Oct 05, 2022 | Rodrigo Seira, amyaixizhang, Jake Chervinsky
However, these arguments stretch the interpretation of the Howey test beyond recognition and fail to recognize that the fundamental purpose of securities laws is to address information asymmetries that are not present in this context.
As explained below, Ethereum’s adoption of a proof-of-stake consensus mechanism does not make ETH (or even staked ETH) an investment contract, and such a finding would result in a nonsensical application of securities laws.
U.S. securities laws require issuers to register any offers or sales of securities with the SEC, unless an exemption is available.2 Registration entails mandatory disclosure that ensures material information is shared with investors to allow for informed decision-making, prevent information asymmetries, and avoid agency problems.
The Securities Act of 1933 enumerates the types of instruments that constitute a “security,” which include an “investment contract.”3 As defined by the Supreme Court’s seminal opinion in Howey, an “investment contract” entails (1) an investment of money; (2) in a common enterprise; (3) with the reasonable expectation of profits; (4) derived solely from the efforts of others.4 In order to meet this definition, a contract, scheme, or transaction must satisfy each of the four prongs.
In decisions interpreting “investment contract,” the Court has rejected a literal construction of the statute, adopting instead a flexible interpretation that focuses on the “economic realities” of the relationship between the promoter and investors.5 In various instances, the Court has applied the economic reality concept to limit the scope of “investment contracts” and the application of securities laws if the underlying economic relationship between the parties is not one of investor and promoter.6
Horizontal commonality is present when each individual investor’s fortunes are tied to the fortunes of other investors by the “pooling of assets, usually combined with the pro-rata distribution of profits.”13 “Pooling” in turn requires an issuer or promoter to commingle investors’ funds and use them toward a common enterprise.14 In other words, courts have stressed that horizontal commonality requires the expected profits of an investor to be tied to other investors “by entrepreneurial efforts of a promoter.”15 Horizontal commonality therefore requires investors to give up any individualized claims to profits, in return for a participatory and pro-rata interest in the ensuing profits distributed by the promoter.16
Some have mistakenly argued that staking ETH implies horizontal commonality because validators deposit ETH into a single smart contract address, which allegedly entails a “pooling of assets”,17 or alternatively that horizontal commonality is allegedly found because there is a perceived “cooperation” amongst validators.18 As shown below, these arguments are conclusory, and misunderstand the mechanics of staking in Ethereum.
To become a validator on the Ethereum network, one is required to deposit 32 ETH to a smart contract address (known as the “Deposit Contract”).19 However, the deposit of ETH to the Deposit Contract is not “pooling” since that ETH is never under the discretionary control of a promoter who can use it to drive value to a common enterprise. Instead, the purpose of staked ETH is to create an incentive mechanism that secures the network; it ensures that validators have some skin in the game so that they can be penalized or “slashed” for behaving dishonestly. Further, while each validator’s ETH is deposited in the Deposit Contract, it is not commingled and remains distinguishable. Each validator will also have the ability to withdraw its staked ETH once that functionality is implemented in a later network upgrade.
Individual validators also do not have participatory rights to any pro-rata distribution of profits generated by an enterprise. As explained further below, rewards vary for different validators and are determined primarily based on each validator’s individual efforts; their fortunes do not rise and fall together based on the entrepreneurial efforts of any promoter.20 Therefore, in analyzing the economic realities of a staking transaction, a court should find an absence of horizontal commonality.21
Some courts have held that the common enterprise prong of Howey can also be satisfied through vertical commonality, which focuses "on the relationship between the promoter and the body of investors."22 However, staking ETH does not entail vertical commonality simply because there is no promoter.
In general, the Ethereum network does not rely on any key party for its success or operation; it is “sufficiently decentralized.”23 To ensure decentralization, Ethereum’s consensus mechanism allows validators to operate self-sufficiently without reliance on any third party. Validators come to the network freely and voluntarily, and they can choose to stop participating at their discretion. Validators can perform their role in the network without depending on anyone else. If they perform their role properly based on the rules of the network, they will receive a reward based on those rules and not on the efforts of a promoter.
Focusing specifically on the economic realities of a staking transaction, it is clear that there is no promoter on which validators rely. Since vertical commonality requires that “the fortunes of investors” are “tied to the fortunes of the promoter[,]”24 the absence of a promoter ends the inquiry.
Inversely, courts have focused on whether the investor had the “ability to control the profitability of his [own] investment.”29 The greater the degree to which an investor relies on their own efforts for their profit, the weaker the justification to characterize the underlying transaction as an investment contract under Howey. In these cases, applying securities laws or disclosure requirements is unnecessary because there is no separation of ownership and control.30 Courts have further outlined several factors (known as the “Schaden factors”) to test an investor’s “ability to control”31 (listed in order of importance): (1) the investors’ access to information, (2) the investors’ contractual powers, (3) the investors’ contribution or time and effort, (4) the adequacy of financing, (5) the nature of the business risks, and (6) the level of speculation.
Some have argued that Ethereum’s transition from proof-of-work to proof-of-stake was also a transition from a competitive to a more “cooperative” mechanism32 since the validation process in proof-of-stake requires multiple parties. According to this view, when staking ETH, each validator is reasonably expecting to derive staking rewards by relying on the efforts of other validators.33
This argument has been supported by the low-level implementation detail that, under Ethereum’s unique proof-of-stake protocol, validators are sorted into committees.34 However, there are multiple other proof-of-stake protocols that do not segregate validators into committees.35
More significantly, this argument misunderstands the mechanics of validator rewards in Ethereum’s proof-of-stake implementation and dilutes Howey’s original standard requiring reliance “solely on the efforts of others” to an unprecedented degree. As we explain below, Ethereum’s validators cooperate no more than miners in the pre-Merge proof-of-work network and do not expect rewards from significant managerial efforts of other validators, but instead expect rewards primarily from their own efforts and funds. To understand why this is the case, it is helpful to have a base level understanding of the rewards validators can earn in Ethereum’s proof-of-stake network.
There are many factors that enter into the calculation of rewards for validators. Under Ethereum’s proof-of-stake implementation, validators receive rewards every epoch (6.4 minutes) that are calculated as multiples of a “base reward.”36 The base reward is itself determined by the number of active validators on the network (the “total active stake”) and dynamically adjusted to incentivise a validator set of a desired size.37 The total amount of stake in the network is arguably the most impactful factor dictating rewards earned for validating transactions.38
According to researchers, assuming a fixed base reward over time, the profits of a single validator are predominantly determined by the balance of ETH the validator has deposited in the network, which is capped at 32 ETH.40 Attesting with a higher balance results in larger rewards and penalties, and vice versa.41 On a finite timescale, a significant portion of validation rewards will also be determined by the random opportunities a validator receives to propose a block.42
Analyzing the economic realities of staking ETH, a court should find that it does not meet the “efforts of others” prong of Howey. Staking rewards are primarily determined by a validator’s individual efforts and not dependent on any managerial efforts of a third party. As explained above, a validator’s rewards are largely determined by the amount of ETH they have staked and the random opportunities they receive to propose a block, both of which are idiosyncratic to the individual staker and do not depend on any third party.
In other words, validators retain the ability to control the profitability of their investment. Applying the Schaden test,”43 a validator’s control is evidenced first by a lack of information asymmetries; rewards are distributed based on open-source protocol and transactions recorded on a public blockchain. The rewards are also determined based on the validator’s contribution of time and effort, as validators must maximize their up-time and remain connected to the network to avoid being slashed.
While a validator is sometimes incentivized to have other validators join the network (e.g., when it would result in an increase to the base reward), and depends on the actions of other validators to maximize rewards (e.g., the requirement for an attestation to be propagated), a validator is never relying on “entrepreneurial” or “managerial” efforts requiring skill and judgment as required by Howey.
As shown above, analyzing the economic realities of staking ETH on Ethereum’s proof-of-stake network, a court should find that staking fail to satisfy the Howey test because there is no “common enterprise” and validators are never relying on the “efforts of others”. While not the focus of this paper, there are also questions about whether depositing ETH to stake would qualify as an “investment of money.” And again, failure to meet any of the four Howey prongs would entail that the transaction is not an investment contract and therefore not a securities transaction.
But beyond the legal analysis, applying the stringent requirements mandated by U.S. securities laws to staking would result in an ill-fitted and absurd application of the law. As we have noted, a raison d'être of securities regulation is to ameliorate information asymmetries that exist between promoters and investors through disclosure. Deeming the staking of ETH to be an investment contract would therefore entail imposing disclosure obligations on an “issuer” or “promoter.”
As we stated above, no identifiable issuer or promoter exists when staking ETH. But if we accept the premise that validators play the role of a promoter or issuer, the clear unreasonableness of attending registration, reporting, and disclosure requirements becomes clear. Would securities laws mandate validators to provide each other with disclosure? What material information would validators be required to disclose? How would this help alleviate any information asymmetries, and how would it serve the public interest? The impracticality of answering these questions illustrates the flawed logic of applying securities laws to validators in the first place: they don’t pose the risks that disclosures are meant to address.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Circumstances vary, and one should consult their own advisers and attorneys for advice. Certain information contained herein has been obtained from third-party sources. While taken from sources believed to be reliable, the authors have not independently verified such information and make no representations about the current or enduring accuracy of the information or its appropriateness for a given situation. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services.
Securities Act of 1933 §5(a). ↩
Securities Act of 1933 §2(a)(1). ↩
While the SEC has argued that the first prong requiring an “investment of money” is typically satisfied (see Framework for “Investment Contract Analysis of Digital Assets” (modified Apr. 3, 2019), available here), the Supreme Court’s opinion in Howey evinces a narrower interpretation of “investment contract” that should not apply to the staking of ETH. While the Court notes that an “investment contract” is a flexible term that can apply to a variety of contracts, transactions and schemes, its purpose is to capture those “who seek the use of the money of others on the promise of profits.” When staking ETH, no investor is giving capital to any promoter or issuer because no promoter or issuer exists to use the money, or promise any profits. ↩
Adam Levitin, Twitter (Jul. 23, 2022), available here (“The common enterprise element is also readily met with staking: the whole validation system requires multiple parties. That's the pooling (i.e., the more demanding interpretation of common enterprise--horizontal commonality). 4/”) ↩
Adam Levitin, Twitter (Sept. 16, 2022), available here (“(2) Common enterprise: in PoS, the validators have to work cooperatively with other validators. A single node has to work with 127 others in a committee in ETH. That's different than in PoW, where miners are competing, not cooperating. 3/”) ↩
328 U.S. at 298 (emphasis added). ↩
SEC Strategic Hub for Innovation and Financial Technology, “Framework for ‘Investment Contract’ Analysis of Digital Assets,” (April 3, 2019), available here. (emphasis added) ↩
Adam Levitin, Twitter (Jul. 23, 2022), available here. (“The key is the switch from competition to cooperation in PoW to PoS. There's lots of good things about that, but it has a securities regulation impact.”) ↩
Adam Levitin, Twitter (Sept. 16, 2022), available here.(“(3) Expectation of profit from the efforts of others: in PoS the validators make or lose money based on successful (timely) validation. That requires the efforts of others in the committee. 4/”) ↩
Vitalik Buterin et al, “Combining GHOST and Casper,” (May 20, 2020), available here. (“Committees: the validators are partitioned into committees in each epoch, with one committee per slot. In each slot, one validator from the designated committee proposes a block. Then, all the members of that committee will attest to what they see as the head of the chain (which is hopefully the block just proposed) with the fork-choice rule HLMD GHOST (a slight variation of LMD GHOST).”) ↩
Pintail, “Beacon Chain Validator Rewards,” (last seen Sept. 23, 2022), available here. ↩
“If there aren’t many validators, the protocol needs to offer a high return, to encourage more validators to join. However if there is already a large number of validators, the protocol can afford to pay less, and save on issuance. The function which does this for the beacon chain is an inverse square root — that is, the level of the reward is divided by the square root of currently validating Ether (the reasoning for choosing an inverse square root relationship is explained in Vitalik Buterin’s design rationale document).” Id. ↩
Ethereum Launchpad, “Validator FAQs,” (last visited Oct. 5, 2022), available here. ↩
“For every slot (a slot is 12 seconds — there are 32 slots in an epoch), one validator, chosen at random, is responsible for producing a block. The block is made up of beacon chain attestations submitted by the other validators, and the block producer is rewarded with a proportion of all the inclusion rewards from attestations in the block.” Pintail, “Beacon Chain Validator Rewards,” (last seen Sept. 23, 2022), available here. ↩
Pintail, “Beacon Chain Validator Rewards.” ↩
Ethereum Launchpad, “Validator FAQs.” ↩
Pintail, “Beacon Chain Validator Rewards.” ↩
Acknowledgments: Special thanks to Lewis Cohen for his review and feedback.
Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors and is not made on behalf of Paradigm or its affiliates and does not necessarily reflect the opinions of Paradigm, its affiliates or individuals associated with Paradigm. The opinions reflected herein are subject to change without being updated.