Liquid Staking Tokens - Financial Instruments Or Crypto-Assets?

• Published date: 27 March 2024
• Law Firm: Plesner
• Author: Mr Rasmus Mand'e Jensen, Simon Lindvig Rasmussen and Jónas M'r Torfason

Recently, the ubiquitous activity of staking in crypto-markets has been supplemented with so-called "liquid staking". But liquid staking carries its own regulatory risks which can be different and more significant than those applicable to the token being staked. Below, investment services and crypto-asset specialists from Plesner consider these important risks.

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...