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SEC can finally declare Ethereum a security. What happens next?

Tanja Nechet

News editor

Oct 5, 2022 at 03:51

A landmark event occurred in September: Ethereum’s Merge switched the network from a Proof-of-Work (PoW) to a Proof-of-Stake (PoS) consensus mechanism. But there is one grim nuance. The U.S. Securities and Exchange Commission may soon recognize the cryptocurrency Ethereum (ETH) as a security.

In September, during The SEC Speaks event, officials promised to continue enforcement and urged market participants to come in and register their products and services. SEC chairman Gary Gensler even suggested that cryptocurrency intermediaries split into separate legal entities and register each of their functions — exchange, broker-dealer, custodian, etc. This is intended to mitigate conflicts of interest and protect investors.

In his testimony before the Senate Banking Committee, Gensler suggested that Ethereum’s move to PoS could put Ethereum under the SEC’s purview because placing coins is expected to profit from other parties’ efforts.

“Looks very similar — with some labeling changes — to lending,” he said.

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What is PoS?

Proof-of-Stake is a consensus mechanism that allows all nodes in a blockchain to agree on the state of the network. It requires nodes, called validators, to propose and validate new blocks. Validators must invest capital in participating in this process (whereas the Proof-of-Work mechanism that replaces Ethereum requires mining nodes to expend energy as they compete to find or “mine” the next block). Such an investment is called stacking.

ETH as securities: game-changing

Most tokens on the market could be considered securities if the SEC declares ETH as a security. In that case, they would be subject to the same U.S. statutory regulation as stocks. According to Georgetown law professor Adam Levitin, any token in any share Proof-of-Stake (PoS) system is likely to be a security.

“Something no one is talking about: after the Merge, there will be a strong case that Ether will be a security. The token in any Proof-of-Stake system is likely to be a security,” he posted on Twitter on July 24.

Thus, exchanges trading Ethereum (i.e., the majority of them) will be subject to more onerous regulatory requirements. ETH is currently treated as a commodity outside the SEC’s jurisdiction.

Major crypto exchanges such as Coinbase, Kraken, and Binance have stated that they will support ETH stacking. They will violate U.S. securities laws if they do not register and take appropriate action.

Any U.S. resident who is a non-accredited investor, which is about 99% of the population, would not be able to trade Ether on most exchanges since it would be unregistered security, which it is legal to offer only to accredited investors.

And for U.S. persons who are not accredited investors, buying and selling Ether will remain illegal indefinitely since there is no issuer of Ether and, therefore, no party to register it.

Security, as defined by the Howey Test, refers to an “investment contract” for which a profit is expected. The Howey Test was developed by the U.S. Supreme Court to determine whether a financial transaction means an investment in a security. The test is considered positive if four conditions are simultaneously met:

  1. an investment of cash
  2. with the expectation of profit;
  3. in a common enterprise;
  4. the expected profit is related to the activities of others.

Investing in the case of Ethereum would be staking with the expectation of profit as a reward for staking (currently about 4.2% p.a.). This fits the common enterprise requirement, but “solely through the efforts of a third party,” which is rather controversial because stackers are also members of the network who do the “work” of checking blocks.

Partner at MetaCartel Ventures DAO Adam Cochran believes that Ether cannot be classified as a security.

“First, the Howey test prongs, we all know: 1) An investment of money 2) In a common enterprise 3) An expectation of profit, to be derived from the efforts of others. It’s important to note that Howey is a three-pronged test but is often misquoted as four prongs. Prong 1 is pretty clear, you must buy ETH to stake ETH, and even if we argue that it is putting ETH up as collateral rather than a purchase, there isn’t a sound argument,” he tweeted.

In addition, Tim Beiko, responsible for protocol support for the Ethereum Foundation, wrote to Levitin that Ethereum has no “verification pools” at its protocol level. In addition, share proof hashing is not as computationally intensive as Proof-of-Work hashing. Therefore, it does not qualify as an “effort by others.”

By the way, Twitter user Stefan Huber noticed an interesting detail. In 2018, before ruling on Ether and Bitcoin, SEC Director of Corporate Finance William Hinman met with crypto investment managers. The post’s author called it “institutionalized insider trading” because the official most likely told these private companies about his upcoming speech and the main talking points.

On that day, July 14, Hinman announced that the commission would not consider Ethereum and Bitcoin to be securities.

Recall that the SEC already equated nine cryptocurrencies to securities in July 2022: AMP (AMP), Rally (RLY), DerivaDEX (DDX), XYO (XYO), Rari Governance Token (RGT), LCX (LCX), Powerledger (POWR), DFX Finance (DFX) and Kromatika (KROM).

You might also be interested in reading this: 

Crypto as a new type of property: Which countries have decided on the status of digital assets and why it matters

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