FINMA provides an update on staking services

With the entry into force of the DLT template, a legal basis for the safekeeping of crypto-based assets was created that protects clients in the event of the insolvency of the custodian. Due to the increasing importance of staking services, FINMA had to answer questions regarding the application of these provisions, as it is possible that the requirements of the DLT template may not be met depending on the constellation. As a result, the crypto-based assets would not enjoy insolvency protection in the event of the custodian’s insolvency.

What is staking?

There is currently no standardised definition of “staking”. FINMA defines staking as the process of blocking crypto-based assets on the staking address of a validator node to participate in the validation process of a blockchain based on a proof-of-stake consensus mechanism. Participants receive staking rewards as a reward for staking crypto-based assets. Unlike the proof-of-work algorithm, the proof-of-stake algorithm does not reward the fastest miner, but a validator who has staked a certain amount of network tokens and is selected at random.

Various types of staking have developed in practice. FINMA distinguishes between custodial staking and non-custodial staking in its supervisory notice.

With custodial staking, the client transfers the crypto-based assets to a service provider. Custodial staking was already reviewed by FINMA in summer 2023. In this review, it was determined that certain models could qualify as a deposit under the Banking Act. Non-custodial staking was not reviewed in summer 2023.

With non-custodial staking, assets are not held in custody or received by third parties; instead, customers retain exclusive control over the withdrawal keys. Withdrawal keys are cryptographic keys for controlling the redemption of staked crypto-based assets, whereby the loss of these keys also results in the loss of the staked assets.

Risks

The use of staking services harbours the following risks:

• There are technical risks of a malfunction of the staking process, in particular the risk of slashing due to misbehaviour of the validator node. Slashing refers to a process in which the staked assets are completely or partially destroyed due to the misbehaviour of the validator node;
• In Switzerland, there is a counterparty risk due to the unclear legal situation in the event of bankruptcy. This legal uncertainty applies all the more if custody or staking is delegated to institutions abroad;
• As staked crypto-based assets may not be sold at the right time due to a delay caused by a lock-up/exit period, there is a market risk. This period defines the minimum duration of staking before the assets can be unlocked again. This period is longer for certain blockchains. If the unstaking orders increase, this can lead to a temporary technical impossibility to sell the assets.

Legal basis for the custody of crypto-based assets

The DLT bill came fully into force on 1 August 2021. This also created a legal basis for the bankruptcy-proof custody of crypto-based assets with the new Art. 242a SchKG. According to Art. 242a SchKG, segregation is possible in the event of the bankruptcy of the custodian if there is individual custody or collective custody with recognisable customer shares and if there is an obligation to keep the crypto-based assets available for the customer at all times.

In line with this, a provision was added to Art. 16 para. 1bis of the Banking Act for institutions subject to banking law, which describes the custody account assets that are segregated from the bankruptcy estate in favour of the custody account customers in the event of bankruptcy.

With regard to these provisions, certain questions of interpretation arise in relation to staking. For the most part, these relate to the key element for protection within bankruptcy proceedings, according to which the crypto-based assets must be kept available for the customer at all times. This would not be fulfilled if the custodian were to engage in staking for its own account. However, the legal situation is unclear if the staking is carried out on behalf of and for the account of the customer. In these circumstances, the specific staking mechanism must be analysed.

Blockchains that do not provide for a lock-up period or a sanction mechanism, so-called slashing, are unproblematic in terms of bankruptcy protection, as the crypto-based assets can thus be made available to the customer at any time. To date, there is no relevant case law or practice on the question of whether crypto-based assets on blockchains with lock-up periods or slashing fulfil the element of the offence of being held ready at all times.

Legal consequences

In the case of staking by authorised institutions, a distinction must be made between staking chains and direct staking.

A staking chain arises when an institution delegates the operation of the validator node to a third party and therefore has a claim against the third party. The receivable can be recognised as a receivable from the third-party provider or, if certain conditions are met, it can be treated as a receivable held in trust and thus as a deposit, provided that the guidelines of the Swiss Bankers Association on fiduciary investments are complied with. The following conditions must be met:

• The counterparty risks are limited by selecting a prudentially supervised institution with a good credit rating;
• Specific due diligence must be carried out to ensure that the third-party provider is not operating without authorisation and that the third-party provider holds the relevant withdrawal keys itself;
• The third-party provider must designate the validator addresses at which it holds the custodians’ crypto-based assets and must communicate these to the custodian;
• The third-party provider has taken all necessary measures to limit the operational risks with regard to the Validator Node operation (validation errors or offline status), to exclude further penalties against the Validator and to ensure business continuity;
• If providers abroad are involved, they must also be subject to equivalent prudential supervision and offer the same legal certainty as Switzerland with regard to the bankruptcy treatment of crypto custody.

With direct staking, on the other hand, the institution operates the staking itself and also has the power of disposal over the withdrawal keys. In the case of direct staking, segregation is not an option under Art. 16 para. 2 BankA. However, if the assets can be clearly allocated to the clients, they are informed of the risks, suitable measures are taken to mitigate the operational risks resulting from the operation of a validator node and a digital assets resolution package is drawn up for risk management purposes, the staked assets must be segregated from the bankruptcy estate in favour of the custody clients in the event of the bankruptcy of a FINMA-supervised institution in accordance with Art. 16 para. 1bis of the Banking Act.

Finally, FINMA states in the supervisory communication that market participants without a licence under banking law may continue to offer custodial direct staking on behalf of and for the account of clients, provided that the staked crypto-based assets are held in custody individually. However, this requires that there is a separate and assignable blockchain address for each client and that the provider has the withdrawal keys. If these requirements are met, FINMA assumes that staked assets can be segregated from the bankruptcy estate in accordance with Art. 242a SchKG.

Sources:

– FINMA supervisory notice on staking services dated 20.12.2023