In the age of regulation through enforcement, it can be easy to interpret a specific regulatory action as a broad move against a particular new innovation or technological development.
At these times, it’s especially important to take a step back and look at the full context. The dialogue around this specific move by the SEC needs to shift away from uninformed scaremongering about staking, and towards rational discussions about why staking exists, and the role that it plays in securing and powering a decentralized network.
The Role of Staking
Staking plays an important utility function for decentralized protocols. This consensus mechanism was developed to address the computational efficiency challenge that exists with proof of work infrastructure (e.g. Bitcoin) and to deliver self-sustaining infrastructure that is subsidized via inbuilt protocol participation mechanisms & transaction fees.
Staking is very different to DeFi yield (e.g. lending & borrowing) where tokens are lent to a counterparty to earn a return on that loan and DeFi transactions execute in smart contracts deployed on the blockchain. The primary focus of the Proof of Stake mechanism is to power and secure the network. It is more efficient than other consensus mechanisms, and ensures the integrity of the network..
Decentralized participation in a Proof of Stake network is important to preserve the security and integrity of the network – the more participants in a network, the more resilient the network is. Servers (“Validator Nodes”) facilitate participation in the network. These servers have been configured with software created by the specific protocol development team.
Resources Needed for Staking
The method of validation used by these Validator Nodes is determined by the protocol. The nodes must follow the consensus rules that have been defined in the protocol specification. These specifications are generally outlined in published technical documents, along with the ability for the code to be viewed and audited by anyone. This means participants have access to all the information they need to understand the risks and rewards involved in staking.
Validator Nodes are selected by the protocol to produce blocks. These blocks include transactions. Users of the system must pay a fee to submit a transaction to the blockchain. It’s the role of validators to prove the integrity of the transactions that will be included in the block. For this effort they are rewarded with a sum of the fees of each transaction and block reward consisting of a fixed allocation of the protocol’s native asset. The fees are essentially the toll paid by users to interact with the distributed compute function of the blockchain network. The toll is a way of preventing spam of transactions in the permissionless system. Generally, the higher the toll fee, the quicker the transaction is selected by a validator for inclusion in the next block.
Blockchains require computing power, and participation comes at a price. Computer hardware, server maintenance, cloud infrastructure, monitoring…all of these entail costs for participation. This reward mechanism subsidises the cost of participation. It’s fundamental to encouraging the level of decentralized participation required to secure the network. Node operators collect toll fees and block rewards to offset the cost of operating infrastructure used to power blockchain networks.
The tokens are distributed by the protocol to the participants. Mechanisms are inbuilt to allow Validator Nodes to take a small commission for operating the servers.
To ensure that the rules are followed, protocols require participants to “stake” a number of tokens to the network as collateral. This discourages malicious activity and serves as a form of guarantee for the network, because punishment for breaking the protocol’s rules is a penalty in the form of some of those tokens being taken by the protocol. When this happens, it’s called a “slashing” event.
The tokens that are staked to the network are usually locked up (“bonded”) for a specified period of time. The length of time differs from protocol to protocol. During this period, the tokens are unable to be removed from the wallet that is being used to stake. Once the time period has elapsed, the tokens can be transferred back to the origin wallet (“unbonded”).
The delegation/bonding action to the protocol is all conducted on-chain with full transparency and auditability. In fact, at all times throughout this staking process, the delegator maintains control and custody of the private keys. Subject to any bonding period that is set by the protocol, the delegator has full control of the movement of tokens. A delegator also has the ability to undelegate/unbond from a specific validator, and re-delegate to another validator without requiring permission.
This is very different from a collective investment scheme where a participant’s assets are removed from their control. When you directly stake to a validator, you know what your tokens are being used for, the risks, the potential reward, and you can withdraw your tokens if you don’t like it. You maintain control over your keys and your tokens. Outside of the bonding period, you don’t need permission to take them back and use them for something else.
Staking in Light of Recent Events
While the recent SEC ruling discusses ‘staking,’ the Kraken program was notably different to staking. According to the complaint, the Kraken program included control and pooling of customers’ assets, determining what assets to stake directly with a protocol, determining the rewards to be paid and when (regardless of the actual rewards received from the protocols) and enabling cashouts faster than protocol lockup time periods; all without the appropriate disclosures.
The enforcement action may not be the best way to regulate the industry; Commissioner Pierce’s dissent is worth a read. However, it certainly highlighted the differences between retail exchange ‘earn’ programs and the Proof of Stake mechanism operated by many blockchain protocols.
Nothing coming out of the SEC recently has changed our mission. Blockdaemon will continue to support an open Web3 ecosystem. We will also continue to serve our institutional and regulated customers. Blockdaemon intends to work with all applicable regulators, including the SEC. This will ensure that they understand and appreciate the Proof of Stake mechanism and will update our customers as we hear additional news.