Ether is not a security.ETH pledges (Solo Staking) are not securities.Kraken’s ETH pledge product is a security.There are differences in the design of various pledge-as-a-service (STaaS) products and they need to be treated differently.Not Your Key, Not Your Asset！

Ethereum is not a security. ETH Solo Staking is not a security. Kraken’s ETH Staking Product is a security. Different STaaS products require different treatments.

On February 7th, 2023, the SEC’s Division of Examinations announced its 2023 work priorities, which included making Emerging Technologies and Crypto-Assets one of its primary regulatory tasks for the year. Subsequently, the SEC swiftly began another round of “Regulation by Enforcement” on the cryptocurrency market, with Kraken and its ETH Staking Product being the first target. This type of regulatory enforcement caused panic in the market, with even absurd claims that “Ethereum is a security”. This article will deeply analyze the fact that “Ethereum is not a security, ETH Solo Staking does not constitute an investment contract, and Kraken’s ETH Staking Product is a security”.

The article will first briefly introduce Staking and its various types, then analyze why Ethereum is not a security and ETH Solo Staking does not constitute an investment contract, according to the U.S. Securities Law and the Howey Test, combined with Paradigm’s article “Ethereum POS staking mechanism does not make ETH a security”. Based on this, we will look at the logic behind the SEC’s determination that Kraken’s ETH Staking Product is a “security”.

**I. What is Staking and what are its types?**According to the Ethereum Foundation website, ETH Staking refers to the act of depositing 32 ETH to activate a validator software. Validators are responsible for storing data, processing transactions, and adding new blocks to the blockchain to maintain the node’s operation and protect the network’s security. Validators earn additional rewards by staking ETH, which comes from the transaction fees paid by users of the execution layer network and the issuance of native tokens of the consensus layer network.

To put it in 0xTodd’s words: if Ethereum is considered a company, then the validators responsible for Staking are employees. Their job is to validate the legality of transactions and then package the blocks to the chain.

1.1 Solo StakingSolo Staking refers to the act of a user depositing 32 ETH to activate a validator identity and independently running an Ethereum node connected to the Internet, allowing the user to directly participate in network consensus. Solo Stakers interact directly with the Ethereum protocol and receive rewards directly from the protocol, as long as they keep their validators online and running smoothly.

Solo Staking validators hold the KEY required for Staking to perform secure operations. After all, “Not Your Key, Not Your Asset!” However, becoming a solo Staking validator is not easy. In addition to the high capital threshold of over 32 ETH (funds need to be locked for a period of time and cannot be used for other purposes), they also need to maintain the nodes themselves (which requires high requirements for software and hardware), which is not achievable by ordinary people. Therefore, there is a Staking as a Service (STaaS) solution to solve the problems of money and work: (1) node maintenance; (2) capital threshold; (3) capital liquidity.

**1.2 Staking as a Service (STaaS)**The purpose of designing STaaS products is to facilitate mass participation in Staking to obtain economic benefits, regardless of the size of their funds, and to solve node maintenance challenges for non-technical users.To solve the problem of (1) node maintenance, STaaS provides a delegated proxy solution. Users transfer or delegate their assets to STaaS service providers, who act as their validators and charge users a fee, usually in the form of a monthly fee.

To solve the problem of (2) capital threshold, STaaS provides a pooled Staking solution. Users transfer their funds (regardless of their size) to the capital pool, and STaaS service providers use the funds raised from the capital pool to act as validators on behalf of users and charge users a percentage of the handling fee. Currently, the STaaS business is largely monopolized by the centralized exchanges Coinbase, Kraken, Binance, and the DeFi Staking platform Lido.

To solve the problem of (3) capital liquidity, STaaS provides a Liquid Staking Derivatives solution, which solves the liquidity issue of Staking assets based on (2). For example, the DeFi Staking platform Lido provides ETH Stakers with stETH with liquidity in a 1:1 ratio to solve the liquidity dilemma that users face due to Staking ETH (locked positions). Users can continue to take stETH to Aave, Compound, and other lending platforms for secondary Staking to earn secondary benefits.

II. The US Securities Act and The Howey Test

The US Securities Act requires issuers of any “security” to apply for registration with the SEC prior to the issuance or sale, unless exempt. Registration requires issuers to disclose information to ensure that investors are provided with important information to make informed decisions, prevent any form of information asymmetry, and avoid agency problems.

Section 2 of the Securities Act of 1933 defines what a “security” is, and its definition is very broad, including stocks, bonds, and other forms of profit-sharing agreements, as well as “investment contracts.” As the Supreme Court defined in the landmark case Howey, an “investment contract” includes(1) the investment of money;(2) in a common enterprise;(3) with a reasonable expectation of profits;(4) derived from the efforts of others.To satisfy this definition, the contract, plan, or transaction must satisfy all four aspects. The court takes a flexible approach to interpret the “investment contract,” with a focus on the “economic reality” between the issuer and the investor. In many cases, the court applies the interpretation of “economic reality” to limit the scope of “investment contract” and the application of the Securities Act.

Similarly, in April 2019, the SEC published a guidance document called “Framework for ‘Investment Contract’ Analysis of Digital Assets,” which is largely similar to the Howey test and can be used for analysis reference.

After Ethereum transitioned to the Proof of Stake (POS) consensus mechanism, some individuals, including SEC Chairman Gary Gensler, believe that Ethereum POS could lead to ETH being viewed as a “security” under the US Securities Act. The reasons are: (1) POS validators need to lock in 32 ETH for “investment”; (2) participate in a “common enterprise” composed of various validators; (3) have an expected profit from the rewards earned by staking; (4) profits come from the efforts of other validators or other parties involved in the validation process. These views extend the interpretation of the Howey test and fail to fundamentally recognize that the basic purpose of the Securities Act is to address information asymmetry in any situation.

III. Ethereum is not a security, and ETH staking (Solo Staking) does not constitute an investment contract.

Based on an article by Paradigm, “Ethereum’s New ‘Staking’ Model Does Not Make ETH A Security,” the reasons why Ethereum and ETH staking (solo staking) are not considered securities are explained. According to the four conditions of the Howey test, regardless of whether the act of a validator depositing ETH into a smart contract constitutes a “money investment,” the view that Ethereum or staking ETH constitutes an “investment contract” cannot be established because it does not satisfy the second condition (common enterprise) and the fourth condition (reliance on the efforts of others) of the Howey test.

First, let’s look at the second condition (common enterprise). The court typically analyzes “horizontal commonality” and “vertical commonality.” When investors connect with other investors by investing their funds into a pool (usually with profits distributed proportionally), “horizontal commonality” arises. The issuer needs to commingle the pool of funds and use them for a common enterprise.

In other words, the court emphasizes that “horizontal commonality” requires individual investors’ expected profits to be tied to other investors through the issuer’s entrepreneurial efforts. It requires investors to give up any personal claims to profits in exchange for the issuer’s proportional distribution rights in the subsequent profit distribution. However, there is no issuer on the Ethereum network, and the validator’s reward mainly depends on the individual efforts of each validator. The validator’s investment will not rise or fall due to the success or failure of any issuer’s entrepreneurial efforts. Therefore, there is no “horizontal commonality.”

The focus of “vertical commonality” is on the relationship between the issuer and the investor, requiring both parties’ wealth to be closely linked.

However, since there is no issuer on the Ethereum network, there is no “vertical commonality.” Therefore, the act of Ethereum or staking ETH (solo staking) cannot satisfy the second condition of the Howey test.Next, let’s consider the fourth condition (reliance on the efforts of others). Validators retain the ability to control investment returns, and their rewards largely depend on the amount of ETH they stake and the opportunity to randomly propose blocks they receive, both of which depend on individual efforts and are not dependent on any third party.

In conclusion, by analyzing the economic reality of Ethereum PoS staking, the court should find that ETH staking (solo staking) does not meet the Howey test because there is no “common enterprise,” and validators do not rely on the “efforts of others” to receive rewards. Similarly, whether depositing ETH into an Ethereum address constitutes a “money investment” is also a question. Therefore, Ethereum and ETH staking (solo staking) do not meet the Howey test, and transactions do not constitute investment contracts, and therefore, are not securities transactions.

IV. SEC’s Determination That Kraken’s Staking as a Service is a “Security” and the Logic Behind It

Paradigm explained through a point-by-point analysis of the Howey test that the act of Ethereum or ETH staking (solo staking) does not constitute an “investment contract” and thus is not a securities transaction. However, why was Kraken’s Staking as a Service considered a “security” by the SEC?

Compared to solo staking, where validators handle the security of the keys required for staking (“Not Your Key, Not Your Asset!”), centralized exchanges like Kraken offer “full custody” through their STaaS solution. This means investors fully entrust the keys required for staking to Kraken or similar centralized exchanges, which present significant risks, as seen in the case of FTX.

In a news release on February 9, 2023, the SEC stated, “When investors provide assets to such STaaS services, they lose control of those assets and assume significant risk related to those platforms, with little or no protection.” After receiving users’ asset keys, Kraken controls the assets for any purpose (with no disclosed information available to investors) and promises users a return.

This is fundamentally different from solo staking on Ethereum or ETH, where validators do not have control over investors’ assets. Kraken, on the other hand, receives investors’ funds (in full control), mixes the funds into a pool used for a common purpose (with no disclosed information), promises returns (up to 21%, significantly higher than Ethereum Foundation’s official ETH staking returns of about 5%), and finally, investors only participate in the investment and receive returns through Kraken’s efforts. This meets all the requirements of the Howey test and constitutes an “investment contract,” which is a securities transaction.

Gary Gensler personally appeared in a video explaining why STaaS products like Kraken’s must comply with the U.S. Securities Law: “When a company or platform offers these types of products to you and promises returns, whether they call their service Lending, Earn Rewards, APY, or Staking, this type of offering an investment contract for investor funds should be protected under federal securities law… This enforcement action should make it clear to the market that STaaS providers must register and provide comprehensive, fair, and truthful disclosure and investor protection.”

As a result, Kraken will “immediately” cease to offer staking services to U.S. users and pay a $30 million fine to the SEC to resolve the charges of offering unregistered securities.

V. Final thoughts

In summary, through the above analysis, we can clearly see that Ethereum is not a security and ETH Solo Staking is not a security, while Kraken’s ETH Staking product is a security. Various Staking-as-a-Service (STaaS) products have different designs and need to be treated differently, as can be seen from Coinbase’s various explanations of their ETH Staking product being non-security. Regardless, always remember Not Your Key, Not Your Asset!

In terms of SEC’s regulatory enforcement, it does have some flaws and shortcomings from the perspective of protecting investors, and products promising such high returns do have a bit of the taste of P2P lending. However, regardless of the circumstances, 2023 is the year when all CeFi will be included in the regulatory framework of traditional finance.

SEC Chairman Gary Gensler may be able to take down Kraken, but he cannot kill Ethereum.