On 27th April 2023, CryptoUK (“CUK”, “we”, “us”) and our members submitted our collective response (“CP Response”) to the consultation paper on the proposed future financial services regulatory regime for cryptoassets (the “Consultation Paper”) published by His Majesty’s Treasury (“HM Treasury”). We are grateful for the opportunity to submit our CP Response, but per our answers to questions 35, 45, and 46, many of our members felt that the issues surrounding the regulation of staking were complex and nuanced enough to require further deliberation and discussion in this Letter. For ease of reference, we have appended the relevant answers from our CP Response as an Annex 1 to this Letter.
This letter intends firstly to state our desire for HM Treasury and the Financial Conduct Authority (“FCA”) to approach the regulation of staking with more definitional clarity, given the fundamental differences between staking and other forms of lending or supplying liquidity, as well as the technical details and inherent intentions underlying each of the various forms of staking.
We thank HM Treasury for the recent response to the Consultation Paper and call for evidence (the “HMT Response”). While the HMT Response marks some progress in addressing our concerns from the Consultation Paper and Guidance Consultation, significant work remains to establish a robust regulatory framework for staking, as we will elaborate on further below. While we appreciate the FCA’s Discussion Paper 23/4 (“Regulating cryptoassets, Phase 1: Stablecoins”, hereafter the “Discussion Paper”) as well as the FCA’s Finalised Guidance 23/3 (“Finalised non-handbook guidance on Cryptoasset Financial Promotions”, hereafter the “Finalised Guidance”), we believe the FCA misses a key opportunity by omitting an adequate examination of staking. Given HM Treasury’s call in the HMT Response for accelerated exploratory efforts and stakeholder engagement on this topic, a robust discussion on staking by the FCA would align with that priority.
Staking is a fundamental part of any proof-of-stake PoS) cryptoasset network, including Ethereum and EVM-based chains, Tezos, Cosmos, Solana, Cardano and others. It is a pivotal part of developing and maintaining such networks, and we believe the misapplication of rules (such as the application of lending or collective investment scheme (“CIS”) regime rules, as below), to true forms of staking, would result in an inappropriate regulatory burden on new and future cryptoasset ecosystems as well as staking service providers. This would in turn have a detrimental effect on the development of new distributed ledger technology (“DLT”) in the UK, as well as act as a deterrent to cryptoasset issuers and cryptoasset service providers looking to access the UK market. Especially due to Ethereum and other PoS network’s acute role in the enablement of Web3, deterring these developments can have broad ramifications on the UK’s ability to lead in the fast-approaching next stages of the internet’s development. As such, our recommendations are that HM Treasury (in conjunction with the FCA) should develop a separate, bespoke regulatory framework for staking, or in lieu of that and at the very least:
(i) create and promulgate a definition of staking that is derived from the fundamental technological basis that underlies staking services; and
(ii) provide guidance on the regulatory treatment of different staking services, possibly through the creation of a non-exhaustive list that recognises and identifies the different types of staking services available, and how which rules may apply to each.
We thank the HM Treasury for making progress on issues (i) and (ii) in the HMT Response by introducing a definition of staking in paragraph 12.17 as well as providing a taxonomy of staking business models and indicating current regimes which may be applicable to each in paragraphs 12.18 to 12.21.
However, and building on the establishment of clear definitions and categories of staking, this Letter also makes the recommendation that staking should be legislatively exempt from being considered lending and/or a CIS (per section 235 of the Financial Services and Markets Act 2000 (“FSMA”)), and should instead be regulated under its own separate regime, as above, if there is regulatory appetite. This Letter also sets out the mechanism which we believe is appropriate to create this latter exemption with.
We believe that these recommendations are in line with the Government’s stated intention to promote and develop the UK as a global fintech and cryptoasset services “hub”. We look forward to any further discussion or questions that HM Treasury or the FCA may have with regards to staking or cryptoassets in general.
1. Identifying “staking”
Our belief is that HM Treasury’s and the FCA’s approach to categorising and so regulating staking through the same lens as lending and CIS may be caused by a lack of a clear definition of staking, and that conversely both issues are much better approached once a coherent framework has been established. While we acknowledge HM Treasury’s commitment to working with industry bodies in the development of a regulatory regime for staking services, we believe that the final definition of staking and its subsequent regulatory treatment should not be decided discussion and consent from the industry. Notwithstanding the above, we note that HM Treasury’s proposed definition of staking in paragraph 12.17 of the HMT Response seems to be guided by staking’s original technical purpose, and we agree that this is a step in the right direction.
Staking is a purpose-led activity, which is to help facilitate consensus within a blockchain network by validating transactions and creating new blocks. Many cryptoasset tokens that allow for staking have the “right to validate” transactions and maintain network consensus baked into the token itself. By staking their token, the user elects to hold and “lock” their token(s) to be used as a validating node, and transactions are sent (usually at random) to that new node to be processed and confirmed, after which a new block in the blockchain is created and the unlocked token(s) are distributed to the owner of the validator node. Staking in this way can be done as both “layer 1” and “layer 2” staking. Layers refer to the technology stack or or the levels built in a technical architecture, that interoperate with each other. For the purpose of this letter a blockchain is the layer one and an application (that is decentralised) is the layer 2.
Staking is the core concept behind the “Proof-of-Stake” (“PoS”) consensus mechanism underlying many popular blockchains such as Ethereum, Cardano, and Solana. It is similar to the mining mechanism used on “Proof-of-Work” (“PoW”) blockchains such as Bitcoin, in that they both incentivise users with rewards for helping the network achieve consensus. However, PoS blockchains have faster transaction speeds, are more scalable, and use significantly less energy in its validation and consensus maintenance, making it much more environmentally friendly. As the Consultation Paper rightly states, these benefits have seen PoS blockchains increase in activity and new developments as compared to PoW blockchains.
There are many arrangements by which a token holder may participate in a PoS consensus mechanism and rewards, and these are governed by a combination of the token’s own smart contract, and by terms and agreements set by third parties. For example, if a user does not hold enough of a token to qualify as a validator node (as some tokens such as Ethereum require a minimum amount), they can still lock their token(s) in a staking pool by delegating their tokens to a third party, usually a staking pool, who would then operate a validation node on the blockchain and utilise the combined tokens to perform the transaction validation (a process also known as “delegation”). Staking pools are offered by both centralised staking platforms (such as Coinbase, Kraken, and Binance), and decentralised staking platforms (such as Lido Finance and Rocket Pool). As another example, there are also tokens that have an in-built “Delegated PoS” mechanism that allows holders to vote and elect which validator node may use those tokens to process transactions, rather than allow the blockchain to select the validator at random.
However, it is important to note that whether a token holder chooses to become a validator node themselves, or become part of a staking pool, the mechanism by which this incentivisation and “holding” is done does not necessarily require the user to exchange their coin or token for anything in return, and the assets (tokens) can continue to be held on the balance sheet of the original owner. The tokens are only necessary insofar as they provide the “right to validate” and so need to be committed to the blockchain (rather than be freely available) to allow the validator node access, to begin processing transactions and provide consensus. The proceeds or “rewards” for staking are produced by the validation activity and the addition of a new block to the blockchain, similar to mining rewards on PoW blockchains, and are not created by any direct or indirect investments of the staked assets.
Let’s also consider a couple of simple examples to show the fundamental differences between staking and a CIS.
Our assertion is that staking in these scenarios is more akin to a service, such as paying a developer’s wage to maintain the function of a network, rather than an investment for the purpose of accruing profits. Ethereum, the largest public POS chain, can be considered public infrastructure. Much like fibre optic cable and the stakers are ensuring that the security of the public infrastructure is maintained.
Also, consider two separate (non related) entities staking on ETHEREUM. In this scenario the two separate stakers are staking their ETH into two different delegated pools, of which support two different network nodes. These two stakers are exposed to asymmetric returns as they will likely not receive the same rewards, all other things being equal (staking size etc). This is due to the concept of slashing which is part of the protocol design. Its purpose is to disincentivise malicious behaviour as slashing is the removal of staked tokens. This can happen for reasons that are not always malicious, such as publishing an incorrect state of the network transactions, or a validator error.
2. Misidentification of staking as lending or investments
Therefore and with reference to questions 35, 45, and 46 of the Consultation Paper, we reject the possibility or assumption that staking (even with the exclusion of “layer 1 staking”), would amount to lending or the creation of a CIS, and/or that it should be considered or treated in the same way from a regulatory perspective.
We believe this erroneous conflation is concerning, and that it may possibly stem from, or be exacerbated by, a few factors. Firstly, this premise that the two operate with the same outcomes and intentions confuses the purpose of staking at the most basic level and the mechanisms by which most forms of staking are carried out, as explored above. This in turn is exacerbated by the considerable ambiguity around the definition of staking in the existing and proposed guidance and rules that have been published, which we discuss further below.
We welcome the FCA’s amendment in its Finalised Guidance to identify the inherent differences of purpose between staking, lending and borrowing and to recognise that the distinct risks and complexities of different models should be communicated to customers. However, the language used throughout the rest of the Finalised Guidance follows a worrying trend of categorising staking, lending, and investment services together as “complex yield arrangements/models”. While we appreciate that the Finalised Guidance does elaborate that this regulatory approach was taken for financial promotions due to the similar way in which these arrangements are sometimes advertised, the use of the sweeping term “complex yield arrangements/models” leads us to believe that any differences, even if identified, will not be adequately considered in the design and application of any other regulatory regime for staking services.
By the same token and as identified by the FCA, we also note that “staking” is sometimes misleadingly used by some market participants to refer to what is in fact better identified as DeFi or CeFi lending, as below. We acknowledge that there are many structures or services offered in the cryptoasset market that may be similar in form to staking, or indeed use the term staking, but which do not actually pool the tokens for the purpose of network consensus. Some examples are:
(i) Yield farming:
Yield farming and liquidity mining are used in Decentralised Finance (“DeFi”) where users directly interact with smart contracts. In yield farming users provide liquidity to a liquidity pool for a decentralised application such as lending protocols. Users are then rewarded for providing liquidity. Importantly, the liquidity pool and the assets within are then made available for other users in the same protocol as loans or to be used for margin trading.
(ii) Liquidity mining:
Liquidity mining works largely the same as yield farming. However, the key difference is that in liquidity mining, users are also rewarded with the platforms own coin as well as the normal rewards.
(iii) CeFi Lending:
In Centralised Finance (“CeFi”) lending, users borrow money by collateral cryptocurrency – it is the same with users using traditional assets as collateral to apply for a bank loan. The centralised provider platform uses other lenders’ savings to lend money to the borrowers, and charge interests from borrowers. The borrowers pay the centralised provider platform an interest rate for borrowing, and that provider passes on some of the interest to the investor.
We believe that these activities should indeed be regulated as lending, but that they are distinct from staking, and that a clear and consistent definition of staking would avoid such conflation and future issues with identification and enforcement. Despite the welcome definition of staking in paragraph 12.17 of the HMT Response, it does not explicitly stipulate that processes such as CeFi lending, yield farming and liquidity mining do not constitute staking. Moreover, paragraph 12.20 indicates that pooled staking activities performed by intermediaries could be captured by other regimes, including financial promotions, custody, lending and intermediation without needing further regulation. This does not establish an adequate distinction between staking and other processes.
3. Defining staking
At present, our opinion is that although paragraph 12.17 of the HMT Response does help to dispel the lack of regulatory clarity regarding staking, it explains only how the term staking is primarily used at present, as opposed to setting out clear definitional boundaries. We submit that any regulatory regime that will eventually apply to staking should not only clearly define what staking is, but also what falls within and without such a definition. For example, the HMT Response makes reference to “layer 1 staking activity”, but does not define what that may include or exclude. As per our CP Response and based on our understanding of the terminology used in the Consultation Paper, we believe that a distinction between layer 1 and layer 2 staking has been drawn to either distinguish between (i) staking done to “validate and secure the network” and staking done “for rewards”; or (ii) direct staking and liquid staking. We believe the former would be a misguided distinction (as fundamentally all instances of staking are meant to bolster the projects’ consensus mechanism), and if it is for the latter dichotomy, we submit that the regulation of liquid staking poses enough complexity that it should be considered fully and consulted on separately. For completeness, neither the Financial Services and Markets Bill nor the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017, SI 2017/692 (as amended by the Money Laundering and Terrorist Financing (Amendment) Regulations 2019, SI 2019/1511 (MLRs 2019)) feature any mention or attempt to define staking. Considering the factors above, our suggestion is that staking should have the same definition across all legislation, where appropriate.
4. Proposed regulatory approach
At the moment, there is considerable uncertainty as to how and which regulatory regimes would apply to staking activities, and we are grateful to the Treasury for the chance to consult on this issue.
As explored above and as with lending, staking differs in both form and function when compared to the investment structures that section 235 of FSMA intends to capture. We acknowledge that there are some staking programs that do resemble, or have features akin to, a CIS, and we believe that they should be appropriately regulated to avoid consumer and systemic harm. However, our priority is to avoid the overgeneralisation of all forms of staking, and particularly to avoid the disproportionate regulation of validation-focused staking activities, which would severely hinder the development and feasibility of new and existing cryptoasset projects in the UK. To this extent, we welcome HM Treasury’s approach in paragraph 12.21 of the HMT Response, and agree with the intention to carve out certain forms of staking from the CIS regime. However, we believe that the creation of a separate regulatory regime for “operating a staking platform” outside of the CIS framework should not be an option in the alternative or in lieu of the carve out option, but that it should be pursued in tandem and in parallel with the carve out.
To that extent and to add to the feedback considered by HM Treasury in pursuing one of these options, there are several factors which we believe differentiates such staking activities sufficiently from other structures or services captured by the CIS regime:
(i) the inherent intention and purpose behind each activity, as set out above;
(ii) staking does not involve pooling of contributions and/or profits from the participants for an investment, and is typically decentralised, which means that there is no central authority “managing” the staked cryptoassets;
(iii) participants have ultimate control over whether to withdraw their cryptoasset for the purpose of staking and can elect to do this at any time during the staking process; and
(iv) the service provider does not have the capability to choose when and how to use the staked cryptoassets to manage market events.
Correspondingly, our recommendation is that such staking activities/scenarios should be exempt from the CIS regime by way of an exemption inserted into the Financial Services and Markets Act 2000 (Collective Investment Schemes) Order 2001/1062 Schedule 001 “arrangements not amounting to a collective investment scheme” (the “Schedule”). We envision such an exemption would be similarly inserted into the Schedule as was done section 6A of the same Schedule for peer-to-peer lending, and find that the policy objectives behind our proposed exemption and those for sections 4 and 6A are alike in that they try to avoid regulatory uncertainty and overburdensome or duplicative regulatory obligations on service providers.
We further propose that a separate bespoke regime for staking should be considered and developed, and that further under this regime the following staking activities would be excluded from regulation:
(i) where an entity stakes their own assets for the purposes of being a validation node and on their own balance sheet, without any form of pooling or any transfer of assets (including all “layer 1” and “layer 2” staking);
(ii) where there is a staking pool, that staking pool (either by way of the terms in a written agreement or smart contract) has the following features:
a. users retain day-to-day control of their staked assets e.g. users retain full ownership and control over their staked assets and have the ability to unstake their assets at any time, consistent with the underlying protocol
b. staking returns are determined by the underlying protocol, as opposed to the staking service provider’s management of the staked assets;
c. the staking returns represent payments for validation services provided to the underlying protocol, rather than a return on investment, and where the staking returns are set by the protocol and are the same whether the customer stakes on their own or through an intermediary service provider (less any service fee) i.e. no pooling of profits or income; and
d. the service provider simply uses publicly-available software and basic computer equipment to perform validation services, rather than provides management services with respect to the staked assets i.e. the provision of IT services, not investment services.
We believe that delineating by these features would sufficiently identify where a staking activity is focussed on validation, and are stringent enough to avoid profit driven or potentially harmful “staking” activities from being unregulated.
Within this separate regulatory regime, staking activities that fall outside of those described above should be regulated appropriately. For example, where a validator provides a custodial service to customers enabling customers to participate in validation activities (and receive a reward as a result) those activities should be subject to a new authorisation category that allows those services to be provided to the validator’s customers. That authorisation should be a stand-alone requirement but also be an ancillary activity to an exchange authorisation, to allow an exchange to perform validation services for its customers within the bounds of its exchange authorisation.
We recognise that the HMT Response does not list staking in the proposed scope of cryptoasset activities to be regulated within 2024 under Phase 2 in Table 4A. We would welcome greater clarification on the timeline for a proposed regulatory approach to staking.
An additional consideration in favour of a staking-specific regulatory scheme is that by virtue of being markedly different from lending services as noted above, it also carries with it unique regulatory risks. As an example, by staking funds on Ethereum to act as a validator and proposer during the block-building process,, a participant may economically benefit from the inclusion of transactions involving or originating from illicit actors, such as sanctioned entities, or transactions that constitute market abuse. The priority fees, or tips, that all Ethereum users pay to have their transactions included in the network make up a part of the rewards that stakers receive for their validation services. Validators ultimately benefit from those priority fees that could be piad by illicit actors in exchange for the inclusion of their transactions.
In addition to transactions involving or originating from illicit actors,, the block-building process that is so fundamental to staking, introduces new ways to engage in potential market abuse, including market manipulation. Transactions occurring on-chain intended to execute a scam or an exploit, stealing funds from other users and distorting asset prices in their favor, also need to pay the validator for inclusion, similar to illicit actors in the previous example. Furthermore, there are new trading strategies within the block-building process that may constitute market manipulation, like “front-running” and other techniques aimed at capturing Maximal Extractable Value (MEV). These strategies can result in an above average amount of rewards realised by validators. Such behaviours and risks can be mitigated via the use of crypto-native approaches and tools which already exist and have been developed by industry participants. In developing a staking-specific regulatory approach, the UK could ensure not only that it does not pose hurdles to this promising new financial and technological advancement, but also that staking service providers offer it to the public and institutions as a safe and de-risked opportunity aligned with the highest levels of regulation pertaining to traditional finance, and that is clean from money laundering, counter-financial terrorism, market manipulation and beyond.
As an example, one CryptoUK member organisation reports working with a traditional financial institution that’s interested in staking on Ethereum. The financial institution holds a large amount of its own and customer-owned ETH and views staking as an opportunity to generate yield on those idle assets. However, they recognize the various risks present during the block-building process that contribute to a large portion of overall staking returns, specifically the potential inclusion of transactions constituting illicit activity. By providing staking-specific regulation, the UK, in view of its government’s objective of becoming a “hub” for cryptoasset activity, could attract staking business, as well as lead on providing regulation that would allow these businesses to operate with strong risk monitoring and compliance tools to prevent illicit activity.
Chapter 12 of the HMT’s Future Financial Services Regulatory Regime for Cryptoassets | Response to the consultation and call for evidence (dated October 2023) provides HMT’s vision of the definition (para 12.17) and the taxonomy of staking (12.18) describing the different staking models including solo staking (staking own crypto assets), delegated staking (validation node is delegated to a third party), decentralised pooled staking (multiple participants’ crypto assets are “pooled” in DeFi (smart contracts) to stake directly or through a third party), centralised pooled staking (multiple participants’ crypto assets are “pooled” in CeFi (exchanges) to stake directly or through a third party).
While there could be different variants of staking, the regulations should address different variants/models of staking based on the different inherent risks associated with these staking activities. For Example, FINMA’s Guidance on Staking Services, distinguishes between custodial and non-custodial staking:
1. Custodial staking: the customer transfers the cryptoassets to a third party. Custodial staking comprises the two variants of direct staking [the service provider operates the validator node itself or outsources its operation to a technical service provider, but retains the withdrawal keys to return the customer’s staked cryptoassets itself] and the staking chain [in a staking chain, the cryptoassets being staked are passed on by the institution with the customer relationship to one or more other institutions who operate the validator node and hold the withdrawal keys]; and
2. Non-custodial staking: the customers maintain exclusive control over the withdrawal keys and therefore there is no custody or acceptance of assets by third parties).
Following are some inherent risks that can be associated with staking activities:
- market abuse risks (money laundering, counter-financial terrorism, market manipulation, etc.)
- technical risks (technological malfunction of the staking process, slashing, etc.)
- counterparty risk (if the custody or staking is delegated to the third party coupled with the jurisdiction risks in case of the cross-jurisdictional arrangement)
- market condition risks (market condition may not allow for unstaking process and leads to delay in returning blocked crypto assets)
Given staking’s peculiar business models and differences in variants, the existing regulations might indeed not be able to provide effective regulations of these services (12.21), therefore introducing a clear regulatory regime for effective risk monitoring in operating staking might be a more effective approach.
We recognise that the HMT Response does not list staking in the proposed scope of cryptoasset activities to be regulated within 2024 under Phase 2 in Table 4A. We would welcome greater clarification on the timeline for a proposed regulatory approach to staking.