need considering in the big picture, namely liquid staking and the role played by validators in Miner Extractable Value (MEV).
The Proof of Stake mechanisms (there are many flavours of the main concept) work, in that the network is secured through the locking up of tokens known as stake and this is confers voting authority. This means that in order to attack the network and take control the attacker would need to acquire tokens, and as the supply is locked in stakes the cost of the tokens would increase as the demand forces the price up and thus make it financially unviable to attack the network. I explored this theme in the aftermath of the Terraform/Luna collapse in a blog post and how Tgrade has taken a layered approach to secure the network.
There are two questions around Proof of Stake which have potential regulatory implications. Firstly the status of the native token used for staking, and secondly the role of validators and their relationships with delegators and MEV relayers.
The status of native tokens used in a Proof of Stake blockchain from a regulatory perspective is not totally clear. In EU the MiCA regulation due to be implemented in 2023/4 is clear what a utility token is:
A type of crypto-asset which is intended to provide digital access to a good or service, available on DLT, and is only accepted by the issuer of that token
It is subject to minimal legislation such as the need to publish a whitepaper, backed by a legal entity in EU, act honestly in the interests of the token holders and notification in your “home state” that you intend to offer the tokens. So far so good. In US it is less clear as clarification is being sought through the courts as to whether utility tokens are indeed securities with the SEC vs Ripple case that rumbles on. On the face of it a utility token is not a security (unless the SEC finds a strong case to say otherwise).
How does staking fit in with the utility tokens? There are several flavours of Proof of Stake, and for the purpose of this discussion I will focus on delegated Proof of Stake. The argument for this centres around a competant validator with a strong technical and devops background but not necessarily flush with capital, to be able to offer a reliable service with 100% uptime, and safeguards to prevent double signing with a fair commission makes it attractive to delegators. In an ideal world, delegators, do their research into the validators, and should spread their tokens across validators.
What has happened in practice is that there are validators offering 0% commission to attract delegators, delegators who do little research other than identifying the top 10 validators and the centralised exchanges pooling their client funds as stake run a validator service. This manifests itself as a concentration of power to the centralised exchanges and large validator operations, a separate topic for now, but gives context to the role of the validators and how they operate in practice.
Where it went wrong for Kraken was that they offered a yield with no-unbonding periods which are common in delegated Proof of Stake networks. It made a compelling argument for self-custody and staking the tokens directly, especially in light of the confusion at FTX about the need to segregate client tokens/funds. It could thus be argued that this is an issue for centralised exchanges and it does not impact the delegated Proof of Stake model as a whole.
For me the key point, and one I have argued before is the role of the validator as an agent and not a principal. As an agent you open yourself to interpretation that you are offering a financial product, especially as the cost of slashing or being jailed is one that can be covered by the validator thus creating a riskless model. Could a regulator look at this activity with the lens that the validators are in effect intermediaries and the delegators profiting from the endeavour of others?
I have made a case for an alternative approach where the validators are principals and raise the tokens they need for staking using bilateral loans. The token holder lends their tokens to a validator for a fee and the validator has an obligation to pay the fee and return the tokens to the holders at the end of the term. It is clear where the boundaries lie and what each party does. The fee would vary on the validator’s performance and reputation in line with the risk and reward balance.
Regulatory clarity will be achieved in the medium term but there are risks of legislation which may impact the delegated Proof of Stake models. This is one of the reasons why the decision was made in Tgrade not to include delegators.
If then add to the mix the role of validators in the growing MEV markets, where they take a commission for the processing of the transactions ordered by a MEV relayer. This could be viewed as another agency role where they are extracting rent from the MEV relayers, or it is also argued that this additional income incentivises more validators to secure the network.
The ethics of MEV and whether it is market manipulation or a good way to make markets more efficient and provide value for the network is another topic to explore. This will be under scrutiny from the regulators as it is has grown since 2019, generating $600m in profits between 2020 and 2022 while impacting billions of dollars of transactions. It would be imprudent to order a complete ban on the activity but the scrutiny may have consequences in examining the roles of the participants namely searchers, relayers and validators. Validators may come into the regulatory cross-hairs through their involvement in MEV and in their relationship with delegators.
Although Tgrade is a public blockchain, businesses building their applications are using the Trusted Circle mechanism for the issuance and trading of digital assets which require onboarding and only participants of a Trusted Circle have permission to own, and trade digital assets in their Trusted Circle. This by definition restricts who can trade and thus makes Tgrade MEV resistant.
