Paradigm: Ethereum's new pledge model does not mean that ETH can be regarded as a security
Original title: "Ethereum's New「Staking」Model Does Not Make ETH A Security."
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Original compilation:old yuppie
1 Introduction
After Ethereum transitioned to the proof-of-stake consensus mechanism ("merger"), different critics believe that Ethereum's new pledge model may cause its original token, Ethereum (ETH), to be considered a security under US securities laws.
These arguments, however, stretch the interpretation of the Howey test to the point of no return, and fail to recognize that the fundamental purpose of securities law is to address information asymmetries, which in this case do not exist.
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2. Introduction to Securities Law
U.S. securities laws require issuers to register any offer or sale of securities with the SEC, unless an exemption exists. 2 Registration implies mandatory disclosure, ensuring that material information is shared with investors in order to make informed decisions, preventing information asymmetries, and avoiding agency problems.
The Securities Act of 1933 enumerates the types of instruments that constitute "securities," which include "investment contracts." 3 According to the Supreme Court's seminal opinion in Howey, an "investment contract" requires (1) the investment of funds; (2) in a common enterprise; (3) a reasonable expectation of profits; (4) s hard work.
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3. Application of Howey to Proof of Stake on Ethereum
The proof-of-stake consensus mechanism adopted by Ethereum has led various commentators to believe that ETH, or more specifically, the act of staking ETH, may meet Howey's definition of an investment contract. The argument is structured as follows: staking ETH as a validator satisfies the Howey test because the validator (1) "invests money" by locking up 32 ETH for staking, (2) is a "common enterprise" of parties involved in the validation process, (3) expect to receive profits in the form of staking rewards, and (4) these rewards come from the efforts of other validators or other parties involved in the verification process.
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3a. Proof of interest does not involve a "joint enterprise"
3ai. Legal standards
An important part of an investment contract is, as the Supreme Court said in Howey, a "joint enterprise." 10 While some courts have held that a common enterprise exists only if there is "horizontal commonality,"11 other courts have held that "vertical commonality" is sufficient to satisfy this principle in Howey.
3aii. There is no "horizontal commonality" between validators
Horizontal commonality exists when the wealth of each investor is linked to that of other investors through “pooling of assets, often combined with a proportional distribution of profits.” In other words, the court emphasized that horizontal commonality requires that an investor's expected profits be tied to other investors "through the entrepreneurial efforts of the promoters." 15 Horizontal commonality thus requires investors to forego any claim to personalization of profits in exchange for a participating and pro-rata interest in the promoter's subsequent distribution of profits.
Some people mistakenly believe that staking ETH implies horizontal commonality, because validators deposit ETH into a smart contract address, which purportedly means "asset pool", 17 or that horizontal commonality is allegedly discovered because validators There is a perceived "cooperation" between them.
To become a validator on the Ethereum network, you need to deposit 32 ETH into a smart contract address (called a "deposit contract"). 19 However, depositing ETH into a deposit contract is not a "pool" because ETH is never under the arbitrary control of the originator, who can use it to create value for ordinary businesses. Instead, the purpose of staking ETH is to create an incentive to secure the network; it ensures validators have something in the game so they can be punished for dishonest behavior. Also, while each validator's ETH is deposited in the deposit contract, it is not mixed and remains distinguishable. Each validator will also be able to withdraw their staked ETH once the feature is implemented in a future network upgrade.
Individual validators also have no proportional participation rights to any profits generated by the business. As explained further below, the rewards for different validators are different and are largely determined by the individual efforts of each validator; their fortunes do not rise and fall together due to the entrepreneurial efforts of any promoter. 20 Therefore, in analyzing the economic reality of pledge transactions, courts should find that there is no horizontal commonality.
3aiii. There is no "vertical commonality" between validators
Some courts have held that Howey's common enterprise doctrine can also be satisfied by vertical commonality, which focuses on the "relationship between the promoter and investor principals"22.
In general, the success or operation of the Ethereum network does not depend on any key party; it is "fully decentralized". 23 To ensure decentralization, Ethereum’s consensus mechanism allows validators to operate efficiently on their own without relying on any third parties. Validators come to the network freely and voluntarily, and they can choose to stop participating at their own discretion. Validators can fulfill their role in the network without relying on anyone. If they perform their duties correctly according to the rules of the network, they will be rewarded according to those rules, not according to the efforts of the promoters.
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3b. Staking ETH does not comply with Howey's "efforts of others" principle
3bi. Legal Standards
According to the Supreme Court's original formulation in Howey, one of the requirements of an investment contract is that the investor expects "to result solely from the efforts of the promoters or third parties." 25 This standard has been watered down by appeals courts, which have read "completely" and instead focused on whether the promoter's efforts were "undeniably significant"26 and "essential management efforts affecting the success or failure of the business." 27 According to SEC guidance, these efforts are typically characterized by “expertise and decisions that affect the success of the business through the exercise of skill and judgment”28.
Instead, the Court focused on whether investors had "control over the profitability of their own investments." 29 The greater the extent to which an investor relies on his own efforts for profit, the weaker is the case for characterizing the relevant transaction as an investment contract according to Howey. In these cases, applicable securities laws or disclosure requirements are unnecessary because there is no separation of ownership and control. 30 The court further listed several factors (known as “Schaden factors”) to test an investor’s “ability to control”31 (listed in order of importance). (1) the investor's access to information, (2) the investor's contractual rights, (3) the investor's contribution or time and effort, (4) the adequacy of financing, (5) the nature of the business risk, and (6) degree of speculation.
3bii. Application to Ethereum
Some have argued that Ethereum's transition from proof-of-work to proof-of-stake is also a transition from a competitive mechanism to a more "cooperative" mechanism32, since the verification process in proof-of-stake requires the participation of multiple parties. According to this view, when staking ETH, each validator has a reasonable expectation of earning staking rewards by relying on the efforts of other validators.
This argument is supported by the low-level implementation detail that validators are divided into committees under Ethereum’s unique proof-of-stake protocol.
More importantly, this argument misunderstands the mechanics of validator rewards in Ethereum's proof-of-stake implementation, and downplays Howey's original criterion of requiring "total reliance on the efforts of others" to an unprecedented degree. As we explain below, Ethereum validators and miners collaborated seamlessly in the pre-merge proof-of-work network and did not expect to be rewarded from the significant management efforts of other validators, but primarily from their own efforts and get a return on funds. In order to understand why this is the case, it is helpful to have a basic understanding of the rewards available to validators in Ethereum’s proof-of-stake network.
3bii1. Validator Rewards in the Ethereum Proof-of-Stake Network
There are many factors that affect the calculation of validator rewards. In Ethereum's Proof-of-Stake implementation, validators receive rewards every epoch (6.4 minutes), and these rewards are calculated as a multiple of the "base reward". 36 The base reward itself is determined by the number of validators active on the network ("total active stake") and dynamically adjusted to incentivize an ideally sized validator set.
Validators can vote for (i) the correct source; (ii) the correct target; (iii) the correct block header (collectively referred to as “accuracy rewards”), and (iv) send their proofs ( their votes) for inclusion in blocks ("inclusion rewards") to earn multiples of the base reward. Inclusion rewards are also split between provers and validators, with validators randomly selected to produce a block.
According to the researchers, assuming a fixed base reward over time, a validator’s profit is primarily determined by the validator’s ETH balance deposited in the network, capped at 32 ETH. 40
3bii2. Validators want to get staking rewards from their own actions, not from "others' efforts".
Analyzing the economic reality of staking ETH, the court should find that it does not comply with the principle of "the efforts of others" in the Howey case. The rewards for staking are primarily determined by the individual efforts of validators, rather than depending on any administrative efforts by third parties. As mentioned above, validators’ rewards are primarily determined by the amount of ETH they stake and their chance of getting a random proposed block, both of which are specific to the individual validator and do not depend on any third party.
In other words, validators retain the ability to control the profits of their investments. Applying the Schaden test,43 the control of validators is first manifested in the lack of information asymmetry; rewards are distributed based on transactions recorded on open-source protocols and public blockchains. Rewards are also determined based on validators' contributions of time and effort, as validators must maximize their uptime and stay connected to the network to avoid being slashed.
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4 Conclusion
Analyzing the economic reality of staking ETH on Ethereum’s proof-of-stake network, as noted above, the court should find that staking fails the Howey test because there is no “common enterprise” and validators never relied on “the efforts of others.” Although it is not the focus of this article, there are also questions about whether depositing ETH for pledge is eligible for "capital investment". And again, failure to meet any of Howey's four principles means that the transaction is not an investment contract and therefore not a security transaction.
But beyond legal analysis, applying the strict requirements imposed by U.S. securities laws to pledges would lead to an inappropriate and absurd application of the law. As we have noted, one raison d'être of securities regulation is to improve the information asymmetry that exists between promoters and investors through disclosure. Therefore, treating the pledge of ETH as an investment contract would impose a disclosure obligation on the "issuer" or "sponsor".
about the author
about the author
Rodrigo Seira is a cryptocurrency legal advisor at Paradigm.
Amy Aixi Zhang is a policy advisor at Paradigm Corporation.
Jake Chervinsky is director of policy at the Blockchain Association, an advisor to the Variant Fund, and a board member for the DeFi Education Fund.
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