Paradigm: The new staking model of Ethereum will not make ETH a security

Written by: Rodrigo Seira, Amy Aixi Zhang, and Jake Chervinsky, Paradigm

Compiled by: 0x11, Foresight News

Original publication date: October 2022

After Ethereum transitioned to a proof-of-stake (PoS) consensus mechanism, new concerns began to emerge within the community: the proof-of-stake model could lead to Ethereum's native token ETH being classified as a security under U.S. securities law. Some even went so far as to claim that tokens in a proof-of-stake system could be considered a type of security.

However, these arguments fundamentally misinterpret the Howey test and fail to recognize that the primary purpose of securities law is to address the issue of information asymmetry, which does not exist in this case.

As described below, Ethereum's adoption of a proof-of-stake mechanism does not make ETH (or staked ETH) an investment contract, meaning that securities law is not applicable in this context.

Understanding Securities Law

U.S. securities law requires issuers to register any securities offerings or sales with the U.S. Securities and Exchange Commission (SEC) (unless exempt). Securities registration necessitates mandatory disclosures to ensure that important information is shared with investors, allowing them to make informed decisions, preventing information asymmetry, and avoiding agency problems.

The Securities Act of 1933 enumerates the types of instruments that constitute "securities," including "investment contracts." As defined in the landmark Supreme Court opinion in the Howey case, an "investment contract" requires (1) an investment of money; (2) investment in a common enterprise; (3) a reasonable expectation of profits; and (4) profits derived from the efforts of others. To meet the definition of a security, a contract, scheme, or transaction must satisfy all four of these conditions simultaneously.

In interpreting "investment contracts," courts have rejected a literal interpretation of the statute, opting instead for a flexible interpretation that focuses on the "economic reality" of the relationship between the promoter and the investor. In various circumstances, if the fundamental economic relationship between the parties is not that of an investor and a promoter, courts have applied the concept of economic reality to limit the scope of "investment contracts" and the applicability of securities law.

Application of the Howey Test in PoS Ethereum

Ethereum's adoption of a proof-of-stake consensus mechanism has led some to argue that ETH, or more specifically the act of staking ETH, could satisfy the Howey test's definition of an investment contract. This argument follows this structure: staking ETH to become a validator meets the Howey test criteria because validators (1) "invest" by locking up 32 ETH, (2) participate in the validation process in a "common enterprise" composed of various parties, (3) expect to earn profits in the form of staking rewards, and (4) those profits come from the efforts of other validators or other parties participating in the validation process.

Setting aside whether validators depositing ETH into a smart contract meet the "investment of money" condition, the argument that Ethereum's adoption of proof-of-stake causes ETH to be viewed as an investment contract fundamentally misinterprets the second and fourth conditions of the Howey test. This conclusion would also lead to an absurd and unnecessary application of securities law, as there is no issuer or promoter entitled to information that could or should be disclosed.

Proof of Stake Does Not Require a "Common Enterprise"

Legal Standard

As stated by the Supreme Court in the Howey case, an important component of an investment contract is a "common enterprise." While some courts have held that a common enterprise exists only when there is "horizontal commonality," others have found that "vertical commonality" is sufficient to meet this requirement. As described below, staking ETH exhibits neither horizontal nor vertical commonality, and therefore cannot satisfy the common enterprise condition of the Howey test.

No "Horizontal Commonality" Among Validators

Horizontal commonality arises when the wealth of each individual investor is tied to the wealth of other investors through a "pool of assets" (often combined with proportional profit sharing). A "pool of assets," in turn, requires the issuer or promoter to commingle investors' funds and use them for a common enterprise. In other words, courts emphasize that horizontal commonality requires investors' expected profits to be "tied to the entrepreneurial efforts of the promoter" alongside other investors. Thus, horizontal commonality requires investors to relinquish any individual claim to profits in exchange for a proportionate share of benefits from the promoter.

Some mistakenly believe that staking ETH implies horizontal commonality because validators deposit ETH into a single smart contract address, which is viewed as a "pool of assets," or because there is a perceived "cooperation" among validators. As shown below, these arguments misunderstand the staking mechanism in Ethereum.

To become a validator on the Ethereum network, one must deposit 32 ETH into a smart contract address (known as the "deposit contract"). However, depositing ETH into the deposit contract does not constitute "pooling," as the ETH is never under the full control of the promoter. Instead, the purpose of staking ETH is to create an incentive mechanism that protects the network, ensuring that validators have a stake in the network's performance. Furthermore, while each validator's ETH is stored in the deposit contract, it does not mix but remains distinguishable. Once this feature is implemented in future network upgrades, each validator will also be able to redeem their staked ETH.

Individual validators also do not have rights to any proportionate profits generated by the enterprise. As further explained below, rewards for different validators vary significantly, primarily depending on each validator's individual efforts; their wealth does not rise and fall collectively due to any promoter's efforts. Therefore, when analyzing the economic realities of staking transactions, courts should find a lack of horizontal commonality.

No "Vertical Commonality" Among Validators

Some courts have held that the common enterprise condition of the Howey test can also be satisfied through vertical commonality, which focuses on the "relationship between the promoter and the investor." However, because there is no promoter, staking ETH does not create vertical commonality.

The success or operation of the Ethereum network does not rely on any single entity; it is "sufficiently decentralized." To ensure decentralization, Ethereum's consensus mechanism allows validators to operate autonomously without relying on any third party. Validators voluntarily join the network, and they can also choose to leave; they can act within the network without depending on anyone else. If they perform their duties correctly according to the network rules, they will receive rewards based on those rules rather than the efforts of a promoter.

The economic reality of staking transactions clearly shows that there are no promoters that validators rely on. Since vertical commonality requires that "the wealth of investors" be "tied to the wealth of the promoter," the absence of a promoter also means that staking ETH does not exhibit vertical commonality.

Staking ETH Does Not Satisfy the Fourth Condition of the Howey Test

Legal Standard

According to the original formulation by the Supreme Court in the Howey case, one of the requirements for an investment contract is that investors expect profits "solely from the efforts of the promoter or a third party." This standard has been softened by appellate courts, which have "read it separately," focusing instead on whether the efforts of the promoter are "undeniably significant" and "fundamental management efforts that affect the success or failure of the enterprise." According to SEC guidance, these efforts are typically characterized by "expertise and decision-making that influence the success of the enterprise through the application of skills and judgment."

Conversely, courts focus on whether investors "have the ability to control the profitability of their investment." The more investors rely on their own efforts to obtain profits, the weaker the justification for classifying the transaction as an investment contract under the Howey test. In such cases, there is no need to apply securities law or disclosure requirements, as ownership and control are not separated. Courts further outline several factors (referred to as "Schaden factors") to test the investor's "ability to control" (ranked by importance): (1) channels for investors to obtain information, (2) investors' contractual power, (3) investors' contributions or efforts, (4) adequacy of financing, (5) nature of business risks, and (6) degree of speculation.

Application to Proof of Stake Ethereum

Some argue that Ethereum's transition from proof of work to proof of stake also represents a shift from a competitive mechanism to a "cooperative" mechanism, as the validation process in proof of stake requires multiple parties to participate. Under this view, when staking ETH, each validator reasonably expects to earn staking rewards by relying on the efforts of other validators.

This argument is supported by the underlying implementation details, as under Ethereum's unique proof of stake mechanism, validators are categorized into committees. However, there are many other proof of stake protocols that do not assign validators to committees.

More importantly, this argument misinterprets the mechanism of validator rewards in Ethereum's proof of stake implementation and dilutes the original requirement of the Howey test that profits must be "entirely dependent on the efforts of others" to an unprecedented degree. As we will explain further below, Ethereum's validators collaborate little with miners in the pre-merge proof of work network and do not expect to receive returns from the work of other validators, but rather primarily from their own efforts and capital. To understand why this is the case, it is necessary to look at the rewards available to validators in Ethereum's proof of stake network.

Validator Rewards in Ethereum's Proof of Stake Network

Many factors influence the calculation of validator rewards. In Ethereum's proof of stake implementation, validators receive rewards every epoch (6.4 minutes), which are multiples of the "base reward." The base reward itself is determined by the number of active validators on the network and is dynamically adjusted to incentivize the desired scale of validators. The total amount staked in the network can be said to be the most significant factor determining the rewards a validator receives.

Validators can earn multiple base rewards through attestations (or accurate voting): (i) correct source; (ii) correct target; (iii) correct block header (collectively referred to as "accuracy rewards"); (iv) having their attestations (their votes) included in a block ("inclusion rewards"). Inclusion rewards are also distributed between the attester and the validator randomly selected to produce the block.

According to researchers, assuming a fixed base reward generated over time, an individual validator's profits primarily depend on the amount of ETH the validator has staked in the network, capped at 32 ETH. Proving with a higher balance leads to greater rewards and penalties, and vice versa. Over a limited time scale, a significant portion of the validation rewards will also depend on the random opportunities for the validator to receive proposed blocks.

Validators Seek Rewards from Their Own Actions, Not from "The Efforts of Others"

Analyzing the economic reality of staking ETH, courts should find that it does not meet the "efforts of others" condition of the Howey test. Staking rewards primarily depend on the individual efforts of validators, rather than relying on third parties. As noted above, the rewards for validators largely depend on the amount of ETH they stake and the random opportunities they receive for proposed blocks, both of which are specific to individual stakers and do not rely on any third party.

In other words, validators retain the ability to control the profitability of their investments. Referring to the Schaden test, the validators' control is first demonstrated by the lack of information asymmetry; rewards are distributed based on open-source protocols and transactions recorded on a public blockchain. Rewards also depend on the time and effort contributions of validators, as they must maximize their uptime and maintain connectivity with the network to avoid penalties.

While there may be incentives for validators to encourage other validators to join the network (for example, when it leads to increased base rewards), and to rely on the actions of other validators to maximize rewards (for example, by propagating attestations), validators never depend on the efforts of others requiring the skills and judgment of others as mandated by the Howey test.

Conclusion

As shown above, analyzing the economic realities of staking ETH on the Ethereum proof of stake network, courts should find that staking fails to meet the conditions of the Howey test because there is no "common enterprise," and validators never rely on "the efforts of others." While not the focus of this article, there are also questions regarding whether staking ETH meets the "investment of money" criterion. However, failure to satisfy any of the four conditions of the Howey test would result in the transaction not being an investment contract, and therefore staking ETH is not a securities transaction.

Beyond the legal analysis, applying the stringent requirements set forth in U.S. securities law to staking would lead to inappropriate and absurd applications of the law. As we pointed out, the rationale for the existence of securities regulation is to improve the information asymmetry that exists between promoters and investors through information disclosure. Therefore, viewing the staking of ETH as an investment contract would necessitate imposing disclosure obligations on a "issuer" or "promoter."

As noted above, there is no identifiable issuer or promoter when staking ETH. However, if we accept the premise that validators play the role of promoters or issuers, the absurdity of subjecting them to registration, reporting, and disclosure requirements becomes evident. Would securities law require validators to disclose information to each other? What important information would validators need to disclose? How would this help mitigate any information asymmetry, and how would it serve the public interest? The impracticality of answering these questions illustrates the flawed logic of applying securities law to validators: they do not constitute the risks that disclosure is intended to address.