Can staking-as-a-service providers be regarded as alternative investment funds?

Staking-as-a-service (StaaS) providers are steadily growing on the crypto-assets market along with the increasing popularity of decentralised networks based on the proof-of-stake consensus mechanism. The growing profile of StaaS providers also raises legal questions about the nature of these business models and the regulatory risk associated with them. In this article we examine one of these risks: the risk of treating the activity of StaaS providers as the activity of an alternative investment fund (AIF).

Basics of staking

As we discussed in previous articles on this blog (“Legal implications of various consensus mechanisms in public blockchains” and “Staking”), blockchain-based decentralised networks require achievement of “consensus.” This is a mechanism enabling verification of transactions executed on the blockchain without the involvement of a designated intermediary but in a manner ensuring the security of the entire network.

For a long time, the most widespread method of achieving consensus was “proof of work” (PoW), but that consumes a huge amount of power. (For this reason, for a while there was a risk that the European Parliament would include in the proposed Markets in Crypto-assets Regulation a ban on the use of consensus based on PoW.) The main alternative to the PoW mechanism is “proof of stake” (PoS), which is a decidedly more ecological solution ensuring the possibility of engagement in the consensus protocol to all participants of the network (and not only those with sufficiently advanced equipment at their disposal enabling them to validate transactions in the PoW mechanism).

What does the PoS model involve? In this consensus system, the participants (nodes) deposit their tokens in an online wallet, where they are frozen. This operation is called “staking,” and the deposited tokens are the “stake.” Then, based on an algorithm that especially rewards the participants who have gathered the most tokens, the network picks the validators of transactions executed on the blockchain. In exchange for a correctly validated transaction, the luck few receive newly “minted” tokens. In turn, if validation of the transaction fails (e.g. due an error), the validator’s stake can be taken over by the network (known as “slashing”).

What is the role of StaaS providers in the PoS model?

Staking ensures on one hand broader access by participants to validation of transactions executed on the blockchain, but on the other hand rewards holders of a larger number of tokens, requires the validator to devote time to verification of transactions, and entails the risk of slashing. The answer to all of these drawbacks is services offered by specialised entities— StaaS providers—who, in simple terms, will assume the burden of conducting validation of blocks of transactions in the PoS protocol. StaaS providers offer this service to numerous participants, and this greatly increases the pool of tokens they can present to the network as their stake. This in turn increases their chances of conducting validation of blocks—and in consequence receiving new tokens, which they can then distribute among the participants after deducting their own fee.

The risk of regarding a StaaS provider as an AIF

Taking a bird’s-eye view of the operation of an StaaS provider, we might conclude that it betrays certain functional similarities to investment activity in general, and particular to the activity of alternative investment funds. This issue has already attracted studies and publications in the United States, where various operating models of StaaS providers are assessed through the prism of the grounds developed in the case law for recognition of a given relationship as an “investment contract”(known as the “Howey test”). In these analyses, American commentators examine whether the relationship between the StaaS provider and the holders of tokens fits within the definition of an “investment contract” as “a transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” (Based on the US case law, the term “money” should be understood broadly, and is not limited to cash.)

While this definition of “investment contract” does not exactly correspond to the definition of an “alternative investment fund” set forth in the Polish act, it does display certain common features causing the analyses carried out in the US not to be entirely irrelevant for the Polish market (and the European market more broadly, as AIFs are governed by an EU directive). Under Art. 4(1)(a) of the AIFM Directive (implemented in Poland at Art. 2(10a) of the Act on Investment Funds and Management of Alternative Investment Funds of 27 May 2004), “alternative investment funds” are defined as “collective investment undertakings, including investment compartments thereof, which raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors” and do not require authorisation pursuant to EU law governing collective investment in securities (specifically, Art. 5 of Directive 2009/65/EC).

Guidance on interpreting the term “alternative investment fund” is provided by the European Securities and Markets Authority. Significantly, according to the ESMA’s “Guidelines on key concepts of the AIFMD,” if the elements in the definition of an AIF are met by the investment division of an undertaking, this should be sufficient to determine that the undertaking as a whole is an AIF. We will examine in turn each of the conditions discussed by the ESMA and consider whether the activity of StaaS providers truly has anything in common with AIFs:

1. “Collective investment undertaking”

According to the ESMA guidelines, if an undertaking exhibits all of the following characteristics, it may be said to be a collective investment undertaking:

  • The undertaking does not have a general commercial or industrial purpose.
  • The undertaking pools together capital raised from its investors for the purpose of investment with a view to generating a pooled return for those investors.
  • The unitholders or shareholders of the undertaking—as a collective group—have no day-to-day discretion or control.

It appears that most StaaS providers would meet the first and third of these conditions. On the second condition there may be doubts. It is true the purpose of StaaS providers is to make use of a validation mechanism in a PoS system that rewards users who can stack the most tokens. In this sense, it could be said that the activity consists of gathering tokens (or facilitating the gathering of tokens) with the aim of investing and generating returns. On the other hand, although this is not expressly stated in the AIF definition or the ESMA guidelines, it seems that an integral characteristic of AIFs is for the investor to cede to a third party some type of managerial decision-making with respect to the investor’s assets. This connection does not seem to arise in every model in which StaaS providers function. Depending on the network in which the StaaS provider operates (“pure,” “bonded” or “delegated”), the relations between the StaaS provider and the participant may be framed entirely differently. In a “pure” network, and also where the StaaS provider offers custodial services to the users, we may indeed identify ceding of control over the user’s assets to the StaaS provider, which might lead to regarding it as a collective investment undertaking. But in the case of a “bonded” or “delegated” network, this situation does not arise, and the person staking the tokens is either the immediate participant or the StaaS provider, but acting not for itself but for a specific participant who delegates his validation rights with respect to blocks to the StaaS provider. In that case, can it be said at all that the StaaS provider is pooling capital and investing it, which implies exercising control over the pooled capital?

2. “Raising capital”

The AIFM Directive refers to “raising capital,” but the ESMA explains that this may involve capital in cash or in kind. The Polish act better conveys the spirit of this rule, referring in this context to raising “assets.” Obviously, staking involves tokens, not cash. Considering the broad understanding of “capital” in the AIF context, it does not help to assert that the StaaS provider raises crypto-assets rather than money. But this argument could offer an effective line of defence against an accusation of conducting unlicensed banking activity.

3. “A number of investors”

According to the ESMA, a “number of investors” could be as few as one investor, if that investor raises capital from other investors and transfers it to a collective investment undertaking. By definition, StaaS providers serve numerous participants, and in light of the ESMA guidelines it seems that attempts to avoid application of the AIFM regime by adding another entity to the chain to intermediate between the participants and the StaaS provider are condemned to failure.

4. “Defined investment policy”

According to the ESMA, an undertaking should be regarded as having a defined investment policy if it “has a policy about how the pooled capital in the undertaking is to be managed to generate a pooled return for the investors from whom it has been raised.” Here we thus return to the issue of the StaaS provider’s “management” of investors’ capital. In models where such management of capital does occur, it cannot be ruled out that assumption by an StaaS provider of an obligation to investors to apply the capital raised in the process of staking with the aim of obtaining rewards could be regarded as a type of strategy on the part of the StaaS provider corresponding to an investment policy in the definition of an AIF.

Consequences of applying the AIF regime to StaaS providers

If the activity of StaaS providers were deemed to be AIF activity, it would have far-reaching consequences for these entities, starting with the need to adjust their activity to the regulatory regime under the AIFM Directive, which in Poland means compliance with the Act on Investment Funds and Management of Alternative Investment Funds, submission to oversight by the Polish Financial Supervision Authority, and the potential need to obtain a licence. Given the diversity of business models for StaaS providers, it is essential in each instance to conduct a legal analysis and assess the risk of classification of the given entity as an AIF. As mentioned, in some situations this risk could be higher than in others.

If it is found that the model does not exhibit the features of an AIF, the legal framework in which the given StaaS provider operates will need to be considered. It is now being argued in the US that the activity of StaaS providers more closely resembles a consignment (or in Polish komis). This is an interesting line of interpretation. Undoubtedly as staking services further evolve, new legal approaches will also arise, perhaps along with adoption of positions by supervisory authorities or new regulatory initiatives. It’s a topic worth following.

Joanna Werner

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