Staking a profit with Decentralized Finance

Article Experience

M. Ridgway Barker co-authored this article with Joseph Bambara, CIPP/US.

Decentralized Finance (DeFi) staking is an activity where a user locks or holds his funds in a cryptocurrency wallet to participate in maintaining the operations of a proof-of-stake (PoS) based blockchain system. PoS protocols are a class of consensus mechanisms for blockchains that work by selecting validators in proportion to their quantity of holdings in the associated cryptocurrency. Put another way, it is the staking of cryptocurrencies to be used as collateral by PoS blockchains to achieve specific outcomes, e.g., validating transactions and earning interest or newly minted tokens as rewards. It is not unlike blockchain mining as it facilitates network consensus while rewarding users who participate. As mentioned in staking, the right to validate transactions is determined by how many coins are “locked” inside a wallet. Just like miners on a proof-of-work (PoW) platform, stakers are incentivized to determine the next block or add a transaction to a blockchain. So, the main difference between mining and staking is the underlying blockchain consensus mechanism used to validate transactions. Mining is used for PoW, most notably in bitcoin (BTC). While staking is used for most cryptocurrencies with PoS blockchain platforms such as Ethereum 2. PoS blockchain platforms represent a significant milestone in the maturation of blockchain technology. They are scalable and have high transaction speeds. Ethereum has recently shifted from a PoW to a PoS consensus mechanism. Staking is the preferred consensus protocol because PoW mining is not a sustainable model. It requires specialized hardware (e.g., GPU), and most importantly, PoW consumes a lot of energy. Staking is widely considered to be more environmentally sustainable, saving over 99% of energy consumption.

How to generate passive income: There are many options for users who want to earn passive income with their idle crypto assets. With Ethereum, the second-most popular cryptocurrency platform, you can earn around 5% per annum by becoming a PoS validator. In order to stake on ETH 2.0, you need to own a minimum of 32 ETH and an Eth1 mainnet client like metamask. This is explained at the link Eth2 LaunchPad. Another more sophisticated option is Tezos (XTZ). It implements a version of PoS called liquid proof-of-stake (LPoS). Tezos’ native currency is called XTZ, and the staking process is called “baking.” Bakers are rewarded using the native coin.

Furthermore, malicious bakers are penalized by having their stake confiscated. To become a staker/baker on Tezos, a user needs to hold 8,000 XTZ coins (approximately $27,500 on August 15, 2021) and run a full Tezos node. There are also “third-party” Tezos staking services which have emerged, allowing coin holders to delegate small XTZ quantities and share baking rewards. Annual percentage yield on XTZ staking ranges anywhere from 5 to 6 percent. Moreover, tokens harvested via staking from these ventures can then be compounded via similar DeFi protocols, creating a cyclical chain of rewards that can quickly add up. For example, the best performing investment fund in Australia, Apollo Capital, generated nearly 700% YTD in April 2021 by staking on behalf of its liquidity providers. Staking stablecoins is a way to hold your funds in the current interest rate environment and earn yields while avoiding market volatility. Stablecoins yields across top exchanges range from 2% for Dai all the way up to 13.93% for Tether (USDT) on the OKEx exchange. Exchanges have entered the staking business as they have an extensive number of users on their platforms. By staking, traders can diversify their income stream and monetize their idle crypto assets on exchanges; the cryptocurrency exchanges Coinbase and Binance support staking. Another form of staking is known as cold staking. Stakers have to keep staked coins in the same address since moving them breaks the lock-up period, which consequently causes them to lose staking rewards.

Ledger is the industry leader for cold wallets. The advantage of hardware wallets is that you still maintain full control of your coins during a staking session. On top of its security, Ledger allows its users to stake up to seven coins. Trust Wallet is a private wallet supported by Binance. The wallet allows users to earn a passive income by staking emerging PoS models, including XTZ, ATOM, VET, TRX, IOTX, ALGO, TOMO, and CLO. Unlike cryptocurrency exchanges and wallets that provide both trading and storage avenues, respectively, staking-as-a-service platforms. are dedicated to staking only. However, these platforms take a percentage of the rewards earned to cover their fees. Staking on these platforms is also known as soft staking. To check yields from DeFi staking, visit the staking reward website.

What are the regulatory concerns: There are securities law considerations for staking services. Depending on the proof-of-stake network, a staker may:
1. Stake their own tokens.
2. Delegate their right to validate transactions while keeping custody of the tokens.
3. Both delegate this right and transfer custody of the tokens for staking.

Validating new transaction blocks earns stakers rewards in the form of created tokens. Delegating is meant to increase member participation by allowing for specialized services, known as staking service providers, to perform the staking function on behalf of individuals. Determining whether the use of a staking service provider qualifies as an investment contract requires analysis under SEC v. W.J. Howey Co. Per the Howey test, investment contracts involve (1) an investment of money (2) in a common enterprise (3) with the expectation of profit (4) based solely on the efforts of others. If one were to apply the four criteria of the Howey test to staking service providers, it becomes clear that some of these requirements will not be met, i.e., staking services should not qualify as investment contracts subject to the securities laws. One could argue that it fails all four test prongs, but the prong concerning the “efforts of others” is worth addressing. Here, the relevant question is whether the staking participant retains significant control over their assets. Typically the staker can delegate staking rights while retaining custody of their assets.

Moreover, individuals may revoke this delegatory authority. This means that an individual participating in staking via delegation to a staking service provider can exert control by their delegatory rights to other providers while receiving a substantially equivalent service. The next consideration is what constitutes “essential managerial efforts” per the expansion of Howey. Generally, a staking service provider may only perform a particular function like validating transactions according to a network’s consensus protocol. Unlike a securities broker, the staking service does not have the authority to manipulate or control the member’s assets. It is only temporarily granted custody for a validation. In that sense, the efforts of a staking service provider are more operational than managerial.

What’s more, the entire network’s success depends on cooperation across a decentralized network, meaning the success or failure of the broader network is independent of a discrete staking service provider’s action. Staking service arrangements not only fail to meet all the required criteria identified by Howey, but their application to securities regulation also fails to advance the intent of the securities laws. Congress passed the Securities Act of 1934 to create the SEC and instill the authority to monitor public companies. Crucial to this mission is the need for investors to have access to complete and accurate information so that they may make informed decisions. There is the same assurance of transparency or material information created by a staking service arrangement in an open blockchain network. Thus, consumers can make fully informed decisions regarding their choice of provider.

DeFi platforms will soon be subject to increased legal and regulatory obligations. Unfortunately, we do see instances of fraud and DeFi market manipulation involving deliberate scams, misappropriation, and other efforts to take advantage of digital assets investors. The activities involved could occur with any service involving digital assets. Money laundering, for example, is a problem for established centralized cryptocurrency exchanges. Some of these activities are actually conducted by DeFi developers themselves. For example, “rug pulls,” or exit scams involve pitching investors to place funds into seemingly legitimate DeFi services, from which they are depleted by the developers, who then evanesce. That said, poorly designed regulatory obligations could themselves be viewed as a risk factor for DeFi. This is the challenge as all significant categories of DeFi activity can be viewed as alternatives to regulated financial services.

The U.S. Senate recently released a draft of its bipartisan infrastructure bill (the “Bill”) that includes broad cryptocurrency reporting requirements. The Bill includes a provision on information reporting for cryptocurrency transactions and cryptocurrency brokers and provides for non-compliance penalties. Specifically, Section 80603 of the Bill would require businesses that transmit digital assets to file tax information reports similar to the Form 1099 requirements for securities brokers. The definition of a person responsible for filing such reports is broad. It states: “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets.” There is opposition in the Senate on the broad scope of the information reporting provision. Sens. Ron Wyden and Pat Toomey have filed an amendment that would narrow the Bill’s scope by excluding persons solely engaged in validating distributed ledger transactions such as mining and staking from the reporting requirements. If the Bill is enacted in its current form, the proposed changes will affect digital assets acquired on or after January 1, 2023, and apply to returns required to be filed and statements required to be furnished after December 31, 2023. However, this bill is a fast-moving work in process, so we anticipate that changes may be made to the bill. U.S. Securities and Exchange Commission Chairman Gary Gensler has recently called for more authority to regulate decentralized finance. He stated that the legislative priority should center on crypto trading, lending, and centralized and decentralized finance.

What are U.S. Tax Law considerations: Receiving staking rewards is a taxable event in the U.S., similar to receiving interest from your crypto from comparable investment vehicles. But when the taxable event occurs may depend on when you actually recognize the income. On May 26, 2021, in Jarrett v United States of America, a lawsuit was filed against the U.S. Internal Revenue Service (IRS) over tax paid on rewards for liquid staking on the Tezos blockchain. The Jarrett’s say they should not have been taxed on the Tezos tokens until they were sold or exchanged. They claim federal income tax laws do not permit the taxation of tokens created through a staking enterprise. The case is ongoing. The IRS has yet to issue specific guidance on the taxation of crypto assets where staking is involved. This is the first major suit filed against the IRS related to crypto staking rewards. The case has potentially far-reaching implications for how contributors to PoS blockchains are taxed for the tokens they receive. The outcome could resonate with users of the much larger Ethereum blockchain. In any event in the U.S., all crypto to fiat or crypto to crypto transactions are taxable events. On June 18, 2021, the IRS released Chief Counsel Advice 202124008 to address whether an exchange of (i) Bitcoin for Ether, (ii) Bitcoin for Litecoin or (iii) Ether for Litecoin qualify as like-kind exchanges under Section 1031 of the tax code. According to the IRS, all three of these swaps were taxable even before 2018. When you invest in crypto in the U.S., you have a series of crypto tax reporting obligations. When you receive staking rewards, you need to report those transactions on your income tax return. If you later sell the crypto you received from staking, you’ll have to report all individual trades on Form 8949 and Schedule D of your Form 1040 after determining the gain/loss on each trade. If you run a staking business in the U.S., like a Bitcoin mining business, you can deduct costs like cloud service, software. Your operating expenses, such as electricity, can also be tax-deductible, lowering your tax bill in the end. However, if you stake as an individual, you cannot claim tax deductions on those costs because investment expenses for individual taxpayers are not deductible under the current tax law.

Summary
Staking is another relatively risk-free way for investors to participate in governing blockchain networks and be well rewarded for their contributions. Besides the profit incentives staking provides for investors, there are numerous advantages to PoS as an alternative consensus mechanism for the growing DeFi and blockchain applications. It’s more energy-efficient than PoW because there is no need to consume vast amounts of electricity nor provision ever-increasing amounts of computing power to solve cryptographic block building. Staking also encourages longer-term participation in securing the blockchain networks because validating nodes must own or put forward a certain amount of the asset to verify blocks. The extent of Bitcoin’s PoW power use has not escaped the attention of cross-governmental bodies and financial regulators. So, Proof of Stake will overtake Proof of Work blockchains in the long run because PoS is more economical, scalable, and environmentally friendly. Certainly, market regulators and policy experts will have these points in their minds when laws and regulations are finally drafted.

Our Withers attorneys can assist and educate clients from a legal and technical standpoint to incorporate these emerging technology trends safely and efficiently to help your businesses stay ahead of the competition. Please contact your regular Withers attorney or the author of this piece with any questions.

Author