The SEC is coming for Ethereum

November 11, 2022

Gary Gensler is at it again.

Following Ethereum’s big software upgrade, the Securities and Exchange Commission (SEC) Chairman Gary Gensler said that cryptocurrencies and intermediaries that allow holders “stake” their coins may be considered as securities under the Howey test. He said this while speaking to reporters after last week’s Senate Banking Committee hearing. Coincidence or not, these reports came on the same day Ethereum moved to a Proof-of-Stake consensus mechanism. Gary’s exact words?

“From the coin’s perspective…that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others.”

And, of course, Crypto Twitter lashed out hard — like Will Smith’s slap to Chris Rock at the Oscars. Or maybe a bit harder.

The thing is, both the SEC and CFTC had previously classified BTC and Ether as commodities — the SEC has however been skeptical about Ether’s status. In a 2018 speech, the SEC’s former Director of Corporate Finance, William Hinman, stated:

“…putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether [at this time, Proof-of-Work], the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities.”

And the Crypto community was never happier.

Now, four years later, the fire-breather is back. With “The Merge,” Ethereum is again in crosshairs with the SEC, and the age-long question resurfaces: Is Ether a security?

Proof-of-Stake Chains and the Howey Test

The Howey test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an “investment contract” and, therefore, would be considered a security. Under the Howey test, an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” The criteria are:

  • There’s an investment of money.
  • There must be a common enterprise towards a goal.
  • Investors expect to profit from such a venture, and the profits are derived solely from the efforts of the promoter or a third party.

Adams Levitin, Professor of Law, Georgetown University Law Center, argues that there is a “strong case” for Ethereum to be classified as a security following its transition to Proof-of-Stake. His points are that, under POS, validators pool their ETH in “common enterprise,” satisfying the second criterion of the Howey test. Also, validators receive rewards when they verify transactions, signifying an obvious motive to make profit.

The problem is that his perception of how staking works is flawed. Cinneamhain Ventures partner, Adam Cochran, pointed this out, and a lot more, in a Twitter thread. Opinions which I agree with.

Arguments against the SEC’s notion

Firstly, to run a full validator node on Ethereum, you are required to stake 32ETH. This staked ETH is distinct and bound to your node. Validators DO NOT pool their funds. You receive a reward when you help verify transactions on the network. Otherwise, you risk your stake getting slashed — permanently lost upon acting maliciously. “Your node succeeding or failing does not impact the interest of others,” Cochran wrote, arguing that the profits of one’s validator do not rely on the success or failure of others.

Note that not everyone who buys ETH stakes them. Many will need ETH to pay transaction fees, interact with dApps, or borrow/lend. The number of people who end up staking is a small percentage of ETH users. Does that mean that ETH should be a security because a minority of its purchases will be directed towards staking? Hell no!

Moreover, staking requires labor, unlike most securities under the SEC’s jurisdiction. These securities issued by registered companies do not need investors to labor to ensure they receive profits on their investment — They invest. That’s all.

“…The expectation of profit to be derived from the efforts of others.”

However, in the case of staking, you must acquire sufficient computer hardware, install the necessary client software and configure it, acquire a strong internet connection, and maintain software upgrades and security to meet minimum requirements. Not to include the in-person hours involved.

This begs the question, is staking not more of a service?

Validators are essentially rewarded for providing vital services to the network honestly. Otherwise, they risk losing their funds. If you are rewarded for honest participation and punished for dishonesty, that must be a sale. Ultimately, because ETH validators are earning from their efforts and not the efforts of others, it shouldn’t be a security.

The only shared opinion between Levitin and Cochran is the trickiness around who “issues” ETH. Ethereum is a decentralized and open-sourced project with thousands of developers worldwide. No one owns the Ethereum protocol. Therefore it’s difficult to argue that the profits validators receive are securities relating to any entity. Even if Ethereum developers stopped working, validators would still be able to add blocks to the chain and earn rewards.

Closing thoughts

I get it — at first, the idea of “buy token, stake token, and earn reward” seems like a security. But, with a nuanced understanding of the operation of a Proof-of-Stake blockchain, I think it fails to be a security even with a significant reading of the Howey test. It has the same principle as the Proof-of-Work chain — miners/validators participate honestly in the network and earn rewards. I certainly don’t think anyone has grounds to state that the move to POS made Ethereum “more likely” a security.

The SEC has always been hostile to the crypto community, which explains the backlash it received over Gary Gensler’s statement. The regulatory body has been keeping a close watch on the crypto space and going after everybody, increasing its body count along the way. It has been knee-deep in litigations with Ripple, the parent company of the XRP token, since 2020. It only recently forced BlockFi to pay $100M because it failed to register high-yield interest accounts that the SEC considers security.

However, there has recently been growing competition for crypto regulations between the SEC and the Commodity Futures Trading Commission (CFTC). The Senate Agriculture Committee, which oversees the CFTC, held a hearing on Thursday to vet a crypto bill. This crypto bill would designate BTC and Ether as commodities, not securities. Under current law, these assets have no federal regulator. The bill will grant the CFTC the authority to regulate digital commodities. And the crypto industry has shown a strong preference to be regulated by the CFTC, as opposed to the SEC — anything to get us away from the SEC…and Gary Gensler.

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