Staking is Data Validation, Not Investment
Much has been made of the recent settlement between the US Securities and Exchange Commission and Kraken concerning the latter’s staking program. Many actors in our ecosystem have advanced their thoughts on the legal and policy implications of staking and have taken this opportunity to educate on the subject. Two among the many views worth considering are Coinbase and the Proof of Stake Alliance, which discuss applicable law and legal policy related to staking.
With the aim of bookending that analysis, we write here to underpin a common understanding of what staking is, demystify where rewards come from, and explore some popular staking mechanisms. While there are many Proof of Stake (PoS) chains, our commentary focuses on Ethereum’s application of that consensus mechanism.
What is Staking?
The move to the PoS consensus algorithm (i.e. the “Merge”) is by our estimation one of the great achievements in the young history of Ethereum. Overnight, the Merge made potential attacks on Ethereum more costly, and radically decentralized network security by enlisting individual validators — anyone with an internet connection and a sufficient ETH balance — to stake from home and secure a portion of the network. The fact that the Ethereum community was able to flawlessly change consensus engines mid-flight is testament to their technical prowess. The community also addressed important issues such as energy usage and environmental impact of the technology they are building. That net carbon emissions of Proof of Stake Ethereum are down over 99.95% as compared with the Proof of Work Ethereum speaks for itself.
So while lawyers, including those who are US regulators, grapple with the legal implications of staking, it is undeniable that staking is good as a matter of public policy.
At the core of Ethereum PoS is a simple mechanism. A participant runs software that participates in maintaining network data. When that participant’s efforts are aggregated with those of others performing the same service, they collectively can maintain the network data in a trustless and secure way. To ensure each participant is diligent and rule-abiding, each must deposit some ETH into the protocol — their “stake” — so that the protocol has a mechanism for financially punishing a participant who is negligent or malicious in performing its role. Along with this stick is a carrot to incentivize volunteers to secure the network: the network software itself compensates the participant through issuing native tokens as payment for the service being provided. Rewards that previously went to miners running specialized hardware and devouring electricity to solve complex puzzles in Proof of Work, now go to validators running software programs that can run on energy efficient, off-the-shelf computers.
These validator rewards are strictly governed by the rules of the open source Ethereum protocol code specification. Rewards aren’t a mythical construct dependent on the acts of a specialized manager, such as funds entrusted to a hedge fund or other money manager who enjoys discretion over how the funds are invested to generate a reward. Rather, rewards for validation come from two places: the protocol-specified rewards and a portion of the transactional fees paid by users who want their transactions added to the network. The amount of rewards and fees that validators might receive fluctuates according to transparent rules, but in short, rewards and fees will go up as the number of validators decreases and demand for blockspace increases, respectively. The opposite is also essentially true.
The protocol’s reward mechanism is as transparent as you can get, and reliant on no counterparty. You can accurately expect what the network will pay for security, and you have an unequivocal real-time record of what the network in fact pays due to the directly viewable public ledger.
How Do We Stake?
Today, a user can generally stake in four ways. The first and easiest to understand is solo staking. A user deposits 32 ETH into the official deposit smart contract, runs open source Ethereum client software, and receives rewards directly from the protocol for keeping their validator properly functioning and online.
The second major type is delegated custodial staking. Users enter into an agreement with a service provider for it to stake the user’s ETH using the provider’s infrastructure. With the provider performing the necessary staking responsibilities, that provider generally receives a service fee that is deducted from the rewards and fees that the user receives for supporting the network. This type is considered “custodial” because the user generally grants the provider custody of the ETH that is to be staked, which in many jurisdictions already carries with it certain regulatory implications.
The third major type is delegated self-custodial software-as-a-service staking. Here, as opposed to delegated custodial staking, the user does not grant the provider custody of the ETH to be staked. Instead, the provider licenses the use of its software to the user, and the user leverages that software to initiate a stake and receive rewards. This arrangement allows the user to benefit from a professional software developer’s staking software and infrastructure in exchange for a service fee. The user never relinquishes to the provider custody of its collateral or any corresponding rewards that are earned because the provider never has the private key to access them.
The fourth major type is smart contract-facilitated liquid staking. This approach allows users to deposit any amount of ETH into an Ethereum smart contract which, upon receiving 32 ETH in total, automatically starts a validator provided by one of many validator operators. These smart contract suites are generally developed by a team which, whether before or after deployment, turns over the authority to make changes to the protocol to a decentralized autonomous organization.
After a user deposits its ETH into one of these liquid staking protocols, what happens to that ETH is determined both by the user’s instructions and the underlying logic of the corresponding smart contracts. In other words, no third party — including the validators — has discretion as to what can be done with the ETH. In a real sense, the logic of the system provides greater assurance than an agreement would in the delegated custodial staking context, discussed above. Whereas a contractual counterparty could be unable to perform or simply refuse to perform in violation of the contract, the liquid staking smart contract protocol can only function as its code and the user’s instructions dictate. These protocol-based systems remove the trust that is required that a real-world counterparty will actually perform as agreed.
In all four staking scenarios above, adjacent rewards and fees, which differ from the protocol dictated rewards and transaction fees described above, might be earned by optimizing the order in which transactions are included in a particular block. This phenomenon, generally called “maximum extractable value” or “MEV,” is available for either the self-staker or the participant who uses a custodial, non-custodial, or liquid staking service via many services including a popular open source service. Whether or not the participant wants to participate in MEV is optional.
Staking Rewards are Compensation for Services
In all four staking types, the economic reality of the transaction is clear. The Ethereum protocol code compensates the staking participant for providing essential support, which in some instances is facilitated, at the staker’s own election, with the help of a third-party service provider or smart contract protocol. Specifically, the staker receives rewards for their validation work in the measure expressly governed by the Ethereum protocol, less any fees it agrees to pay for any technical assistance received from a third-party provider or protocol. Financial responsibility for a slashing event — i.e. when the protocol punishes the staker by destroying some of its staked ETH — is also clear from the beginning.
The crux of validation, for which staking is a prerequisite, is running software that performs a critical function for the network. Without validation, the network’s global data set is not updated with new transactions nor maintained over time with essentially absolute certainty about its history. Some validate on their own, and some pay third parties, including smart contract protocols, to help them stake. Such economic relationships between service providers and service users are not novel and almost never implicate the investor protection laws.
They do not here, either. Rewards and fees are compensation for services rendered, whether they are received directly or through a service provider’s platform that the staker relies on for technical support. Rewards and fees are not yield on a loan, nor are they a dividend on investment. Staking is a data integrity mechanism that Ethereum and similar blockchain networks require to function, not an investment scheme. Service agreements that offer technical staking solutions are not investment contracts or any other type of enumerated security.
American access to and participation in these blockchain networks should be on par with everywhere else in the world. That is especially true as it relates to participation in the data consensus mechanism, which is arguably the network’s most revolutionary feature. ConsenSys is committed to continuing the fight for this result.