Liquid staking tokens - financial instruments or crypto-assets?

What is liquid staking?

Proof of Stake (PoS) is one of the most prominent blockchain consensus mechanisms used on e.g. the main decentralised-finance (DeFi) blockchain Ethereum. PoS blockchains select transaction validators from a pool of validators who earn a reward when they are selected and subsequently validate a block of transactions. The likelihood of being selected increases with the size of the validator's stake of the blockchain's native token and hence there is an incentive for validators to increase their stake. Validators will therefore offer other token-holders compensation if those holders temporarily deposit - called "staking" - their tokens with the validator. In this way, staking is a possibility for a token-holder to earn a passive income on the staked token while it is staked with a validator (in this context often referred to as a "staking provider").

Once staked, the tokens are blocked and cannot be redeemed, used or sold by the original token-holder. Liquid staking addresses this issue and has increasingly become a fixture of the DeFi space over the last couple of years. Liquid staking entails the issuance by the staking provider of a separate crypto-asset, a liquid staking token, in exchange for the staked tokens. Although the precise mechanism of staking and liquid staking can vary significantly between platforms and providers, liquid staking tokens generally share the feature that they can be traded separately on exchanges or used within the DeFi ecosystem, including to pay for the execution of transactions.

Although many of the tokens currently being staked in the market - ether (ETH) being the most widely used - are generally considered not to be financial instruments, that does not mean that the liquid staking tokens issued in exchange for staked tokens might not be, and it is important that market participants consider this when assessing the regulatory landscape both holders and staking providers navigate when engaged in liquid staking.

What are "financial instruments"?

The regulatory treatment of liquid staking tokens in the EU primarily turns on the concept of "financial instruments" as defined in the EU Markets in Financial Instruments Directive (MiFID II). This Insight focuses on the two kinds of financial instruments which will often be most relevant to consider in respect of liquid staking tokens: debt instruments and derivatives. Market participants should note, however, that depending on the specifics of the liquid staking token in question, it may be relevant to consider other types of financial instruments, such as certificates of deposit or units in alternative investment funds.

Debt instruments, such as bonds, reflect a debt of an issuer. Pursuant to item (b) of the MiFID II definition of 'transferable securities', debt instruments are transferable securities (and thereby financial instruments), if they are a class of securities which are negotiable on the capital market and are not an instrument of payment, as further elaborated on below. The holder of such instruments usually (although not necessarily) receives interest payments (whether paid regularly or capitalised/rolled up) and possibly instalments of principal with a final repayment of the outstanding principal and accrued interest at maturity. Such instruments must be "transferable" to be considered financial instruments under MiFID II.

Derivatives cover a wide range of quite different instruments which do, however, share some core features. A derivative is a contract between two parties, where the economics of the agreement depend on an external event either occurring or not occurring and where the two contracting parties have opposing interests in whether such event occurs or not. The "event" (called the underlying) can be almost anything but is commonly tied to the development of an asset or reference, such as a change in the price of a commodity, stock or currency relative to a reference price (the strike price), changes in an interest rate or an index or the contractual default of a specific debtor under its financial arrangements. Derivatives thus create exposure against the event's occurrence (or non-occurrence).

Are liquid staking tokens financial instruments?

Debt instruments

Liquid staking tokens issued by third-parties could be considered to be debt instruments. The staked tokens are comparable to the original purchase price of a bond. The "staking yield" received by the original holder of the token is comparable to the interest payment and return of the staked token is comparable to the repayment of principal. The secondary trading and "use" of the liquid staking token have many similarities with the secondary market for bonds in either trading, lending or use as collateral.

The concept of "debt" is traditionally understood as a (fiat) monetary payment obligation and so it remains doubtful whether regulators will consider a token denominated in a crypto-asset to be "debt instruments" within the meaning of MiFID II. It must, however, be acknowledged that if a non-fiat currency denominated instrument could not constitute a "debt instrument", that would make circumvention of MiFID II very easy, since debt instruments could then just be denominated in a cryptocurrency, e.g. a stablecoin, and the subscription proceeds converted by the issuer into the fiat currency to which the stablecoin is pegged immediately after issuance. On the other hand, such an issuance would likely be subject to regulation under the EU Markets in Crypto-Assets Regulation (MiCA) once that enters into force in the second half of 2024.

On 29 January 2024, the European Securities and Markets Authority (ESMA) issued a consultation draft of guidelines on the conditions and criteria for the qualification of crypto-assets as financial instruments. With respect to transferable securities, the guidelines make no mention that crypto-denominated debt or equity instruments should per se be incapable of constituting financial instruments. According to ESMA, crypto-assets can be deemed a transferable security (which includes bonds and other traditional debt instruments) if they are (i) part of a "class of securities", (ii) negotiable on the capital market and (iii) not an "instrument of payment" (as that term is used within the definition of "transferable securities" in MiFID II).

A crypto-asset will be deemed to have formed a "class" of securities if it (i) is interchangeable with other crypto-assets within such class, (ii) is issued by the same issuer, (iii) has similarities to other crypto-assets within the class and (iv) provides access to equal rights within the class. The negotiability criterion must be interpreted broadly to include crypto-assets which are capable of being transferred or traded on capital markets. The term "capital markets", in this regard, should also be interpreted broadly to include all contexts where buying and selling interests in securities meet and where funds are raised for the operation of business. 

Generally, none of the factors above decisively preclude liquid staking tokens from being classified as "debt instruments" and it is unlikely that tokens would qualify as an "instrument of payment". The main question therefore remains how far ESMA's "substance over form" approach will go and whether debt instruments categorically must be denominated in fiat currency to be considered financial instruments.

Derivatives

Since the value of the liquid staking token is linked to the underlying staked token, it could also be considered a derivative instrument, with the staked token as its underlying asset. 

A liquid staking token will often not act as a conventional derivative instrument in economic terms, since the "strike price" of the liquid staking token is not fixed and should generally move in lockstep with the price of the staked token. Consequently, it is difficult to assess of which bet the two contracting parties would be taking opposite sides of the transaction. 

Normally, the liquid staking token is "purchased" with the staked token (in derivative terms, the payment of a premium) and the staked token is what the original token-holder receives once the staking period has lapsed (the underlying), so any changes in the price of the underlying asset are not economically relevant. This is comparable to e.g. purchasing a forward agreement for 100 Danish kroner (DKK) (the underlying) for the price of DKK 100 (premium). Although such a forward agreement would still be a derivative, at the end of the contract term, the price difference between the two sides of the trade should be zero.

However, if the "purchase price" of the liquid staking token is something other than the underlying staked token , e.g. if the liquid staking tokens are purchased for fiat currency (creating a "synthetic" exposure to the development of the exchange rate between such fiat currency and the staked token), a mismatch in the price development between the premium (fiat currency) and the underlying asset (staked tokens) is possible and the comparison to derivatives becomes more obvious. This exposure would be comparable to purchasing a forward agreement for DKK 100 (underlying) for the price of an equivalent value in US dollars (USD). Any changes in the exchange rate between DKK and USD over the contract term will be a gain or a loss on the trade. In the same way, in the example with liquid staking tokens, any changes in the conversion rate between the relevant fiat currency and the staked token will be a loss or gain on the "trade". The instrument has created exposure to price volatility which can be used for hedging or speculative purposes without holding the underlying asset, and the parties to the "trade" have opposite interests in the development of the conversion rate between the staked token and the relevant fiat currency or other asset used to acquire the liquid staking token.

Conclusion

Depending on the specifics of how liquid staking tokens are structured and issued, they run a varying degree of risk of being classified as "financial instruments". Liquid staking tokens issued by identifiable third-parties, rather than as a native function of the relevant blockchain, are significantly more likely to be considered financial instruments, since an issuer or counterpart can easily be identified and the tokens are more readily comparable to traditional financial instruments. However, native liquid staking tokens are not necessarily excluded from being considered financial instruments even though a specific counterparty cannot be identified. This assessment will be highly contingent on the specific facts in each case.

Regulatory consequences

Liquid staking tokens as financial instruments under MiFID II

If liquid staking tokens are "financial instruments", issuing and trading them will be subject to MiFID II and all other existing financial regulation applicable to "financial instruments". The consequences of this would include - but by no means be limited to: 

• liquid staking providers and ancillary service providers, including those executing orders to exchange a token for a liquid staking token (or vice versa) and facilitating any trading on an exchange, e.g. with reception and transmission or execution of trade orders or the operation of a trading platform, would need a license as an investment firm, regulated market etc. as applicable depending on the services provided and would need to comply with trade reporting, transparency, market abuse rules and other extensive requirements under the EU financial services regulatory regime;
• the liquid staking provider would likely also be regulated as an issuer of financial instruments and be subject to various disclosure obligations under the Prospectus Regulation (if the liquid staking tokens are deemed to be "transferable securities") and the Market Abuse Regulation (if the financial instrument is traded on an exchange), including in many circumstances the obligation to prepare and publish an approved prospectus; and
• when involved in proprietary trading, liquid staking token-holders would usually not be regulated under MiFID II as dealing only on own account is in many cases exempt pursuant to Article 2(1)(d), although other legislation, such as the Market Abuse Regulation (including its prohibition of insider trading and market manipulation), would apply.

Liquid staking tokens as crypto-assets under MiCA

If liquid staking tokens are not considered financial instruments, the "joy" of absence of regulation will be short-lived as the tokens will then become regulated as crypto-assets under MiCA from 30 December 2024 (or, if the tokens are stablecoins, in some respects already from 30 June 2024). MiCA draws very heavily on existing EU financial regulation for investment services and payment services and will introduce a similar framework for crypto-assets. Key aspects of the regulatory environment for liquid staking tokens which are crypto-assets include:

• liquid staking providers and most ancillary services providers, including anyone executing trades or conversions between liquid staking tokens and other types of DeFi instruments (or vice versa) or operating a market place for liquid staking tokens would be crypto-asset service providers, and would need to obtain a licence as a crypto-asset service provider;
• the liquid staking provider would likewise be an issuer of crypto-assets, which triggers requirements to publish a crypto-asset white paper and other disclosure and marketing obligations; and
• liquid staking token-holders would not be regulated as crypto-asset service providers, as proprietary trading is not a crypto-asset service. However, MiCA does contain provisions in line with the Market Abuse Regulation forbidding insider trading with crypto-assets and prohibiting market manipulation.

Importantly in a MiCA context, any crypto-asset service which is provided in a "fully decentralised" manner without any intermediary will be exempt from the scope of MiCA but pending further guidance from competent authorities, it is uncertain whether the exemption will be relevant to liquid staking in the form currently being prevalent in the market where it is provided with the intermediation of liquid staking providers.