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To Stake or Not to Stake: The SEC Coinbase Debate

The Securities and Exchange Commission sued Coinbase in early June for offering unregistered securities services to its users, including its staking feature, which allows everyday individuals to participate in validating transactions on blockchain protocols. The lawsuit spurred conversation in the crypto community about government regulation of cryptocurrencies — specifically about how crypto assets should be labeled.

With the emergence of blockchain technology, all protocols must determine a mechanism to validate on-chain activity. Such a mechanism safeguards against malignancy, ensuring that it is difficult to change data on the blockchain. Consensus systems are established by the protocol’s creator upon inception, and they ensure that all nodes on the blockchain are in agreement. Blockchain technology is decentralized, all data exists on a distributed ledger; therefore, reaching a “consensus” is easier said than done.

Bitcoin, the first blockchain use case, implements a consensus system called Proof of Work. Proof of Work verifies the accuracy of data added to the blockchain through miners. Miners operate computers which race to solve cryptographic puzzles for the blockchain. The first miner to solve the puzzle earns the right to edit blockchain’s data and in return receives the cryptocurrency yielded from transaction fees. A drawback to this process is that these cryptographic puzzles require significant computational effort and time to solve. Bitcoin’s aim was to present an alternative to traditional, fiat currencies; therefore, because of its relatively simple purpose, Proof of Work is a scalable consensus mechanism.

Ethereum, on the other hand, is far more complex: its creator, Vitalik Buterin, intended for the software to be used as a building block for decentralized financial applications. The computational time and effort necessary for Proof of Work is unviable for a blockchain like Ethereum. Proof of Stake was developed as a solution to this problem. Individuals stake a portion of their cryptocurrency, so that they can be selected to add new data to the blockchain. Like miners, stakers receive cryptocurrency from adding new data to the blockchain, also in the form of transaction fees.

Both mining and staking have relatively high barriers to entry because, in addition to the technical expertise required, they require individuals to have one or multiple computers devoted entirely to the mining or staking process. Because this is financially challenging for many, some cryptocurrency exchanges have offered staking programs for their users. Most notably, Coinbase, a popular centralized cryptocurrency exchange, released a staking feature to its users in 2019. This feature allowed everyday users (i.e. those not able to become full blockchain validators) the ability to participate in and — potentially — profit from staking.

The SEC’s lawsuit against Coinbase alleges the company offers users brokerage, exchange, and clearing services all of which are unregistered and unregulated. S.E.C v. W.J. Howey Co. established the “Howey test,” a legal test determining whether a financial agreement qualifies as an investment contract. According to the SEC, this “so-called ‘Howey test’ applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities.” The “Howey test” alleges that an investment contract is defined as “the investment of money under a common enterprise with reasonable expectation of profits derived from the efforts of others.”

The SEC specifically pointed to Coinbase’s staking service calling it an “unregistered offer and sale of securities.” Paul Grewal, Coinbase’s Chief Legal Officer, challenged the SEC’s lawsuit asserting that the “Howey test” is inapplicable in this context. Grewal writes that Coinbase has not violated the laws put forth by the SEC because “staking is not a security.” He asserts that participants in staking are not “investing” their crypto assets as they are not trading for “a separate financial interest.”

While Grewal is correct that stakers are not explicitly trading their assets for a “separate financial interest,” his assertion that stakers maintain “full ownership” of their crypto assets is not entirely correct. Through Coinbase, stakers are not able to stake and un-stake their cryptocurrency immediately, something that Coinbase itself acknowledges when outlining the “risks of staking.” This is because staked cryptocurrency is locked up during a vesting period and individuals are unable to use the assets for other purposes.

Grewal continues to argue that staking services “do not meet the ‘common enterprise’ prong of Howey.” He writes that they “are only connected by the blockchain technology and validate transactions through a community of users.” Stakers are simply participants in a blockchain ecosystem. They are, therefore, not connected by a “common enterprise,” as blockchains can house a plurality of use cases — some of which are financial, some of which are not. It is imprudent of the SEC to use such an umbrella term to refer to this environment.

Addressing the final qualification of “Howey’s test,” the cryptocurrency yielded from staking is not a return on investment. As described above, stakers dedicate their computer systems towards validating on-chain activity. The transaction fees accrued from staking are payment for this service from the blockchain ecosystem. By providing a staking program, Coinbase lowers the barriers to entry that staking poses. Rather than maintaining their own computer system, however, stakers contribute to the maintenance of a joint Coinbase computer system through fees they pay.

Ultimately, it is hard to say whether or not the SEC is right in suing Coinbase. Grewal’s defense of Coinbase’s actions is robust and accurate; however, governments across the world need to institute some basic form of regulation to protect industry participants from fraud and other financial crimes. As crypto becomes integrated into mainstream financial systems, existing government systems must be amended to accommodate this revolutionary technology. If not, the unproductive struggle between the cryptocurrency industry and government agencies that we see today will persist.