Ethereum vs. the SEC

Welcome back. The Merge may be over, but its ripple effects (and our coverage) sure aren’t. This month’s upgrade marks the beginning of a new era for Ethereum—and we don’t just mean ETH 2.0.

It’s time to talk about regulation—and how the switch to proof-of-stake could put Ethereum back in the crosshairs of the SEC. Let’s go.

—Angelina

Is Post-Merge ETH a Security?

They say it’s never really a party until the cops show up. In Ethereum’s case, SEC Chairman Gary Gensler crashed post-Merge festivities before anyone could even suggest a round of beer pong. Without specifically addressing Ethereum, Gensler proclaimed on the day of the Merge that proof-of-stake-based cryptos may be subject to securities’ law. Coincidence? We think not.

Regulators have already classified bitcoin as a commodity, but now they’re hard-pressed to determine the status of altcoins, with ETH at the forefront. The regulatory future of Ethereum, regardless of how it’s classified, will have lasting effects on crypto writ large. But the all important decision hasn’t been made just yet. So…let’s take a closer look at what’s behind all of this securities talk.

What is a security, exactly?

Generally speaking, a security is an investment contract from which profits are expected. The Howey Test helps determine whether an asset should be deemed a security. The test has four main components—if an asset meets these criteria, it’s considered a security:

1. An investment of money,

2. in a common enterprise,

3. with an expectation of profit,

4. solely from the effort of others.

Does ETH pass the Howey Test?

In 2018, former SEC Director of Corporate Finance William Hinman suggested that Ethereum was decentralized enough to not classify as a security. And earlier this year, two U.S. senators publicly agreed that ether, along with bitcoin, acts like a commodity. But with the Merge now in the rearview mirror, regulators could change their minds. So what’s the general consensus in crypto right now?

The argument suggesting Ethereum is a security, according to law professor Adam Levitin of Georgetown University:

• The Howey Test bit about an “investment of money” is commonly interpreted as an investment of value. Putting up ETH for staking classifies as such. First Howey criterion: check.

• The fundamental validation process for proof-of-stake requires multiple parties. Stakers pool their ETH in what could be considered a “common enterprise.” Second Howey criterion: check.

• Stakers receive rewards from their own validation efforts and those of others in the network. According to Gensler, that suffices as an expectation of profit derived from the effort of others. Regulators also refer to staking rewards as dividends. Third and fourth Howey criteria: check and check.

But this argument isn’t exactly airtight. Here’s the flip side:

Ethereum (probably) won’t be classified as a security, because ETH differs from traditional securities like stocks in several very important ways.

Starting here: Investors must actively engage with Ethereum’s network to receive profits. While stock investors simply buy a dividend-paying security to qualify for payouts, ETH stakers are required to perform special duties (such as ensuring the proper operation of validator nodes) to claim their staking rewards. Rather than solely profiting off of others’ efforts, stakers are rewarded for performing validation services—their own efforts, which could refute the last Howey component.

Plus: Unlike stock that’s issued by a publicly-traded company, ETH doesn’t have an identifiable issuer from whose efforts investors directly benefit. Even if the Ethereum developers were to go MIA, validators would continue adding blocks to the chain, ensuring staking payouts. Ethereum is a decentralized system, meaning there isn’t one single entity responsible for Ethereum’s profit-generating activities.

With that, there are two possible future scenarios for Ethereum.

1. Ethereum is classified as a commodity and the CFTC takes up the regulatory mantle.

2. Ethereum is classified as a security and falls under SEC jurisdiction.

Zoom out: Crypto enthusiasts generally prefer the first scenario, expecting that the CFTC would be less stringent than the SEC in rule-setting for ordinary trading activity.

The SEC regulating Ethereum, however, would mean serious consequences for the U.S. crypto industry. The SEC already has a bad rap among crypto proponents, with many accusing the commission of regulating via brute enforcement, not rules.

• If the SEC gains primary jurisdiction over crypto, more exchanges would have to register as broker-dealers (resulting in the forced adoption of certain technology systems and more complex transactions for customers).

• And stablecoins and new tokens would come under increased regulatory scrutiny.

So who will ultimately take regulatory responsibility? That’s for Congress to decide. But the CFTC is pretty confident that it will be crypto’s new watchdog.

And that’s what you need on your crypto radar this Sunday. I’m going to spend the rest of today wondering whether Gary Gensler ever played beer pong (or if he was too busy being the UPenn crew team’s coxswain). See you here again on Tuesday!