Staking: what legal qualification for what regulatory framework?

Behind this question lie not the whims of a theorist fanatical about legal truth but the very concrete thoughts of the LBCA (Legal Blockchain & Crypto Association), led by a small group of legal professionals, all of whom have been confronted in the course of their profession with this need to legally qualify staking. The detailed results of this work can be consulted on the association's website: https://lbca.io/rapport-staking/

This is no trivial exercise and the stakes are high because, while the MiCA Regulation has for the time being excluded decentralised finance (DeFi) and mining, and therefore in some respects staking, from its scope, understanding what you expose yourself to when you take part in the staking process is the business of every blockchain user.

Even more so as the European Securities and Markets Authority (ESMA) recently published a document that goes some way towards treating staking as a MiCA-regulated activity. The LBCA working group report qualifies this approach by carrying out an in-depth analysis of staking mechanisms in several modalities and on several blockchains, which concludes that there is not necessarily custody of crypto-assets in all cases.

But first of all, what does the concept of staking cover?

Although the terms differ from one blockchain to another, the concept can be summarised as the immobilisation of a certain quantity of crypto-assets in order to participate in the validation of transactions on a blockchain.

This validation process is referred to as "proof of stake" and participation in this process is referred to as "staking". Validators who have immobilised a sufficient quantity of crypto-assets may be selected to participate in the process and receive a reward in the form of crypto-assets (of the same nature as those immobilised); they may also be penalised and lose all or part of the immobilised crypto-assets (slashing) if they fail to do so.

With proof-of-stake validation becoming increasingly widespread, members of the LBCA working group focused on three protocols representative of the ecosystem, namely Ethereum, Tezos and Avalanche.

On these three protocols different forms of staking exist and again you need to know what you want to analyse. In particular, staking can be done directly (e.g.: one person holds 32 ETH, the threshold required for staking on Ethereum, and immobilises them to become a validator on the Ethereum blockchain) or, more commonly, indirectly (e.g..

In direct staking, the validator makes a commitment to the network to validate transactions using the crypto-assets it owns. In the working group's view, the relationship between the validator and the blockchain is akin to a form of sui generis contract.

It is therefore more useful to look more closely at indirect staking. Indirect staking involves any holder of crypto-assets native to a blockchain delegating or transferring these assets to a validator who will carry out the staking activity on the network and pay the corresponding share of the rewards to the delegator.

For the validator, the point of indirect staking is to have more crypto-assets pledged to the protocol so as to increase his chances of being selected by the algorithm to validate transactions and therefore receive rewards.

For the delegator, this enables him to receive rewards linked to the staking activity even if he does not have the minimum quantity of crypto-assets to deposit as initial collateral to be able to be a validator or if he does not have the technical skills to carry out the staking.

Depending on the blockchain, indirect staking can be carried out via digital asset service providers (PSAN and soon PSCA), decentralised finance protocols (DeFi) or directly with a natural or legal person validator.

Even the layperson will note that it is a question, on the one hand, of participating in the operation of a computer protocol (a blockchain) and, on the other, ideally, of generating an income. The first question is whether staking is a technological or financial activity.

On the one hand, staking could be likened to tying up a sum of capital in order to hope for a return, in the same way as investing in a financial product. The widespread use of indirect staking on centralised exchange platforms argues in favour of this insofar as holders of crypto-assets do not themselves participate in the validation network and participate in staking with the aim of earning a return.

On the other hand, staking is akin to a technological activity consisting of maintaining a non-centralised distributed ledger. The rewards of staking would then come to remunerate, not an invested capital that would be made to grow, but rather the provision of a technical service of maintaining the blockchain.

It is these two conceptions that guided the working group in its analysis and enabled it to identify four plausible qualifications in French civil law.

1. First of all, the contract for the hire of things. On the Tezos blockchain, for example, delegators who wish to participate in the validation of blocks must delegate, or make available, XTZ to the validator's delegation address on the Tezos blockchain, which will be blocked for 21 days. According to this definition, the reward paid by the validator to the delegators would qualify as rent. On the other hand, this rental does not involve a transfer of ownership and does not give the validator the power to dispose of the delegated XTZ.
2. The contract of enterprise (also known as a lease of services) accompanied by an ancillary deposit agreement. On the Ethereum blockchain, for example, the delegator can be considered to be renting the services of the validator so that the latter can proceed with the staking of the transferred ETH. It is acceptable for the ETH owner to expect the validator above all to carry out a staking operation, thereby contributing to the smooth running of the Ethereum network. The accessory being the deposit of his ETH by the delegator to the validator. The parties can then agree to share the profits made by the entrepreneur thanks to the thing deposited, as well as to share certain risks, in particular slashing.

The main difference between these two forms of leasing (of things and services) is that the first considers staking from the point of view of the validator (who leases crypto-assets to third parties to achieve an own objective), while the second considers it from the point of view of the delegators (who lease the services of a validator to achieve a common objective).

1. Lending for use. It is in fact also conceivable that users of a ****pr blockchain temporarily lend their crypto-assets to a validator in order to facilitate the validation of transactions on the blockchain, with the onus on the validator to return them in identical form at the agreed term. This qualification may be appropriate for the Tezos protocol, in which delegators are guaranteed to have all their delegated XTZ returned, even in the event of slashing.
2. The deposit. On the Avalanche blockchain, for example, just like depositing funds with a bank which, when withdrawn by the customer, returns values of the same amount, indirect staking does not require the validator to return the same AVAX tokens as those initially deposited by the user, as these assets are fungible by nature.

Beyond these four possible qualifications others, such as consumer loan, mandate or affected credit, were explored by the LBCA, which ultimately ruled them out.

It should be noted with regard to liquid staking that the most appropriate legal qualification seems to be an exchange contract. Indeed, on the Avalanche blockchain, for example, in exchange for a deposit of AVAX the user receives a token called a Liquid Staking Token (LST) which will constitute proof of ownership of the AVAX deposited in staking, as well as the staking rewards obtained thanks to this deposit.

The working group then looked at the regulatory qualifications of staking.

It first concluded that tokens used for staking purposes naturally qualify as digital assets under French law and as crypto-assets under the MiCA Regulation. In the context of liquid staking the LSTs issued could possibly be qualified as "asset referenced tokens" (ARTs), although the spirit of the MiCA text aims rather to include stablecoins backed by so-called traditional assets in ARTs.

As regards the services provided by validators, it should first be noted that indirect staking often involves the provision of custody services, both for crypto-assets pledged as collateral by the delegators and for those received as a reward by the validator. However, this qualification is not systematic and depends on how staking operates on each blockchain.

Next, the working group notes that the new crypto-asset transfer service resulting from the MiCA Regulation could apply to staking given its very broad definition. However, recital 93 of MiCA expressly excludes staking from the scope of such a service by specifying that validators, nodes or miners involved in confirming transactions and updating the status of the underlying distributed ledger technology are not providing a crypto-asset transfer service.

Staking therefore appears to be excluded overall from the existing French and European regulatory regimes. The question may therefore arise as to the appropriateness of creating specific regulation for staking. Regulations generally arise from society's need to control risks, and staking is not exempt from them: slashing, theft or loss of capital or reward, non-payment of reward by the validator, failure to return underlying crypto-assets or loss of anchoring to the underlying (depeg) in liquid staking, etc.

The LBCA notes, however, that a non-negligible proportion of indirect staking activities are already de facto subject to regulation relating to the custody of digital assets, whether national or, tomorrow, European.

As for staking operations via DeFi, these are largely exempt, but some will argue that delegators are free to choose whether they prefer to participate in staking via regulated intermediaries (e.g. PSAN) or via decentralised and therefore unregulated protocols.

In all cases of indirect staking, it is not obvious that financial-type regulation is necessary. Indeed, analysis of the three blockchains Ethereum, Tezos and Avalanche tends to show that the staking activity itself is more of a technological activity than a financial one. On the other hand, it would be desirable to formalise the relationship between the validator and the delegator, as well as to increase the transparency and information requirements regarding the validator's past performance and the risks associated with each blockchain.

In conclusion, while direct staking can be classified as a sui generis contract, indirect staking activities fall under several possible legal classifications (rental contract, business contract with an ancillary deposit contract, loan for use, deposit). Liquid staking, on the other hand, can be likened to an exchange contract. These activities are not currently covered directly by the regulations (although the custody service is often provided on an ancillary basis as part of indirect staking). Does this mean that it would be appropriate to create a regulatory framework for this activity, particularly in light of the risks identified? The LBCA does not believe so at this time as the occurrence of the risks identified seems low and often already largely apprehended within the framework of the indirect staking proposed by the players in centralised finance (e.g. PSAN and soon PSCA).

*LBCA: Arnaud Grünthaler, Partner, Forvis Mazars, Stéphanie Cabossioras, Company Secretary, Société Générale-FORGE, Emilien Bernard Alzias, Partner, Simmons & Simmons LLP, Hugo Bordet, Legal Counsel, Kramer Levin and Annabelle Bernal, General Counsel, Société Générale-FORGE