April 27, 2023
 min read

Understanding counterparty risk: The future of regulatory compliant staking

Thomas V. Daugaard

Who are you staking with?

The change in approach from US regulators and the implications for the US crypto industry will likely impact custody and staking infrastructure providers, as well as institutional investors.

US regulators have set a new legal precedent for sanctioning smart contracts which are, either purposefully or inadvertently, used as mixers and relevant for everyone who has interacted with these smart contracts.

The listing of the Tornado cash smart contract (https://home.treasury.gov/news/press-releases/jy0916) on OFAC’s sanctions list presents several regulatory issues that impact current custody and staking infrastructure providers.

Today, many decentralized staking protocols are integrated into custodians, MPC wallets, infrastructure, and software providers. These staking protocols leverage Ethereum-based smart contract functionality in order to stake Ether. The high-level architecture design comprises a deposit to the protocol’s smart contract, which acts as a gate to the Eth2 smart contract. The Eth2 smart contract then uses public validator keys and the eth1 address on the protocol’s smart contract to designate a validator node to stake the deposit of 32 ETH.

Although these staking protocols are developed by non-custodial staking infrastructure providers, their use of smart contracts is analogous to a mixer, because they cannot control the inflow and outflow of funds in a way that distinguishes between the legal title of those funds.

Three key issues can be identified:

1. Commingling of funds in the protocol’s smart contract or on the staking nodes, which may belong to sanctioned entities, with proceeds from illicit activities, e.g., money laundering activities.

2. Institutional investors have no assurance that their funds — inadvertently or otherwise — have not contributed to the generation of staking rewards that may have benefited sanctioned entities.

3. Nowhere, from the point of transaction to the protocol’s smart contracts, are there checks on funds and UBOs that satisfy KYC/AML/CTF/proof-of-funds requirements.

The knock-on effects for custody providers and institutional investors using these protocols will be risking enforcement actions for breaching current US AML/CTF laws, as all of these protocols and custodians have legal exposure to US jurisdiction.

Further to this point, any service provider granting their users access to these smart contract-enabled non-custodial staking providers may be at risk.

The institutional investors using these providers will likely face knock-on effects, which will probably lead to fines and legal actions due to unknown or unchecked counterparty exposure to these providers.

But there is a way forward.

Safeguarding and future-proof staking products are needed, in order to mitigate this unmanaged risk. These include ring-fencing the deposit and withdrawal of funds locked in validator nodes on Ethereum so that investors have the assurance that their funds have not been exposed to any third-party contagion.

Ring-fencing also ensures that no unknown counterparty exposure exists, and investors can have full control of the legal title to the staked funds.

Institutional investors can only mitigate the risk of legal exposure when controlling the entire flow, from deposit to staking on validator nodes to withdrawal, while complying with common AML/KYC practices and laws.

The growing need for regulatory compliant staking products shows how far blockchain and crypto have come.

At Northstake, we provide institutional investors the opportunity to have a stake in the future economies built on blockchains through regulatory compliant staking products.