Analysis of Blockchain Transactions to Understand and Establish Fact Patterns | cornerstone research
Blockchain analysis is a powerful tool that provides insight into what is happening on a blockchain network. Who trades with whom? Which wallets are most active on decentralized financial exchanges? Which wallets send and receive funds from central exchanges? Which validators confirm new blocks and what rewards come with them? These are all questions that can be answered by examining blockchain data and, with the right expertise, creating a clear and concise factual record of events.
Kraken’s Staking-as-a-Service (SaaS) Agreement with the SEC – How blockchain analytics can help verify SaaS composition
As part of the settlement with the SEC, Kraken agreed to end its staking-as-a-service program for US customers. This case is one of the more recent examples of the push by US regulators in enforcing digital assets and the blockchain-related events in particular.
Given that a lot has already been spilled when discussing the Kraken settlement from a legal standpoint, including what components of the Kraken service might meet the Howey test requirements, we’d like to offer a slightly different perspective. In particular, by bringing to light the underlying blockchain transactions, tracing user-to-exchange and exchange-to-blockchain flows, and examining the details of validator rewards and payouts, we can better understand the structure and composition of an exchange’s staking service .
Staking is a necessary part of many blockchains. Some of the largest blockchains, including Ethereum, Cosmos, and Solana, rely on a proof-of-stake mechanism to validate transactions. Here, users deposit tokens in escrow (i.e. they “stick” cryptocurrencies) in exchange for the ability to validate transactions and add new blocks to the chain. Users who successfully propose or validate blocks are rewarded with the blockchain’s native cryptocurrency (e.g. ETH on the Ethereum blockchain). However, the validators are not guaranteed a win. When validators make mistakes, they can be “cut,” a process in which validators lose some of their wagered assets.
Although simple in theory, staking requires technical expertise and sufficient seed capital. For example, Ethereum requires users to stake 32 ETH to create a validator node (the software that validates transactions) and be eligible to earn ETH tokens. With the current value of over $1,800 per ETH, it would require more than $50,000 in initial capital — a sizable sum for the average crypto market participant. In addition, staking requires knowledge of complicated software systems that may not be accessible to an average market player.
Given that market participants have a desire to participate in blockchain validation but may not have the technical expertise or capital required, many exchanges have attempted to expand the accessibility of deployments by offering their customers “deployment as a service.” ” offer.
SaaS programs stake certain crypto tokens on behalf of customers using customer deposits. Exchanges lower seed capital requirements for individuals by pooling client assets and handling all the technical hassle involved in staking (e.g. running a validation node) for a fee. Users earn interest on their deposits into the program based on the rewards they receive through stake validation determined by the blockchain. Exact details of programs vary by exchange.[1]
Looking at the blockchain, one can observe which address proposed each block and how much that address received in rewards.[2] Combining this data with a list of staking addresses would allow the calculation of the staking income received from each validation node. See the stylized example in Figure 1.
The next step would be to compare total betting earnings to, say, the exchange’s payments to users who participated in the SaaS program.
As can be seen in the stylized example in Figure 2, payments to users are closely related to rewards in the chain, suggesting that the exchange is not simply balancing idiosyncratic reward distribution with arbitrary reward allocation.[3] In other words, the rewards were generated by the stake itself and not by an exchange-provided “fixed return,” a result that might be useful when examining aspects of the Howey test.
Understand blockchain data
Staking rewards evaluation is just one application of blockchain data analysis. Questions about trading activity, liquidity provision, value transfers and more can be answered by accessing the underlying blockchain data if you know where to look. In the context of class action lawsuits, determining user involvement and tracing cash flows to users can also help identify potential class action lawsuits.
Blockchain data is a black box for many, so it pays to understand on a comprehensive level how it is stored and how it can be used. Using Ethereum as an example, Figure 3 shows the blockchain structure. Ethereum blockchain data is stored in multiple tables. These tables can be linked based on the block number and transaction hash in each table.
For restaurateurs, the blockchain could be thought of as a restaurant recording its catering establishments.
A block is the equivalent of a restaurant’s nightly ledger. This includes receipts for meals served and drinks consumed, tips received, and the person who performed the service. Blocks record the summary information but not the details.
The transactions that make up the blocks are more like receiving each table. On the blockchain, we watch the value shift from one wallet to another, much like a table of guests paying for their meal. Just as a receipt can contain multiple line items (appetizers, drinks, entrees, etc.), transactions on the blockchain can involve multiple arguments. For example, on popular decentralized financial exchanges, the transaction requires inputs such as the coins to trade and the prices at which the transaction is to occur. In order to complete a transaction, merchants must provide these necessary components. The receipts at a restaurant contain a clear record of what was served. Transactions on the blockchain contain clear records of the functional requirements for making transactions. Both are value transfers.
Unlike the high-level data recorded at the block and transaction level, events provide the actual details of what is happening in each transaction, analogous to what is happening in the kitchen while a meal is being prepared (proteins cooking, preparing sauces, or assembling the plate). The events record every component of a transaction – where the coins were sent and what happened to them along the way. This can be multiple smart contracts, token swaps, or liquidity pools. The contracts that wallets interact with govern the number and type of events stored.
Properly assembled, blockchain data can be used to tell a compelling story and uncover fact patterns.
Blockchain transactions remain in focus
Given the volume of transactions on the blockchain and the multitude of trading opportunities available to participants, it is not surprising that regulators want to be more involved. The SEC is by no means the only government agency seeking a stronger hand in regulating crypto assets; Congress also seems interested. The Digital Asset Anti-Money Laundering Act of 2022, introduced by Senators Elizabeth Warren and Roger Marshall, proposes: “[e]Extend Bank Secrecy Act (BSA) responsibilities, including know-your-customer requirements, to digital asset wallet providers, miners, validators and other network participants who may act to validate, secure or secure digital asset transactions facilitate by instructing FinCEN to designate these stakeholders such as Money Service Businesses (MSBs).”[4]
Aside from the potentially far-reaching implications of what that means, it’s worth noting that the common theme between the bill introduced by Senators Warren and Marshall and the SEC measure is a desire to better understand what’s happening on blockchains and by whom . While the pseudo-anonymity of the blockchain makes answering these questions difficult, it is not always impossible.
One of the great advantages of blockchain data is that it is a complete and freely available historical record. Although the data is publicly available, expertise is still required to collect, decode, and interpret the data. Additionally, the abundance of blockchains and the sheer size of the data stored on them can make them even more difficult to process and analyze. But once the data is in, the “blockchain” mystery begins to unravel, and the transactions, transfers of value, and smart contract events are clearly visible.
As Chairman Gensler said in his now famous “office hours” stakeout video:
“Whether they describe their services as lending, merit, reward, APY, or engagement, that relationship should come with the protection of federal securities laws. Investors should receive important information. For example, what do you actually do with your tokens?”[5]
Blockchain analysis can often provide answers to this question.
Originally published in Law360.
The views expressed herein are those of the authors and do not necessarily reflect the views of Cornerstone Research.
[1] Two of the most well-known U.S. exchanges, Coinbase and Kraken, are prime examples of how different SaaS programs can be and how important those differences can be in the context of SEC enforcement actions. While Kraken owns, pools, and allocates users’ wagering deposits, Coinbase users retain ownership of their deposited assets. See Coinbase User Agreement at https://www.coinbase.com/legal/user_agreement/united_states; SEC Complaint at https://www.sec.gov/litigation/complaints/2023/comp-pr2023-25.pdf. This leads to significant differences in the timing of commit/decommit, staking rewards, and the use of unspent assets.
[2] For example, one can observe that Hiveon Pool proposed block #15537386 on Ethereum and received 2,071 ETH as a reward. See https://etherscan.io/block/15537386. Blockchain data makes it possible to observe reward information at the transaction level as well. See https://etherscan.io/tx/0x660daa64a1cec6ad92790b90b732dd5a18c8eddc07e21f0dce55f9704f7377dd#statechange.
[3] The SEC complaint against Kraken alleged that Kraken’s asset pooling and proportional compensation met the criteria of the Howey test.
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