Proof of Stake Alliance Offers First Legal Research and Analysis on Liquid Staking Tokens: Urges Industry to Self-Regulate
2/21/2023
Conclusions of research from industry working group – including Willkie Farr, Alluvial, and Lido – address regulatory and tax considerations of liquid staking in the United States
Two legal white papers published today by the Proof of Stake Alliance represent the first legal research and analysis to define and consider key legal questions surrounding the regulation and taxation of liquid staking in the U.S.
By building on well-established case law and legal precedent, these papers provide scholarly legal research and analysis for the industry and lawmakers, offering a framework for meaningful legislative codification or elucidation.
Research by the working group of legal, policy, and industry experts reason that:
Liquid staking receipt tokens (LSTs) for digital commodities should not be considered investment contracts or notes, and, therefore, should not be treated as securities under the U.S. federal securities laws;
LSTs should not be considered swaps under U.S. federal commodity law;
The conversion of cryptoassets for receipt tokens should not be considered a taxable transaction for U.S. federal income tax purposes;
It is important to name tokens appropriately based on the reality of the nature of the relationship between the underlying token and the receipt token. The group recommends accurately and appropriately describing liquid staking receipts as “Liquid Staking Tokens”or “LSTs” instead of the inaccurate but commonly used term “Liquid Staking Derivatives” or “LSDs.”
Today the Proof of Stake Alliance (POSA), the action-oriented, nonprofit industry advocacy alliance focused on forward-thinking public policy to foster innovative proof of stake ecosystems, announced that they have developed industry principles aimed at improving the regulatory landscape that surrounds liquid staking. Building on their work which outlined industry principles for staking-as-a-service providers, POSA urges key industry players to accurately describe liquid staking receipts as “Liquid Staking Tokens” or “LSTs,” instead of the inaccurate—but commonly used—term “Liquid Staking Derivatives” or “LSDs,” amongst other recommendations.
These principles build on two legal white papers developed by POSA’s liquid staking working group of members from over 10 industry organizations, co-chaired with representatives from Alluvial and Lido, along with legal experts at Willkie Farr & Gallagher. They represent the first collaborative industry effort to define and consider key legal questions around liquid staking and to call upon the industry to self-regulate. By bringing together legal and policy experts, business leaders, and even competitors, to align on what matters most to the industry for establishing the growth of liquid staking, we hope to foster greater adoption of liquid staking technology, blockchain innovation, and participation in the security of decentralized networks as a whole.
The papers address regulatory and tax considerations for liquid staking in the U.S., representing the first legal research and conclusions on the regulatory and tax status of liquid staking receipt tokens, the lack of clarity around which has been cited as a primary barrier to liquid staking’s widespread adoption and development domestically in the United States and globally.
“Liquid Staking offers an important way to interact with proof of stake blockchains, which are quickly becoming the predominant network structure in the broader crypto ecosystem,” said Justin Browder, Partner, Willkie Farr and Gallagher LLP, Co-Head, Willkie Digital Works. “Willkie is proud to partner with POSA and its members to outline a framework in which liquid staking can serve as a foundational feature of proof of stake networks and allow for continued innovation in the cryptoasset space.”
“Our white papers on liquid staking are a key step in moving policy conversations forward. The analysis of the broad group of legal experts we convened gives our entire industry common legal analysis to stand on as we work to design common sense rules for participants in these ecosystems,” said Alison Mangiero, Executive Director of POSA. “As an organization, we believe the industry makes greater policy progress together than we do apart. In the wake of recent SEC actions against staking-as-a-service providers, we believe that revisiting and updating our industry principles to reflect new innovations like liquid staking will help unite those who participate in staking ecosystems and strengthen all of our advocacy efforts.”
Driving Responsible Growth with Industry Principles
Proof of stake (PoS) blockchains continue to grow in popularity, due to attractive benefits such as using 99% less energy than proof of work alternatives, their capacity to support novel applications, and more. These benefits are evidenced by the dominant market share of proof of stake networks, which represent 19 of the 20 largest smart contract platforms today. Ethereum, the world’s second-largest blockchain, switched from proof of work to proof of stake in September 2022.
Liquid staking is a technological solution that provides liquidity and increased capital efficiency for participants in proof of stake blockchain networks. Liquid staking lowers the barrier to entry to protocol staking, enabling anyone with any amount to participate, without losing access to their liquidity. This makes staking more accessible and capital efficient, which helps make PoS networks more secure. The solution has grown in adoption despite being hindered by a lack of regulatory and tax clarity surrounding liquid staking tokens, such as LsETH or stETH.
As more Americans demand access to liquid staking, we need to ensure its continued and responsible growth. POSA is advocating that those who are engaged in liquid staking and developing liquid staking protocols adopt the following industry-driven standards:
1. Use appropriate terminology to describe liquid staking tokens (LSTs) and the nature of activities
In a liquid staking deposit, the staker owns the deposited token and the protocol staking rewards that it accrues. Liquid Staking Tokens (LSTs) are a type of token that evidence ownership of the holder’s staked token. They are distinct from derivatives, which are more commonly used to convey synthetic ownership of an asset, a right to receive or purchase an asset in the future, or a right to sell an asset in the future—unlike a derivative, there is no synthetic or speculative exposure to the price and rewards with an LST. Instead, the LST serves as a blockchain-based document of title certifying that the holder has staked the corresponding token, owns such token and can present the document to withdraw it from being staked on demand.
It is important to name tokens appropriately based on the reality of the nature of the relationship between the underlying token and the receipt token. This means that the name of the liquid staking receipt token should accurately reflect the underlying asset that it represents. Put simply, it is inaccurate to name a liquid staking token an LSD or liquid staking “derivative.”
For example, if a receipt token evidences ownership of staked ETH, it should be called an "ETH LST” or an “ETH receipt token” rather than an "ETH LSD" to accurately reflect the economic reality that the receipt is a document of title that provides the benefits and burdens of staking the corresponding asset as well as legal and beneficial ownership of such asset.
Additionally, it is important to avoid using phrases like "pools" when describing underlying token groupings, as this can imply that ownership of the underlying tokens or assets is not maintained. In reality, LSTs represent a direct link to the underlying asset, and ownership of the underlying asset is maintained throughout the life of the LST. Liquid staking does not involve any operator that manages a pool of staked tokens on behalf of stakers.
2. Focus on increased liquidity, without sacrificing what is of utmost importance – security & participation
Advertising should focus on the fact that liquid staking unlocks opportunity for token holders, while ensuring that they can continue to participate in both the consensus protocol and maintaining the security of the network by staking their tokens.
Highlighting the benefits that liquid staking provides for token holders can include emphasizing the ability to participate in the consensus protocol and maintain network security while also having increased control and flexibility via LSTs. Additionally, advertising can focus on the benefits of liquid staking for the network and how it can help to increase participation and security, such as by emphasizing how liquid staking can increase the number of token holders participating in the network, as well as how it can make the network more secure by having more tokens actively staked.
3. Develop tools to enable direct staking with access to liquidity, not staking-backed yield products
As we’ve mentioned elsewhere, In recent years, the term “staking” has been co-opted to describe a variety of activities that do not involve validating transactions on a blockchain. These other activities typically involve users receiving payments for storing or transferring certain digital assets to a third-party who exercises discretion over the assets and uses them for a variety of activities.
Liquid staking protocols and staking as a service providers should further develop existing technical services to democratize network staking participation.
Liquid staking protocols should not exert effort to boost advertised “yields” for customers, as doing so would remove themselves from providing purely technical services.
4. Refrain from providing investment advice
Similar to the principles that apply to StaaS providers, those developing liquid staking protocols and/or servicing them should not provide investment advice to market participants, nor make any recommendations as to whether or not a market participant should purchase a particular proof of stake digital asset.
Service providers should make no representations to market participants as to potential appreciation in the value of the underlying staked digital asset, nor the LST.
Liquid Staking White Papers and Their Focus
The main conclusions of the white papers are that liquid staking receipt tokens for digital commodities should not be considered investment contracts or notes, and therefore should not be treated as securities under the U.S. federal securities laws, as well as the fact that receipt tokens should not be considered swaps under U.S. federal commodity law. The papers also conclude that the conversion of cryptoassets for receipt tokens should not be considered a taxable transaction for U.S. federal income tax purposes.
“Just as warehouse receipts, bills of lading and other documents of title unlocked the ability to transfer ownership of physical commodities while in storage or transport, liquid staking tokens enable proof of stake network users to transfer ownership of digital commodities without unstaking them. These white papers support the view that receipts for digital commodities should not be regulated disparately from receipts for physical ones,” said Michael Selig, Counsel, Willkie Farr and Gallagher LLP.
By building on well-established case law and legal precedent, these papers provide a framework for the industry and lawmakers as liquid staking continues to emerge as a critical pillar of decentralized finance (DeFi). The research and analysis in the white papers is expected to serve as a legal foundation that can help unlock a new phase of responsible development and participation in the proof of stake ecosystem.
“Shared legal research and analysis will provide a safe path for the next wave of users to participate in PoS blockchains and earn rewards while securing a decentralized internet,” said Matt Leisinger, Co-Founder and CEO of Alluvial. “The POSA whitepapers address the foundational questions at the heart of the taxation and regulatory status of receipt tokens.”
The first white paper, “U.S. Federal Securities and Commodity Law Analysis of Liquid Staking Receipt Tokens”, focuses on the regulatory issues surrounding the classification of liquid staking receipt tokens. The paper examines whether liquid staking receipt tokens should be deemed to be “investment contracts” or “notes” under the U.S. federal securities laws, and/or “swaps” under U.S. federal commodity law.
The second paper, “U.S. Federal Income Tax Analysis of Liquid Staking”, examines whether the conversion of a liquid staker’s cryptoassets for liquid staking receipt tokens should be treated as a taxable transaction. The U.S. Treasury Department and the U.S. Internal Revenue Service have issued limited guidance on the tax treatment of “virtual currency” transactions and no guidance on liquid staking activities. This paper examines the application of general tax principles and precedence around tax ownership, realization requirements, and separate entity treatment in the context of a liquid staking arrangement.
"We, in Web3, can either wait for the ax to fall or help drive the outcome. Our goal in joining POSA is to grow the size of the industry and scale adoption through collaboration,” said Jacob Blish, Head of Business Development, Lido. “These white papers and the industry principles that will derive from them are a first step in helping to address some of the core issues around taxation and regulation in order to give participants and the industry the clarity we need to grow and thrive.”
Looking Forward
The analyses outlined in the white papers provide important guidance for the millions of Americans who are now participating in proof of stake networks and liquid staking as people and enterprises worldwide continue to increasingly use and and benefit from proof of stake networks.
For too long, crypto has been mired in regulatory uncertainty from lawmakers and regulators, specifically around issues of U.S. federal securities and commodity law and taxation. This ongoing ambiguity has led to confusion and the need to rely on guidance gleaned from settled enforcement actions. The industry needs common sense rules to ensure that Americans can safely participate in and benefit from this technology, which underpins the new global internet of value, with clarity.
While much digital asset innovation has slowed due to larger market and macro conditions globally, we know that advocating for proof of stake networks and their participants is crucial whether markets are up or down. We expect the publication of these white papers to provide the much-needed legal clarity required for liquid staking to continue its rapid growth, especially as new innovations in the staking space continue to develop in the months and years to come. POSA members started to engage on these issues in 2019 when the technology and many ecosystems surrounding it were nascent, and will continue to engage lawmakers and regulators in an ongoing dialogue concerning this legal analysis in the months and years ahead.
The papers are publicly available and can be found on POSA’s website (U.S. Federal Securities and Commodity Law Analysis of Liquid Staking Receipt Tokens; U.S. Federal Income Tax Analysis of Liquid Staking). We invite all liquid staking protocols and their participants to join the process to build standards and procedures to help shape policy and educate regulators globally.
Conclusion
We urge all liquid staking protocols and ecosystem participants to join the process of helping to build robust industry standards, processes, and principles, to shape policy and educate regulators globally.
These legal white papers represent the first step in creating a coherent set of policies governing liquid staking in the United States. Through continued advocacy, industry collaboration, and engaging with lawmakers and regulators, POSA and its members remain committed to fostering innovation-friendly policies that allow the liquid staking industry to flourish.