In March 2022, Bitcoin enthusiast Michael Saylor postulated that Proof of Stake cryptocurrencies are securities:
The only settled method to create digital property is via Proof-of-Work. Non-energy based crypto approaches like Proof-of-Stake must be deemed to be securities until proven otherwise. Banning digital property would be a trillion dollar mistake.https://t.co/h8FTGaGJKi
— Michael Saylor⚡️ (@saylor) March 12, 2022
This isn’t exactly a new idea, as several other Bitcoin fans have agreed with Michael Saylor since before 2022. (E.g. a quick Twitter search yields many similar ideas from years past.)
So, how do we determine whether something is a security or not? Will the SEC intervene and consider all PoS platforms securities, leaving only Proof of Work DeFi as commodities?
These are interesting questions, so let’s take a look at what it takes for an asset to be considered a security.
A 1946 US Supreme Court case established the definitive algorithm for testing whether an equity is or isn’t a security under US regulations. In the SEC v. WJ Howey decision, SCOTUS decided that a security must have the following properties:
Checking whether an equity matches these requirements is what has become known as the Howey Test.
So, let’s see how Proof of Stake coins fare off in the Howey Test!
At first sight this seems obvious. We’d be tempted to say every single PoS cryptocurrency is an investment of money.
But is it so?
If a given cryptocurrency is obtained through a direct sale, then it obviously qualifies as an investment of money.
But, what if the assets were obtained via an airdrop or some kind of mining procedure? What if the cryptocurrency was distributed by a network against your participation in a incentivized testnet. Both Avalanche and Cardano distributed early coins to testnet volunteers, for example.
For these reasons, among others, Cryptos are notoriously difficult to classify. DeFi assets leverage new technologies which decentralize many tasks traditionally performed by brokers. It’s quite easy proving that a given a traditional centralized finance transaction was an investment of money, but not quite so when dealing with DeFi.
Whether the crypto-specific forms of obtaining digital assets qualify as an investment of money is yet to be ruled on by the courts. Several decisions have been made based on ICO’s, but most real DeFi projects have no central player like ICOs did.
Proof of Stake has absolutely no relation to whether a coin was obtained via an investment of money or not. Both PoW and PoS allow for new coins to be minted by a completely decentralized process that does not involve the transfer of money between parties.
Some authors claim this is also an obvious one, though you could argue otherwise in many cases.
The SEC has stated that coins obtained via ICO’s probably qualify as securities.
Fine.
But, as in the previous section, what do the courts have to say about coins obtained in a totally decentralized fashion? Or via some crypto-specific method such as the various forms of mining (geomining, social mining, proof of work, proof of stake and so forth) or even distributed by smart contracts in a completely decentralized process (such as in a DAO of some kind)?
What, exactly, is the common enterprise involved in Bitcoin or other decentralized platforms? The blockchain? The algorithms involved? All these are common to both PoW and PoS systems. So, if Bitcoin were to be considered a common enterprise by these criteria, then all cryptos would as well, including PoS systems.
As you can see, aside from ICO’s, this is not a trivial question.
While the 2017 ICO boom gave the SEC several reasons to group all cryptos into common enterprises, this one will really have to be decided by the courts in a case by case manner. Texts claiming that this is a closed issue are likely based on ICO-related rulings and do not apply do decentralized projects.
Again, the fact that a coin uses a Proof of Stake transaction validation system makes no difference here.
What happens when the community performs the actions which cause the digital asset to gain value?
A loosely formed group of anonymous persons arbitrarily meet in some online chat room and decide they all love an asset, which causes them to buy the asset, which in turn increases the price of whatever is involved (e.g. coins or NFT’s). Can this action be attributed to a legally identified party who can be held responsible for these efforts? Is there organized labor involved? The answer to both these questions is no. Random actions by anonymous groups can’t be attributed to a common enterprise on which the profits depend.
The Howey Test was meant to be applied to common activities from the 1940’s. Such as agriculture (which originated the Howey test itself), industry, commerce, patented ideas and so on.
But how does this apply to cryptos? You’re not buying shares in a fruit company and expecting to get rich based on a fantastic crop. You’re not investing in some new invention created by Thomas Edison or Nikola Tesla. You’re investing in stuff designed by someone like Satoshi Nakamoto or Rocket Team who nobody knows who they actually are, who they worked for, if anyone, and so on. It’s an ad-hoc organization which spontaneously originates from the Internet.
There’s no central entity to which you’re handing money in exchange for potential future profits. It’s just an ad-hoc group of avatars spontaneously gathered in some message board for the purpose of pushing a new coin forward.
In the case of Proof of Stake coins, what, exactly, qualifies as the efforts of others? The stake required to be locked in a validator for Sybil attack protection? The rental of cloud or physical infrastructure to perform the validation work? All these apply equally to Proof of Work coins.
Nothing in this specific test is specific to Proof of Stake. Therefore either all cryptos, PoS or not, are considered to have value derived from the efforts of others, or none are.
It does not seem like Proof of Stake is much different from Proof of Work as far as the Howey Test is concerned. Which means that, should the courts decide that PoS coins are securities, then so will all PoW coins be securities as well. Having said that, this is probably a very unlikely outcome.
Please note that several ICO’s were, indeed, tokenized securities. But these are very easily identified, since the tokens are controlled by a central organization on which the profits depend. ICO’s which simply tokenized real world assets or services are almost always obvious securities. Projects in energy and agriculture, for example, depend on a common enterprise and the profits derive from third party work (such as running the energy grid or agriculture, to give just two examples). This isn’t the case with PoS coins such as Avalanche or Cardano, where there isn’t a centralized entity on which the profits rely. Decentralized PoS coins’ profits depend solely on market conditions, not on a common enterprise or the specific work of others.
Decentralized Layer 1 platforms are likely not securities, regardless of the mining algorithm involved, PoS or not. But this will have be ruled on by the courts for a definitive answer. The point being that Proof of Stake is likely not the main deciding factor.
Disclaimer: This opinion article does not constitute legal advice. Please consult an attorney should you need professional guidance on the subject.