Whether Liquid Staked Tokens can be classified as Security or Commodity under US Law?

 

What are Liquid Staked Tokens?

Liquid Staked Tokens (LST) are a new type of digital asset that has emerged in the decentralized finance (DeFi) space. These tokens are created by staking proof-of-stake (PoS) assets, such as Ethereum, and then issuing a token that represents the staked asset i.e., Receipt Token[1]. The token can then be traded on various exchanges, providing liquidity to the underlying asset.

Preliminary reading of both Securities and Commodities Act.

The Securities Act of 1933 defines a security as “any note, stock, treasury stock, security future, bond, debenture…or investment contract.” The Howey Test[2] is often used to determine whether an investment contract exists. The test has four criterion: (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits; (4) solely from the efforts of others. Thus, any security meeting all four criterion will indicate the existence of an investment contract.[3]

The Commodity Exchange Act defines a commodity as “all goods and articles…in which contracts for future delivery are presently or in the future dealt in.” The Commodity Futures Trading Commission (CFTC) has jurisdiction over commodities and commodity futures contracts.

Therefore, based on the preliminary reading of the law, the classification of LSTs would depend on their specific characteristics and how they are marketed and sold[4].

i. If the tokens are marketed and sold as investment contracts with an expectation of profits primarily from the efforts of others, they may be classified as securities under US federal securities laws. The Howey Test is often used to determine whether an investment contract constitutes a security.

ii. If the tokens are marketed and sold primarily as a means of exchange or a store of value, they may be classified as commodities under the Commodity Exchange Act (CEA). The CEA defines a commodity as any physical or virtual good, article, service, right, or interest that is the subject of a futures contract or option on a futures contract.

Whether Liquid Staked Tokens can be classified as Securities or Commodities?

Regulators in the United States are divided over whether cryptocurrencies should be classified as Securities or Commodities under existing law. SEC Chair Gary Gensler has emphasized that all cryptocurrencies except Bitcoin are securities and are subject to SEC oversight. Gensler stated that ETH adopting a proof-of-stake consensus model would classify it as a security.

On the other hand, the Commodity Futures Trading Commission has ruled that cryptocurrencies are commodities under the Commodity Exchange Act on two separate occasions. The first instance was the complaint against the FTX founder Sam Bankman-Fried and the second was against Samuel Lim and Changpeng Zhao, the leadership of Binance.

This divergence in opinion has created much confusion as to how cryptocurrencies ought to be defined under US law. This is illustrated very clearly in the KuCoin dispute. Wherein recently, the New York State Attorney General (NYAG), Letitia James filed a suit against KuCoin, claiming that ETH can be classified as a security. Ms. James argued that ETH is a security because it was marketed and sold as a profit opportunity that was contingent on the growth of its network, which was dependent on the managerial efforts of its founders and management team. Additionally, sums of ETH's distribution were reserved for its founders and management team, thereby appearing to tie the fortunes of the token holder to the management teams, creating a common enterprise. Therefore, according to the NYAG, ETH meets the definition of an investment contract under US federal securities law and could be classified as a security under the Securities Act.

Furthermore, the NYAG also argued that the shift to proof-of-stake significantly impacted the core functionality and incentives for owning ETH, because ETH holders now can profit by merely participating in staking. Having said that, Ms. James in the same complaint against KuCoin also alleged that under the Martin Act tokens like ETH, Luna and UST can be classified as both securities and commodities. It is unclear whether the courts will apply the Martin Act or the Securities Act in the present case thus making it’s classification still unclear.

There is however still considerable debate surrounding the classification of Liquid Staked Tokens which is highlighted by the recent whitepaper published by the Proof of Stake Alliance (POSA), wherein they argued the following:

Receipt Tokens, regardless of the liquid staking arrangement, do not satisfy any element of the Howey test. It is evident, from the analysis that liquid staking does not involve an “investment of money”. Therefore, Receipt Tokens represent legal and beneficial ownership of staked cryptoassets, which can be traded on secondary markets for liquidity purposes. Following are the criterions in the Howey Test:

i. Investment of Money - Proof of Stake Alliance (POSA) argues that liquid stakers do not make an investment of money when they allocate their cryptoassets to a protocol or service provider to be staked in exchange for receipt tokens. This is because liquid stakers retain legal and beneficial ownership of their staked cryptoassets[5], and any fees retained by the protocol or service provider are made in exchange for services rather than as an investment[6].

ii. Common Enterprise - Based on the relationships between Liquid Stakers and the protocol or service provider, POSA submits that Liquid Stakers do not participate in a “common enterprise” with the protocol or service provider (either under a horizontal or vertical commonality theory), but instead engage in a bailor-bailee relationship with the protocol or service provider whereby the bailee safeguards and stakes the bailor’s cryptoassets for a fee.

iii. Profits or Returns – Profits earned by a Liquid Staker in excess of those that the staker would earn by staking directly or via a staking-as-a-service provider, if any, are “far too speculative and insubstantial to bring the entire transaction within the Securities Act.[7]

iv. Efforts of Others - Liquid Stakers retain the actual power and authority to decide whether or not to stake their cryptoassets and engage a liquid staking protocol or service provider, and once engaged, each Liquid Staker retains the power to terminate the liquid staking relationship, which is the essential managerial decision[8], effectively precluding dependency upon the efforts of others for their profits. Liquid Stakers have full control over their ability to either redeem their Receipt Tokens for their staked cryptoassets or exchange their Receipt Tokens for another cryptoasset. Accordingly, Liquid Stakers do not rely on the essential efforts of any “other” to realize economic benefits from liquid staking activities.[9]

In conclusion, according to the Proof of Stake Alliance (POSA), LSTs do not satisfy any element of the Howey test and therefore should not be classified as securities. They argue that liquid staking does not involve an investment of money, LST holders do not participate in a common enterprise, the profits or returns are too speculative and insubstantial, and LST holders retain control over their staked assets and decisions. As such, POSA concludes that LSTs are not securities.

On the other hand there is an equally robust opposition to cryptocurrencies being classified as a commodity due to the relatively lax regulations surrounding commodities.

Conclusion

While there is differing opinion amongst various stakeholders as to whether Liquid Staked Tokens are to be classified as commodities or securities, what we can glean from the above discussion is that their classification varies far too greatly between agencies and ultimately it boils down to the same idea that it is quite difficult to categorize LST’s or cryptocurrencies in general into either of these categories as the Act’s regulating securities and commodities were not designed with assets like cryptocurrencies in mind. Thus the creation of a separate asset class for cryptocurrencies is the best answer.

However, as per the current laws and regulations Liquid Staked Tokens can be classified as either a security or commodity depending on the cryptocurrency on which the LST is based.

[1] U.S. Federal Securities and Commodity Law Analysis of Liquid Staking Receipt Tokens, Proof of Stake Alliance
[2] SEC v. W.J. Howey Co. [1946]
[3] U.S. Securities and Exchange Commission. “How We Howey, https://www.sec.gov/news/speech/peirce-how-we-howey-050919#_ftn5.” Accessed 19 April 2023
[4] The State of New York, by Letitia James, Attorney General of the States of New York v. MEK Global Ltd. and Phoenixfin Pte. Ltd. d/b/a KuCoin, https://iapps.courts.state.ny.us/nyscef/ViewDocument?docIndex=XDXIUrIw3tVafxqwEqVfKw==
[5] El Khadem v. Equity Sec. Corp., 494 F.2d 1224, 1228 (9th Cir. 1974).
[6] SEC v. Rubera, 350 F.3d 1090
[7] United Housing Foundation, Inc. v. Forman, 421 U.S. at 856.
[8] Affco Invs. 2001 LLC v. Proskauer Rose L.L.P., 625 F.3d 185, 191 (5th Cir. 2010). See also Williamson v. Tucker, 645 F.2d 404, 421 (5th Cir. 1981) (“So long as the investor has the right to control the asset he has purchased, he is not dependent on the promoter or a third party for ‘those essential managerial efforts which affect the failure or success of the enterprise.’”)
[9] Moreover, to the extent that liquid staking arrangements could be viewed as eliminating barriers to entry for stakers – insofar as Liquid Stakers need not operate and manage the hardware required to be a validator – we note that Liquid Stakers can select from a broad swath of liquid staking arrangements providing substantially identical technological solutions. Any efforts by a liquid staking protocol or service provider in making staking more accessible should not be viewed as “essential” efforts.