Regulatory Issues of Crypto Staking

Many individuals consider purchasing a particular crypto asset as a means of profiting from crypto assets (virtual currency) and selling it when the value of the crypto asset increases. Additionally, there is a method called staking that allows for earning rewards while holding crypto assets.

At present, cryptocurrency staking remains a relatively unknown concept. However, it is crucial to exercise caution as it may be subject to regulations under Japan’s Financial Instruments and Exchange Act. This article aims to provide an explanation of staking in crypto assets for businesses and investors considering staking their crypto assets.

Understanding Crypto Asset Staking

Crypto asset staking is a method of earning rewards by holding crypto assets and participating in the blockchain network associated with them. To participate in crypto asset staking, it is necessary to hold a certain amount of crypto assets or more. For example, in Ethereum, holding 32 ETH or more is required to participate in PoS, which will be explained later.

To stake crypto assets, one must deposit them onto the network (staking pool) rather than simply holding them. It should be noted that the deposited crypto assets will be locked and cannot be transferred.

Staking is primarily based on PoS (Proof of Stake) or comparable consensus algorithms. Through staking, you can acquire the privilege to act as a transaction approver (validator) based on the quantity and duration of your cryptocurrency holdings.

Participants in PoS-based crypto assets can earn newly-issued tokens as rewards simply by holding their assets and contributing to the network. This system encourages long-term holders and contributes to the overall value and stability of the asset ecosystem.

There are multiple variations of this consensus algorithm that vary depending on the crypto-asset in question. These algorithms can help to alleviate issues caused by the energy-intensive process of crypto-asset mining associated with Proof of Work (PoW).

Overview of staking business 

Individuals can potentially engage in crypto asset staking, but the required amount of crypto assets may be substantial depending on the type. For instance, Ethereum stipulates a minimum of 32 ETH, which equates to several million yen in Japanese currency. Thus, the barriers to enter for personal participation in crypto asset staking are considerable. Consequently, some business operators may gather funds and employ them to undertake staking operations instead.

As previously stated, crypto assets that are deposited into a staking pool are not able to be transferred. Additionally, in the event of a company engaging in staking activities, there exists a mechanism to release an alternative token of equal value to the deposited crypto assets, thus allowing for trading and exchange with other crypto assets. It is important to note that the staking of crypto assets is distinct from the mining of crypto assets, as it involves the holding of crypto assets by a business operator.

Staking Business Scheme

There are two types of staking business schemes: the simplest scheme and a scheme that issues alternative tokens. In the following sections, we will elaborate on these two types.

The Simplest Scheme

To put it simply, the user initially deposits their crypto assets with the business operator. The operator then utilizes the deposited assets to stake and subsequently allocates the rewards earned from staking to the users.

This scheme is the most straightforward option in the staking industry.

Scheme for Issuing Alternative Tokens

As previously stated, staking involves locking your crypto assets into a staking pool, which restricts your ability to move them freely. To counteract this disadvantage, an alternative token issuance scheme is utilized.

When participating in a program that generates substitute tokens, users must first deposit their crypto assets with the operator. This is a distinct feature of programs that generate substitute tokens, however, the operator is responsible for issuing the substitute token to the user.

Some schemes, such as the most straightforward one, involve taking the crypto assets deposited by users, staking them, and then distributing the rewards gained by staking back to the users. With schemes that issue alternate tokens, the tokens can be utilized for trading or exchanging with other crypto assets.

 By avoiding the practice of locking crypto assets in staking pools, some of the drawbacks associated with this method are mitigated.

Regulations for Crypto Asset Staking

The business of staking crypto-assets, as previously discussed, involves the holding of such assets by operators. As a result, there are numerous distinctive factors to contemplate in relation to this practice. So now, we will outline the legal requirements and regulations governing the staking of crypto-assets below.

Cases of Non-Custodial Crypto Asset Staking by Staking Companies

If the staking company fails to deposit the crypto assets for staking (neither for deposit nor investment), it is deemed to be the delegate. Such a staking company does not entrust crypto assets to users, therefore, the services provided by the staking company do not qualify as custody business.

Hence, the staking firm involved in this instance is not classified as a provider of crypto asset exchange services and is exempted from being regulated under Japan’s Payment Services Act. Moreover, if the staking firm does not receive any entrusted crypto assets from users, it cannot be construed that the user is investing in the staking company. Consequently, it is not perceived as a collective investment scheme and thus not liable to be regulated under Japan’s Financial Instruments and Exchange Act, even in relation to collective investment schemes.

One can consider lending crypto assets as a means that is distinct from deposits or investments. However, it can be challenging to determine whether it qualifies as a loan or a deposit in practice. The Japanese Financial Services Agency has issued guidelines for the crypto-asset exchange business that outline the management of crypto-assets. The guidelines state that if an individual manages crypto-assets for another person through a non-legal arrangement like a loan, it falls under the category of crypto-asset management. Consequently, one must register with a Japanese crypto asset exchange firm.

Staking Company Entrusting Crypto Assets

If a staking company accepts crypto assets from users, the staking business will be categorized as either a custody business or a collective investment scheme.

If a staking company accepts deposits of cryptocurrency from users, it is categorized as a custody business. Furthermore, if a staking company receives investments in cryptocurrency from users, it is regarded as a collective investment scheme.

It is crucial to differentiate the legal evaluation of staking business as either a deposit or investment.

Classification of staking business as deposit or investment

Regarding the differentiation between deposits and investments, the general criterion is based on the presence or absence of profit distribution. Essentially, a lack of profit distribution would classify it as a deposit, while profit distribution would classify it as an investment.

If a staking company is required to return all crypto assets deposited by users and receives a reward that is not tied to revenue, it cannot be classified as revenue sharing. As a result, it can be regarded as a deposit.

On the other hand, even if the staking company is obligated to return all of the deposited crypto assets by the user, there may be instances where revenue-linked rewards are received and considered as a deposit with associated rewards. Alternatively, it can be viewed as an investment with a specific agreement to compensate for any losses.

In addition, if the staking company is not obligated to return the full amount of crypto assets deposited by users and receives compensation that is not linked to earnings, it may be considered an investment with a cap on compensation. Conversely, if the company receives compensation that is linked to earnings under the same conditions as above, it would be considered a typical investment.

In the staking industry, the choice to deposit or invest is contingent on the specific scheme. Consequently, if it is classified as an investment, it may be subject to regulations under Japan’s Financial Instruments and Exchange Act as a collective investment scheme. Furthermore, if it is categorized as a deposit, it may fall under the ambit of regulations outlined in Japan’s Payment Services Act as a crypto asset exchange business.

Hence, careful consideration is required when engaging in a crypto asset staking business to determine the applicable scheme and the regulations that it will be subjected to.

Crypto Asset Staking Regulations

Up to this point, we have provided information on staking crypto assets for businesses and investors considering this option. Successfully staking crypto assets requires expertise not only in legal matters, but also in the field of crypto assets.

If you plan to launch a staking business involving crypto assets, we recommend seeking advice from a lawyer with expertise in this area.

Guidance of Countermeasures by Our Office

Monolith Law Office is a highly specialized law firm in both IT, particularly the Internet, and law. Our firm offers comprehensive support for businesses involved in crypto assets and blockchain.