Staking and Regulation

Hi everyone, this is Charles Hoskinson broadcasting live from warm, sunny Colorado. Today is February 9th, 2023, and I want to make a quick video to talk about staking and regulation, as well as the hot topics of the day. Undoubtedly, many of you have seen the CoinDesk article that came out today, probably about an hour ago, stating that Kraken and the SEC are about to settle over some concerns the SEC had about the staking they offer on their platform. Additionally, Brian Armstrong tweeted yesterday that the SEC is looking aggressively into staking services. No doubt, they have probably had some informal or formal communications through private channels.

This prompted me to reply to that tweet because someone asked me to. I mentioned that Ethereum staking is somewhat problematic, and I figured I’d make a more extended video to discuss the landscape and what's exactly going on. We have this issue where there is no canonical definition of what delegation, staking, liquidity, and custodianship really mean. Avalanche, Polkadot, Tezos, Cardano, Ethereum, and Algorand, even though these are all staking systems, operate very differently. Some are custodial and non-liquid, while others are liquid and custodial or non-custodial.

Some involve a bonding or slashing mechanism, while others involve no bonding or slashing mechanism. The problem is that these nuances translate to regulatory overhead. One of the first challenges from a regulatory perspective is if you have an asset and you have to transfer that asset to another party for them to do something on your behalf to generate a return. In some jurisdictions and interpretations, that actor doing that may be a regulated entity because they have custodial risk and potential information asymmetries. Your returns are based entirely on their efforts and their efforts alone.

You’re not in a common enterprise where you’re working together; rather, you have lent or given an asset to them with the expectation of a return. This is where the rub comes in when you compare that with a Bitcoin model of mining pools or a Cardano model of stake pools. In the case of Bitcoin, the custody of the underlying asset is your hash resources, your actual work payload. In the case of Cardano, it's the synthetic resources that still belong to you. What you've done is delegated it to them, and now you’re collectively working together with others to perform an action to build a block.

Only if that work is done are you guaranteed a return, but you have to actually do the work to get the return. It’s a very different model, and there’s no information asymmetry; both parties know the same thing. There’s no custodial risk, and the return is based on your efforts as much as it is based on the efforts of the pool. Both of these are technically proof of stake, and the matter gets further conflated when you look at the fact that many of these staking services go beyond staking and potentially put it into some sort of DeFi play to augment a yield. This means there could be risks involved, or in some cases, to provide you with liquidity, they issue a synthetic asset and say, "Here’s this thing, and it has redemption rights.

" There are all kinds of variations here, especially if there’s a bonding component and an opportunity cost to losing access to those funds. None of this is figured out, and every jurisdiction is going to have a slightly different opinion. It’s clear that the SEC is converging to a point where, at the very least, exchanges doing this on your behalf is problematic. I’m not going to complain too much about exchanges getting out of the staking business because I would like small stake pool operators, and I would like staking to be very distributed and decentralized. It feels intrinsically uncomfortable if one entity has 40 percent of the resources and doesn’t even own that asset, yet they’re able to vote with it and stake with it.

It’s probably better to pull that off exchanges if possible, so that’s a good thing. That said, it is an inconvenience to the industry as a whole. What usually happens is they try to apply one-size-fits-all interpretations and understandings to nuanced things. If Ethereum staking, for example, in its current model with the majority of its actors is a regulated activity, they may just decide that all staking is a regulated activity and say, "Well, you litigate it in court, and we’ll figure it out." I’m not saying they’re going to do that, but it is within the spectrum of options and possibilities as a result of these actions.

If there is a settlement between Kraken and the SEC, something will come of it, and we can read more and dig into the facts and circumstances to really understand where the problem points are in the analysis and why people have issues. Again, it’s a very nuanced topic. If you’re a stake pool operator, you may become regulated, or there’s pseudo-regulation. There are layers to that with the infrastructure bill that was passed in the United States, which includes an unenforced statutory mandate about the collection of information regarding the people you have a business relationship with. It was a frustrating thing; many of us tried hard to remove it from the bill, but unfortunately, politics got in the way, and it passed with a very bad provision.

A strict interpretation of the U.S. infrastructure bill would say that if you’re a stake pool operator and someone’s delegated to you, you have a KYC requirement to know enough about that person to provide that information to an actor the IRS if requested. Now, in practice, the Treasury Department says they’re not going to enforce that. That said, it raises an interesting question about changing staking models to accommodate regulatory nuances.

On the Cardano side, one of the discussions we’ve had for a while, which we just haven’t had the time to write up, is the idea of introducing a new stake pool certificate. Right now, when you want to be a stake pool operator, you register a stake pool certificate on-chain, and that’s that. People can delegate to it, and these are push transactions, meaning that as an SPO, you don’t consent to them coming your way until you saturate. We could introduce a concept of contingent staking, which would be two-sided multi-signature. Here’s how that would work: if Alice wants to delegate to Bob’s pool, Alice would send a transaction that would be pending, and Bob, the stake pool operator, would also have to sign that before they can broadcast that transaction as a legitimate delegation.

The idea is that there would be a metadata payload, and Alice would provide some information to Bob to make him feel comfortable. Bob would then have records about Alice, which changes the push non-consensual relationship to a bilateral consensual relationship. Both parties would have to agree for it to work. This is not just for regulatory purposes. Many of you in the Cardano ecosystem get involved in things called ISPOs, where there’s usually some sort of promise stating that if you delegate to my pool, I’ll keep the ADA revenue for a while and then keep a ledger to track what your return should have been and give you tokens in another project.

However, many of these operators say, "I’m sorry, we can’t do this for U.S. citizens for a variety of reasons." They blacklist the United States, and many people do that. How they tend to reconcile this is that when you go to redeem the tokens, they say, "All right, prove who you are.

" But you’ve already given them the money and your stake pool rewards. With contingent settlement, before any business relationship is established, there would be an exchange of information. In this case, it wouldn’t just be a KYC point to verify that you’re not a U.S. citizen; you’d probably have them sign a contract, some form of distribution agreement, stating, "I agree to the following terms and conditions, and I make the following warranties and representations.

" They would sign it, and actually signing with the transaction would be a legally binding act. If you audit that stake pool, they would have the compliance log, and 100 percent of the participants would have an upfront contractual relationship. Both of these would be introduced with contingent staking. Now, if stake pools are regulated, an interesting question would be whether you could operate by syndicating the license of an actor. For example, people may be an RIA or whatever the regulatory structure may be.

They could provide a white label where you can be the operator of the pool, run the pool, but you’re running under the license of that operator, and other stake pools are as well. Alternatively, you could become a direct regulated entity. If regulation goes in an uncomfortable and wrong way for our industry, this might end up being how people run stake pools in the United States. They could also use contingent staking to blacklist U.S.

delegations, creating a regulated and unregulated set. Welcome to really bad regulation; this is the route we’re going down. Until Congress passes a law reining in very unreasonable agencies, we’re probably going to be dealing with this for the next 12 to 24 months. We’re tracking it on our side. There’s certainly a lot of great technology that can be brought to bear to optimize and reduce the overhead and make the life of an SPO better.

It’s important to point out that, as it stands right now, it does not seem that any complaint about the Ethereum custodial staking model is transitive to the Cardano liquid non-staking model. This is certainly something that should be litigated if someone asserts that because I think it’s completely wrong, and there are no facts and circumstances to equate the two. I believe we fall under the same work package model as Bitcoin mining pools, which have been in operation for almost 13 years in our industry without incident or complaint. However, there’s going to be a national discussion about these things, especially now that Kraken and others are getting involved. It does not appear that there’s any attempt to say that staking mechanics somehow make the underlying asset a security.

You’ll probably see a lot of FUD over Twitter, Reddit, and other places saying, "Oh, if staking is a security, that must mean the underlying asset is." Let’s be very clear: you can take wheat, which is a commodity, or gold, a commodity, and put it into some sort of package or structuring where that package is a security, or that activity you’re doing with it is regulated. But that doesn’t make wheat or gold a security. You don’t have that transitivity where what you do with stake pools could infer that the underlying asset has a problem. We haven’t seen any attempt to do that at the moment.

Governments are unpredictable, and facts and circumstances could change. We see things at the same time you do, so we’ll cross that bridge if it comes. As it stands right now, the ecosystem is fine. I don’t think there’s any issue with Cardano as it sits, nor do I think there’s any issue with our staking model as it stands. Unfortunately, the conflation of what Ethereum is doing with Cardano may drag us in an uncomfortable direction, and we, as an industry, have to work on these nuances and details.

The good news is that there are plenty of other ecosystems with more sensible consensus models, and as a result, they would likely litigate and fight against bad regulations. Exchanges and other operators will have to figure out how to operate on our side. We could do things proactively, like using OtoLaprism and DIDs and contingent staking if we want to scale up as an industry and ecosystem on the regulatory side. As it stands, if you’re an SPO right now, it is not a regulated business to the best of our understanding, but again, things can change. So it’s something to think about in your future planning over the next 12, 24, or 36 months.

Or maybe all this goes away with the U.S. government changing from one political party to another, and they’re more reasonable than the current one about the status of cryptocurrencies in the United States. Perhaps a law will be passed that creates statutory clarity about where and when we’re supposed to operate, the FIA had with the concept of an auxiliary asset, for example. Until then, we’re still living in a regulation-by-enforcement paradigm.

We’re still in a “we’ll let ” and “best of luck” situation, which is the absolute worst way of running an economy. It’s counterproductive and destructive, and all it does is convince people to offshore and blacklist the United States, which is happening en masse now. Our loss is Dubai’s gain, and our loss is Switzerland’s gain, among other jurisdictions. It’s not to say there aren’t bad actors; every industry has them. FTX is the pinnacle of that for our industry, but it’s just one of many we’ve dealt with for almost 14 years now, whether it be Silk Road, Mt.

Gox, BitConnect, or OneCoin. These things do happen, and oftentimes they have the same structure: it wasn’t the crypto; it wasn’t a failure of a protocol; it was a centralized actor saying, "Trust us." You trusted them, and then they screwed you. By the way, custodial staking does suffer from this problem. If you give your funds to somebody else to do something with them, they can screw you too.

That’s why regulation exists; it comes into play when these problems arise. As always, my comments on Twitter, which were solicited, were then taken and turned into a cryptocurrency article. This always happens, and that article is posted on cryptocurrency Reddit, where people basically say I’m the worst human being alive, that Charles is an idiot and a pathological liar. That’s the level of maturity of discourse in many channels in our industry. I will remind everybody that the only way we’re ever going to achieve a satisfactory outcome—meaning that we have our liberty, can operate, build great things, and chase the future—is if we come together and treat each other with civility.

It is perfectly reasonable to point out that protocol design choices people have made may inadvertently create problems from a regulatory viewpoint. That’s just a fact, and that’s where we’re at. It’s creating a systemic problem for the industry. It’s not fair that when people criticize that and say we now have to deal with the consequences of those decisions, they just attack others. At the end of the day, how are we actually going to come together and solve these problems?

I will continue doing what I can on my part. We’ll continue doing what we can as a protocol and an ecosystem on the Cardano side, and I hope we, as an industry, can find sensible ways to come together. I spoke before Congress last year and didn’t mention Cardano once; I tried to represent the industry as a whole. I will continue doing that where and when asked, and I’ll keep advocating for sensible policy so that every single actor—not just us, but every single actor—has fair and equal consideration for their business operations, and the government gets out of the way of innovation. We must acknowledge that there have been bad actors, and we also must recognize that many of those bad actors were enabled by prominent figures who still raise money, still manage funds, and have faced no recourse for their actions.

It’s kind of like South Park with the BP CEO saying, "We’re sorry." If we are tolerant of that and accept it, we have to expect that at some point it’s going to invite increasing escalation of regulatory scrutiny on the industry because it’s clear we’re not self-regulating as an industry. It’s an inconvenient truth, but it’s something we have to live with. If you want to shoot the messenger, go ahead; cryptocurrency Reddit is great at that. But it doesn’t change the reality we all have to live with and the facts and circumstances we’re converging toward.

I do believe technology can solve a big chunk of this, but at the end of the day, there’s an old axiom: if you trust somebody, they have the power to screw you. In human relationships, you have to understand that every time you turn over your private keys to someone else and they’re now in charge, you’re taking a leap of faith. Be very careful who you get into bed with because you might catch fleas. On another piece of news, I finally got the data room for CoinDesk. I’m under NDA, so I can’t mention anything about it, but if anything comes to that, I’ll obviously make an announcement when that’s not in violation of the NDA.

I just wanted to give a brief update there because you guys keep asking me about that. We’ll keep you in the loop about things as they materialize on the regulatory side.