DeFi staking is in the regulatory limelight in the U.K., one of the first big jurisdictions to address staking head on.
Prior to the U.K. General Election being called in May, the Economic Secretary to the Treasury and City Minister, Bim Afolami, was a regular on the London spring conference scene repeatedly reiterating the U.K. Government’s commitment to tackling DeFi staking within the coming months.
Getting it right will require a lot of hard work by policymakers and regulators who are being encouraged to double down on industry engagement and input. DeFi staking is a nuanced area, with many policymakers and regulators leaning toward the view that staking is either lending, or a collective investment scheme and thus the basis for a security – it is neither.
DeFi staking is at the core of Web3’s economic development and the internet’s next scalable model to better incorporate money and payments. Even the Bank of International Settlements (BIS) is getting on Web3 with their vision for Fintenet – the (global) financial system for the future. When central bankers get excited about digital technology and innovation, policymakers and regulators are advised to pay close attention.
It is estimated that there are more than 22,000 Web3 developers globally, down from a high of 27,000 in 2022 following crypto winter. DeFi developers are now one tenth of the engineers that work in the global semiconductor industry, also a strategic industry. These numbers signal a significant enough decentralized cross-border global industry network to merit economic attention.
According to Market.us, the projected value of the global Web3 market is anticipated to be $4.6 billion by 2023 and is expected to witness substantial growth, reaching $178 billion by 2033 with a Compound Annual Growth Rate (CAGR) of 44.1 percent 2024 to 2033.
DeFI powered Web3 is emerging as an important growth industry that governments must pay close attention to, more than AI which has garnered attention because of its potential harms. From kids coding clubs, to secondary and tertiary education programs, through to job reskilling, DeFi and Web3 gives citizens the tools for capital creation, especially in the small and mediums sized business segment – the growth engine of most economies.
Governments must also recognize that a DeFi powered Web3 is funded privately, not by governments, and is one of the best decentralized tools to move beyond industrial era economies. As we move into crypto spring, the interest in Web3 technology has never been stronger, and the number of developers is forecast to grow.
Staking regulation will need to be proportional as it puts at stake the large number of developers, entrepreneurs and investors who fund the development of the Web3 foundation built on DeFi though staking.
All eyes are on U.K. policymakers and regulators who must judiciously consider how to design an appropriate and proportionate framework for DeFi staking. If implemented in the second half of 2024, the the framework will likely set a (global) legal precedent.
The outcome of this regulation may very well have profound effects on Web3, and as importantly, the U.K.’s ability to compete in digital markets and attracting world class talent and capital.
Who Funded The World Wide Web?
The internet was originally funded by the U.S. Department of Defense, ARPANET, which officially changed to the TCP/IP (intenet protocol) standard on January 1, 1983, the birth of the Internet. All networks could now be connected by a universal language through the TCP/IP protocol.
Tim Berners-Lee research at CERN in 1989–90 resulted in the World Wide Web (WWW), linking hypertext documents into an information system, accessible from any node on the network and Web1 was born.
The advent of TCP/IP, the open and interoperable internet standards for Web1 text, emails, and websites, championed by Berners-Lee were enough to incentivize private markets to invest in the decentralized communication nodes and infrastructure to scale Web1, and the rest is history. Anyone was free to build on it, it was funded by industry.
The dot.com era and Web2 arrived in the late 90s and we moved from Web1 – read, to Web2 – read, write, as e-commerce was born and the rise of the “walled garden” closed-end ecosystems like “shop” with Amazon, “search” with google, and “connect” with Facebook. We are currently transitioning from Web2 to Web3. Anyone is free to build on Web2, it is funded predominantly by the Web2 industry.
Web3 – read, write, execute is the next evolution of the blockchain-based web that is decentralized, democratized, and an open-end ecosystem. With the help of blockchain technologies, also known as Distributed Ledger Technology (DLT), developers are building websites, platforms, and applications that are more secure, privacy-preserved, and censorship-resistant. Anyone is free to build on it, and its early phase of funding is largely by users – people like you and me – though now that Web3 is scaling, larger private industry funders are emerging.
So, What Is DeFi Staking?
Staking is the funding mechanism for DLT protocols that underpin Web3, often referred to a decentralized finance or DeFi protocols, and form the base layer bedrock of DLT.
Staking is the process of distributing the economic incentives of Web3 across the network, while defraying and reducing the many risks of network participation, to help ensure the bedrock remains stable. New transactions are added to DLT networks through Proof-of-take (‘PoS’) consensus mechanisms, allowing users who stake tokens that they buy to earn rewards in return.
Broadly there are two different approaches to staking. Firstly, there is sovereign, or “solo staking” which involves an entity directly staking its own assets from its bank account or company balance sheet. Secondly, there is staking via an intermediary or validator, also known as “staking as a service”, which is offered to individuals and companies via digital exchanges, custodians, fintechs.
With staking, your “staked” capital is locked in the DeFi protocol ecosystem, the cross-border “digital rails” of the Web3 network, and you earn incentives as new user transactions use the network digital rails. It is all managed algorithmically, and does not belong to one entity and does not exist in any any one sovereign jurisdiction – it is the internet, Web3.
Regulatory frameworks need to reflect these differences, based on the varying risk profiles. In the case of solo staking, which is done directly without an intermediary, regulation is not currently warranted.
The Role Of Staking in the DeFi Ecosystem
DeFi is a rapidly growing but nascent ecosystem. It utilises distributed ledger technology (DLT) to empower consumers and businesses to use financial services in a cost-efficient manner, without the use of intermediaries, and provides an opportunity to participate in a new type of financial system.
There is a continuum of decentralization that exists, from traditional centralized finance operating on elements of DeFi technologies, also known as HyFi (hybrid finance), to DeFi.
Staking is a central feature of PoS consensus mechanisms, which is critical to the DeFi and cryptoasset ecosystem. To develop and grow a functioning network, users will stake (or lock up) their tokens which demonstrates the network’s security, and in turn builds trust and allows the network to continue to grow.
In return for staking their tokens, the user receives rewards. Beyond it being an essential process for ensuring stable, efficient consensus mechanisms, staking offers other benefits. It allows users to make returns on their tokens, which would otherwise be earning nothing until sold or transferred.
“It is important to underscore that staking activity be defined as separate and distinct from lending” notes Laura Navaratnam, U.K. policy lead for the Council for Crypto Innovation (CCI). “The objectives, underlying processes, and risks are different, and so the activities do not warrant the same treatment or regulation.
“For example, staking does not involve the transfer of title, a party only delegates certain rights. Staking does not present the same risks to consumers that lending does – risks relating to hypothecation, counterparty credit risk, or information asymmetries, for example. It is therefore inappropriate to extend lending regulations to staking.”
Why Does it Matter, Now?
Staking has been contemplated by U.K. regulators for some time, and indeed is also the subject of international debate, however, very few jurisdictions have introduced a staking regime. Even the European MiCA regulations, which are widely regarded as the most progressive, do not include specific provisions on staking.
Yet as market evolutions continue, more and more jurisdictions are showing an increasing interest in developing appropriate regulation for both institutional engagement with DeFi, as well as the broader decentralized ecosystem.
Elise Soucie, Global Director of Policy & Regulation at Global Digital Finance notes, “This interest, was likely spurred in part by IOSCO’s consultation on DeFi last year as well as their final policy recommendations for applying their principles for financial market infrastructures (PFMI’s) which were published in December.”
IOSCO, the International Organization of Securities Commissions, has a global reach with its members comprising 35 of the world’s largest securities regulators who will now need to implement these recommendations.
Adds Soucie, “The principles may have a profound influence, shaping regulator frameworks in the U.K., and around the world.”
A key question the principles grapples with is at what point in the DeFi stack, regulation should be implemented. Industry feedback to IOSCO emphasized that appropriate regulation should apply where a financial service or product is being offered, and not at the base layer protocol level.
Yet despite encouragement for jurisdictional regulators to progress regulation on DeFi, staking has not been explicitly addressed until now. The regulatory discussion about staking has been mired by the skepticism with which cryptoassets are viewed: This often confuses the positive fundamentals of the DeFi ecosystem of transparency and traceability.
This is especially the case where poor governance or fraud have emerged. Basing regulation on generalizations like this can risk hampering innovation.
The U.K., however, is taking steps to be a global leader in regulating staking. A statutory instrument is looking increasingly likely when the U.K. Parliament gets back to work after the July General Election and summer recess, with subsequent consultations and implementation of guidance and regulation to follow.
Allow Market Participant To Choose
As industry awaits the U.K.’s verdict on staking regulation, it is critical that policymakers do not favor perceived winners amongst nascent technologies, nor develop generalized regulation that conflates bad actors with responsible innovation.
Soucie comments, “As staking only applies to certain blockchains, imprecise or overly stringent regulation could easily disincentivize the use of PoS mechanisms. This would be a mistake and overlooks the complex trade-offs between different mechanisms, including energy consumption, bandwidth and security.”
Navaratnam concludes, “As DeFi continues to progress, industry must work collaboratively with regulators and policymakers to evolve DeFi to meet the market demands for greater access to innovative digital products and services, while meeting appropriate and robust regulatory outcomes.”
As regulatory frameworks evolve, policymakers should allow market participants to choose for themselves the most effective technology based on viable use cases and business needs.
