Ethereum’s new staking model does not mean that ETH can be considered a security

1. Introduction

Following Ethereum’s transition to a proof-of-stake consensus mechanism (the “merger”), various commentators have argued that Ethereum’s new staking model could cause its native token, Ethereum (ETH), to be considered a security under U.S. securities laws.

However, these arguments stretch the interpretation of the Howey test to an untenable extent and fail to recognize that the fundamental purpose of securities laws is to address information asymmetry, which in this case does not exist.

As explained below, Ethereum’s adoption of a proof-of-stake consensus mechanism does not render ETH (even staked ETH) an investment contract, and such a conclusion would render the application of securities laws to Ethereum meaningless.

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 applies. 2 Registration enforces disclosure, ensuring that material information is shared with investors to enable informed decision making, prevent information asymmetry, and avoid agency problems.

The Securities Act of 1933 enumerated the types of instruments that constituted “securities,” including “investment contracts.” 3 According to the Supreme Court’s seminal opinion in Howey, an “investment contract” requires (1) the investment of money; (2) in a common enterprise; (3) a reasonable expectation of profits; and (4) the investment to be made solely from the efforts of others.

In decisions interpreting “investment contracts,” courts have rejected literal interpretations of statutes and instead adopted a flexible interpretation that focuses on the “economic reality” of the relationship between promoters and investors. 5 In various cases, where the underlying economic relationship between the parties is not that between an investor and a promoter, courts have applied the concept of economic reality to limit the scope of an “investment contract” and the application of securities laws.

3. Howey’s application of Ethereum Proof of Stake

The Proof of Stake consensus mechanism used by Ethereum has led various commentators to argue that ETH, or more specifically, the act of staking ETH, may meet the Howey definition of an investment contract. The structure of the argument is as follows: staking ETH as a validator meets the Howey test because the validator (1) "invests money" by locking up 32 ETH for staking, (2) is a "common enterprise" of the parties involved in the validation process, (3) expects 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 validation process.

Regardless of whether the validator depositing ETH into a smart contract meets the conditions of "investment of funds",9 the argument that Ethereum's adoption of proof of stake causes ETH to be considered an investment contract fundamentally misunderstands Howey's second and fourth principles, and the failure of any one of them is fatal. This conclusion also leads to an absurd and unnecessary application of securities laws, because no issuer or promoter has the privilege of obtaining information and can or should be forced to disclose it.

3a. Proof of interest does not involve "joint enterprise"

3ai. Legal standards

As the Supreme Court said in Howey, an essential component of an investment contract is a “common enterprise.”10 While some courts have held that a common enterprise exists only when there is “horizontal commonality,”11 other courts have held that “vertical commonality” is sufficient to satisfy the Howey principle.

3aii. There is no "horizontal commonality" between validators

Horizontal commonality exists when each investor’s wealth is tied to that of other investors through “the pooling of assets, usually combined with a pro rata distribution of profits.” In other words, the court emphasized that horizontal commonality requires that an investor’s expected profits be tied to those of other investors “through the entrepreneurial efforts of the promoter.” 15 Horizontal commonality therefore requires that the investor give up any individualized claim to profits in exchange for a participation in and pro rata interest in the profits subsequently distributed by the promoter.

Some people mistakenly believe that staking ETH implies horizontal commonality because validators deposit ETH into a smart contract address, which allegedly implies “asset pooling,”17 or that horizontal commonality is allegedly found because there is perceived “cooperation” between validators.

To become a validator on the Ethereum network, 32 ETH is deposited into a smart contract address (called a “deposit contract”). 19 However, depositing ETH into the deposit contract is not a “pool” because ETH is never subject to 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 mechanism to protect the network; it ensures that validators have skin in the game so that they can be punished for dishonest behavior. In addition, 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 do not have a pro rata share of any profits generated by the enterprise. As further explained below, the rewards to different validators are different and are determined primarily based on the individual efforts of each validator; their wealth does not rise and fall together as a result of the entrepreneurial efforts of any one sponsor. 20 Therefore, in analyzing the economic reality of the pledge transaction, the court should find that there is no horizontal commonality.

3aiii. There is no “vertical commonality” between validators

Some courts have held that the Howey common enterprise doctrine can also be satisfied through vertical commonality, which focuses on the “relationship between the sponsoring and investor entities”22.

In general, the success or operation of the Ethereum network does not depend on any key party; it is "sufficiently decentralized." 23 To ensure decentralization, Ethereum's consensus mechanism allows validators to operate effectively on their own without relying on any third party. Validators come to the network freely and voluntarily, and they can choose to stop participating at their own will. Validators can perform their roles 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 promoters.

When it comes to the economic reality of staking transactions, it is clear that there is no promoter on which validators rely. Since vertical commonality requires that the “fate of investors” is “bound together” with the fate of promoters…24 the investigation ends without promoters.

3b. Staking ETH does not comply with Howey’s “others’ efforts” principle

3bi. Legal standards

One of the requirements of an investment contract, as originally formulated by the Supreme Court in Howey, is that investors expect “exclusive results from the efforts of the promoter or third parties.”25 This standard has been diluted by appellate courts, which have read “exclusively” into focusing instead on whether the promoter’s efforts are “undeniably significant”26 and “fundamental management efforts that affect the success or failure of the enterprise.”27 According to SEC guidance, these efforts are typically characterized by “expertise and decisions that affect the success of the enterprise through the exercise of skill and judgment.”28

Instead, courts focus on whether the investor has “control over the profitability of its own investment.”29 The greater the extent to which the investor earns profits through its own efforts, the weaker the case for characterizing the transaction as an investment contract under Howey. In these cases, application of securities laws or disclosure requirements is unnecessary because there is no separation of ownership and control.30 Courts further list several factors (referred to as the “Schaden factors”) to test the investor’s “ability to control”31 (listed in order of importance): (1) the investor’s access to information, (2) the investor’s contractual power, (3) the investor’s contribution or time and effort, (4) the adequacy of financing, (5) the nature of the business risk, and (6) the degree of speculation.

3bii. Application to Ethereum

Some argue 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 validation process in proof of stake requires the participation of multiple parties. According to this view, when staking ETH, each validator reasonably expects to receive 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 dilutes Howey’s original standard of requiring “sole reliance on the efforts of others” to an unprecedented degree. As we explain below, Ethereum’s validators, who work closely with miners in pre-merged proof-of-work networks, do not expect to be rewarded for the significant management efforts of other validators, but rather primarily for their own efforts and funds. To understand why this is the case, it is helpful to have a basic understanding of the rewards that validators can receive in Ethereum’s proof-of-stake network.

3bii1. Validator Rewards in Ethereum Proof of Stake Network

There are many factors that influence the calculation of validator rewards. In Ethereum’s Proof of Stake implementation, validators receive rewards every epoch (6.4 minutes), which are calculated as multiples of a “base reward.” 36 The base reward itself is determined by the number of active validators on the network (“total active stake”), and is dynamically adjusted to incentivize an ideally sized validator set.

Validators can earn multiples of the Base Reward by proving (or accurately voting for) (i) the correct source; (ii) the correct destination; (iii) the correct block header (collectively, the “Accuracy Reward”), and (iv) having their proof (their vote) included in a block (the “Inclusion Reward”). The Inclusion Reward is also split between Provers and Validators, who are 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, which is capped at 32 ETH.

3bii2. Validators hope to obtain staking rewards from their own actions, rather than from "other people's efforts".

Analyzing the economic reality of staking ETH, the court should find that it does not meet the "efforts of others" principle in the Howey case. The rewards of staking are primarily determined by the individual efforts of the validator, rather than relying on any management efforts of a third party. As mentioned above, the rewards of validators are primarily determined by the amount of ETH they stake and the chance they get to propose random blocks, both of which are specific to individual validators and do not rely on any third party.

In other words, validators retain the ability to control the profits of their investment. Applying the Schaden test,43 validators’ control is first reflected in the lack of information asymmetry; rewards are distributed based on the open source protocol and transactions recorded on the public blockchain. Rewards are also determined based on the contribution of validators’ time and effort, as validators must maximize their uptime and stay connected to the network to avoid being slashed.

While validators are sometimes incentivized to get other validators to join the network (e.g., when it results in an increase in the base reward) and rely on the actions of other validators to maximize rewards (e.g., the requirement that attestations be propagated), validators never rely on “entrepreneurial” or “managerial” efforts that require skill and judgment as Howey requires.

4. Conclusion

As discussed above, analyzing the economic reality of staking ETH on Ethereum’s proof-of-stake network, the court should find that staking does not satisfy the Howey test because there is no “common enterprise” and the validator never relies on “the efforts of others.” While not the focus of this article, there is also the question of whether depositing ETH for staking qualifies as an “investment of funds.” And similarly, failure to meet any of the four Howey principles means that the transaction is not an investment contract and therefore not a securities transaction.

But beyond the 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 pointed out, one raison d’être of securities regulation is to improve the information asymmetry between originators and investors through disclosure. Therefore, treating the pledge of ETH as an investment contract would result in the imposition of disclosure obligations on the “issuer” or “originator.”

As we said 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, then the obvious unreasonableness of participating in registration, reporting, and disclosure requirements becomes obvious. Will securities laws force validators to provide information to each other? What material information will validators be required to disclose? How will this help alleviate any information asymmetry, and how will it serve the public interest? The impracticality of answering these questions illustrates the flawed logic of applying securities laws to validators: they do not pose the risks that information disclosure is intended to address.