Where could staking regulation be going in the UK?

Back in February 2023 HM Treasury put out a consultation to collect industry thoughts on how the UK can best regulate the cryptoasset space whilst still fostering innovation. The consultation, titled “Future financial services regulatory regime for cryptoassets” received 131 responses from across legal firms, academia, tradfis and crypto native companies.

Then last week, Economic Secretary Bim Afolami announced at the Innovate Finance Global Summit that regulation for stablecoins, operating an exchange, taking custody of cryptoassets and staking activity were expected to land in July of this year. The stated aim of the legislation is to cement the UK as a global hub for crypto, and it certainly feels like the UK is watching the USA’s failing approach to crypto regulation, comparing it to the positive response of the EU’s MiCA regs and wants to be more aligned with the latter.

There were a whopping 52 questions within the consultation ranging from topics such as sustainability ( Question 47: When making investment decisions in cryptoassets, what information regarding environmental impact and / or energy intensity would investors find most useful for their decisions? ) to market abuse ( Question 26: Do you agree that the scope of the market abuse regime should be cryptoassets that are requested to be admitted to trading on a cryptoasset trading venue (regardless of where the trading activity takes place)? ), from stablecoins ( Question 12: Do you agree that so-called algorithmic stablecoins and cryptobacked tokens should be regulated in the same way as unbacked cryptoassets? ) to lending and borrowing ( Question 32: What types of regulatory safeguards would have been most effective in preventing the collapse of Celsius and other cryptoasset lending platforms earlier this year? ).

And 3 specific questions on staking…

• Question 44: Is there merit in regulating mining and validation activities in the UK? What would be the main regulatory outcomes beyond sustainability objectives?
• Question 45: Should staking (excluding “layer 1 staking”) be considered alongside cryptoasset lending as an activity to be regulated in phase 2
• Question 46: What do you think the most appropriate regulatory hooks for layer 1 staking activity would be (e.g. the staking pools or the validators themselves)?

Q44: Is there merit in regulating mining and validation activities in the UK? What would be the main regulatory outcomes beyond sustainability objectives?

As the saying goes, there are only three certain things in life; birth, death and the argument coming around again that Bitcoin is destroying the planet with its energy use.

There is ongoing fantastic research by Cambridge University on Bitcoin’s (and now also Ethereum’s energy use): https://ccaf.io/cbnsi/cbeci and I always point people towards the Bitcoin Mining Council’s research on renewable energy use by Bitcoin miners — this currently stands at almost 60% of the energy mix usage! https://bitcoinminingcouncil.com/bitcoin-mining-council-survey-confirms-year-on-year-improvements-in-sustainable-power-and-technological-efficiency-in-h1-2023/

However there’s often calls by legislators to ban or limit mining over environmental concerns.

I was therefore not surprised to see this question come up.

However it appears that the Treasury is taking a more pragmatic approach than some other legislators and countries, and noted in the consultation their belief that regulating the limited mining activity in the UK could lead to offshoring.

With bitcoin mining in the UK likely in the lower % figures (n.b over 60% of mining activity is from unknown locations and so most probably bumps up from the 1.21% known figure), I agree that taking action or putting onerous requirements on the small group of miners in the UK could push them elsewhere. It’s also not likely to be a high impact area from a consumer protection or tax perspective which is what governments and legislators tend to focus on.

The outcome of the proposal and consultation for this topic was that the government doesn’t intend to regulate mining as a regulated activity and doesn’t consider it to be classified as a financial services activity.

Time will tell in July when the proposed regulations are tabled, but for now it appears that anyone operating as a bitcoin miner or mining other proof-of-work assets won’t be under the purview of the new laws.

Q45: Should staking (excluding “layer 1 staking”) be considered alongside cryptoasset lending as an activity to be regulated in phase 2? & Q46: What do you think the most appropriate regulatory hooks for layer 1 staking activity would be (e.g. the staking pools or the validators themselves)?

The key distinction with these questions is around the definition of what it means to ‘stake. Primarily there is staking of a layer one asset which allows someone to lock up their assets at the protocol level, complete validation activities and be paid in the native asset for their service. However the term ‘staking’ has also be co-opted by applications and projects to encompass any situation where assets are locked and a reward is given. As such, it’s possible to ‘stake’ many governance tokens to earn a reward e.g BLUR, LDo, FXS and the Bitcoin layer 2 “Stacks’ offers a form of staking, where STX tokens can be locked to earn BTC.

It’s promising to see that the Treasury understands that these types of activity are distinct in both the technological and risk sense.

Within the consultation response they noted a commitment to creating a robust definition of staking to differentiate these different types, and proposed the following:

“The process where a given amount of native cryptoassets are locked up (staked) on smart contracts in a PoS consensus mechanism blockchain (on-chain), in order to activate validator nodes (computers) which collaboratively validate subsequent transactions and achieve consensus on the network’s current state.”

The key element in this definition is the specific inclusion of ‘native’ assets to help draw out the distinction from layer 2 ‘staking’ and other lock-and-reward based models on the app layer.

The definition continues to cover the rewards aspect of staking:

“Rewards, consisting of newly minted native tokens and/or a portion of transaction fees on the blockchain, are then subsequently allocated to the network participants staking their cryptoassets and to the validator node operators.”

The mention of ‘validator node operators’ reflects the different set up models for validating and they double down into this with a proposed taxonomy of the different staking models that can be deployed;

The proposal notes:

“At present, the government considers that the specific process of operating a validator node using on-chain staked cryptoassets would generally constitute a technical function essential to the operational activities and security of a PoS blockchain, rather than a financial services activity.”

Which will be a promising signal for solo stakers as this likely puts them outside any regulatory boundary from a financial services perspective. In line with this, across the pond in the US when considering the potential for staking to fall under the SEC’s broad definition of Howey as applied to cryptoassets, the lack of “common enterprise” from solo staking could give also some regulatory breathing room for the c4–20% of solo stakers across the network:

https://dune.com/hildobby/eth2-staking

From the consultation response it appears that decentralised and centralised pool staking providers will be the focus of any new regulations as the government notes that such activities can involve taking custody of funds (which was specifically noted by Afolami last week as within the scope of the new regulations), and that the issuance of liquid staking tokens can present consumer protection risks.

What’s unclear from the October consultation is whether new regulations would be needed or if these activities can be brought within scope of existing regulations e.g updated finprom guidance or around lending and borrowing.

One additional hot topic mentioned in responses to the initial consultation was fears around whether staking falls under the definition of a Collective Investment Scheme (CIS). The current definition for this is:

(a) any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income; and (b) which are not excluded by the Financial Services and Markets Act (Collective Investment Schemes) Order 2001 (SI 2001/1062).

The challenge around staking falling under the CIS definition is the this could mean a staking provider would need to be registered and regulated under the FCA. There could also be limitations on who can stake, potentially limiting this activity to qualified investors only. If this doesn’t already sound like a high barrier for entry and costly situation to adhere to — try taking a look through the 612 pages of the Collective Investment Scheme handbook! https://www.handbook.fca.org.uk/handbook/COLL.pdf

Fortunately the government’s signal in their response is that they are potentially looking to carve out certain types of staking from the CIS definition — I would expect (and hope) solo and delegated staking. However if pooled staking falls within the CIS framework then there are some challenging times ahead for centralised exchanges who currently offer staking to UK customers and big questions about what this could mean for pooled staking providers like Lido and Rocketpool who’s decentralised service means they can’t adhere to regulation in the same way as a tradfi business with mutable business practices and systems.

This will certainly be an area I’m keen to study closely when the regulations are revealed!

So now we wait for July when the regulations are due to drop. However with a general election imminent, Mayday and Whitsun recesses in between then and now, and the summer recess starting on July 23rd; whether we’ll see progress on this bill before the UK political scene is thrown into Election fever seems a big question mark!

[The views and opinions expressed in this post are strictly those of the author and do not represent or reflect the policies, positions, or beliefs of their current or any previous employer.]

Originally published at https://www.linkedin.com.