A key feature in the NFT space - and a feature which has quickly become an integral element of many token projects - is the ability of a token holder to give up certain rights in a token in exchange for ongoing rewards. This feature is often referred to as staking and usually takes the form of one of two kinds of transactions: (1) staking as part of a "proof of stake" protocol; and (2) liquidity mining. The former may not implicate the securities laws; the latter will almost always implicate the securities laws.

Staking in Proof of Stake Protocols: Generally Not a Security

What is Staking in Proof of Stake Protocols?

A blockchain is a series of "blocks" of data, with each block containing a series of transactions. Blocks are added to the chain by “miners” or “validators” (collectively “operators”) i.e. persons that supply their computational or financial resources to the ongoing operation of the blockchain network through the process of validating and adding blocks to the network. If an operator proposes the addition of a new block to the “chain” but other network operators fail to accept the validity and addition of the proposed block to the chain, the proposed block will be rejected.  Thus, the acceptance of a new block’s validity and addition to the chain is a means for the network to achieve consensus on the “state” of the chain (i.e., on the transaction history that has occurred). In addition, this consensus mechanism also makes is difficult for a single bad actor to tamper with the blockchain.

Many blockchain networks (e.g. Bitcoin) use a "proof of work" protocol to dictate when a miner can propose new blocks to the blockchain. Under a proof of work protocol, a miner must first solve highly complex cryptographic problems before being permitted to propose the addition of a block on the blockchain. The electricity required to run computers that can solve the cryptographic problems is expensive, thereby dissuading bad actors from tampering with the blockchain.

Multiple other blockchain networks (e.g. Solana, Ethereum, and Cardano) now use a "proof of stake" protocol rather than a proof of work protocol. Under a proof of stake protocol, a validator must first lock up their own digital assets as a form of collateral before being permitted to propose a block on the blockchain. Since a validator can lose their staked collateral if they tamper with the blockchain, a proof of stake protocol dissuades bad actors while minimizing the electricity costs involved in the proof of work protocol.

Does staking in the form of a “proof of stake” protocols implicate the securities laws?

Where staking as part of a proof of stake protocol only involves the offering of collateral to be able to validate transactions on a blockchain, the staking itself is probably not a security because the validator is providing a key service to the network. The cryptocurrency reward a validator receives is direct compensation for the service provided to the network. In short, there's no or limited expectation of profits based on the efforts of others. In addition, a validator that locks up their collateral is not guaranteed to be compensated for their services - a network only selects a portion of all validations submitted by validators.

Staking in the Form of Liquidity Mining: Almost Always a Security

What is liquidity mining?

In liquidity mining transactions, token holders (or "liquidity providers") pledge their token to a "liquidity pool" of tokens in return for a passive income of other tokens. Often, a liquidity pool is established so that "automated market makers" ("AMMs" i.e. smart contract book orders operating on a blockchain) can facilitate the liquid trading of tokens. Rather than connecting buyers and sellers, buyers and sellers can transact directly with the liquidity pool via the AMM, and holders are rewarded for funding that liquidity pool.

Does liquidity mining implicate the securities laws?

Probably. Liquidity mining looks a lot like a typical financial product involving the contribution of an asset in return for a passive investment. The SEC is paying close attention to these kinds of arrangements. In September 2021, SEC Chair Gary Gensler highlighted the potential securities issues in these relationships, stating that:

....if you're investing on a centralized exchange or a centralized lending platform, you no longer own your token. You've transferred ownership to the platform. All you have is a counterparty risk. And that platform might be saying, as many of them do, we'll give you a four percent or seven percent return if you stake your coins with us or you actually transfer ownership and we the platform will stake your tokens. That takes on all the indicia of what Congress is trying to protect under the securities laws.

Conclusion

Using liquidity pools in a protocol and facilitating the liquid trading of tokens requires careful design to ensure compliance with laws relating to broker-dealers and the sale of securities. Reach out to a member of our team to discuss how to deploy your project while complying with applicable law.