A recent SEC investigation into insider trading has revived debates over whether Ethereum could qualify as a security.
Some have argued that ETH passes the Howey test due to the way it was launched and Ethereum’s move to Proof-of-Stake.
As ETH stakers earn revenue from validating blocks on the Ethereum network, there is an argument that ETH investors buy the asset with the expectation of a profit. However, a security classification from the SEC seems unlikely.
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Could the SEC have the grounds to classify Ethereum as a security once it completes its “Merge” to Proof-of-Stake? Crypto Briefing explores one of crypto’s most hotly contested issues.
Ethereum and the SEC
Almost seven years after the Ethereum network began producing blocks, the debate over whether its token should be classified as a security still rages.
Ahead of Ethereum’s launch in July 2015, the network sold its native token, ETH, through an initial coin offering (ICO) in exchange for Bitcoin. Approximately 50 million ETH were sold during the ICO, netting the Ethereum Foundation, a non-profit set up to steward the network’s development, over $18 million.
In Ethereum’s infancy, many argued that ETH would have passed the SEC’s Howey test. Used to assess whether or not an asset constitutes a security, the Howey test seeks to determine if a given transaction is an investment contract under three criteria: whether it is an investment of money, whether it is in a common enterprise, and whether there is an expectation of profit, derived explicitly from the efforts of others.
The Ethereum Foundation sold ETH directly to the public, meaning it met the requirement of an investment of money. Additionally, the Ethereum network, for which ETH is the currency, required the direct input of over 100 developers to launch, likely qualifying as a common enterprise. Finally, the Ethereum ICO happened in August 2014, 11 months ahead of the network’s July 2015 launch. This suggests that investors had a reasonable expectation that their purchased ETH would increase in value when the network launched, something that depended on the efforts of Ethereum’s developers. Therefore, a lawsuit filed against the Ethereum Foundation at the time would likely have determined ETH to be a security under the Howey test.
However, despite ambiguity over Ethereum’s status as a security plaguing its early years, the SEC has since weighed in on the network’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, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”
Based on Hinman’s evaluation, the SEC would be unlikely to retroactively classify Ethereum as a security. He argued that by the time he made his speech in 2018, the Ethereum network had sufficiently decentralized to the point where its token, ETH, could no longer be considered a security under U.S. law. Hinman also added that regulating ETH transactions under securities laws would add “little value” for investors or regulators.
While Hinman’s comments quashed immediate fears that ETH could be labeled a security, the Ethereum network’s upcoming “Merge” to Proof-of-Stake has reignited the discussion. The update, scheduled to take place later this year, will significantly change the underlying structure of how the Ethereum network functions. The current Proof-of-Stake system, in which independent miners compete to solve complex equations and mine blocks, will be replaced by a Proof-of-Stake validation mechanism. While Proof-of-Stake is commonly used among other blockchain protocols, in the case of Ethereum, the specifics of how the new validation system works could affect Hinman’s earlier evaluation.
Although protocol changes from the Ethereum Merge could revive ambiguity surrounding whether or not Ethereum is a security, other developments, such as a recent insider trading lawsuit, have helped clarify the SEC’s position on which crypto assets it might consider securities. The lawsuit, filed against two former Coinbase employees and their friend, alleges the trio purchased and sold 25 different crypto assets on insider information and explicitly said that “at least nine” could qualify as securities.
The wording used in the lawsuit expanded on the definition of a security outlined in the Howey test. Most notably, it explained the SEC’s view that if the organization that issued a crypto asset removed itself from the project’s development and the asset could not continue functioning, it should be classified as a security. Aided by the new clarification, the SEC made the case that the AMP, RLY, DDX, XYO, RGT, LCX, POWR, DFX, and KROM tokens either fully constituted securities or displayed significant security-like features.
The combination of new filings from the SEC and Ethereum’s highly-anticipated Merge update has brought a once-settled question back into question among crypto enthusiasts: Could the SEC classify Ethereum as a security in the future?
Will Post-Merge ETH Qualify as a Security?
To gauge whether or not the SEC has grounds to deem Ethereum a security after the Merge, it’s important to understand exactly how the update will affect the network.
Ethereum currently uses a Proof-of-Work validation mechanism where blocks are proposed and validated by miners, who use computing power to solve the complex equations needed to mine blocks. The network automatically rewards miners with two ETH per block mined plus any priority fees included in transactions.
After the Merge, Ethereum mainnet will dock with the Beacon Chain, switching validation to a Proof-of-Stake mechanism. Under Proof-of-Stake, anyone who owns at least 32 ETH can set up a full validator node on the Ethereum network and join a pool of other validators to validate blocks. After each block is validated, eligible validators will earn a small reward along with any priority fees from transactions.
The upcoming technical changes that Ethereum will undergo as part of the Merge have led to some discussions surrounding its security status. Adam Levitin, Professor of Law, Georgetown University Law Center, has argued that there will be a “strong case” for Ethereum to be classified as a security following the Merge. He says that under Proof-of-Stake, validators pool their ETH in a “common enterprise,” satisfying the second point of the Howey test. Furthermore, because validators will receive rewards from themselves and others validating the Ethereum network, there is an expectation of profit “derived from the efforts of others.”
However, Levitin has received some pushback over his interpretation of Ethereum’s Proof-of-Stake validation mechanism. Cinneamhain Ventures partner Adam Cochran refutes Levitin’s claims, arguing that those running validators on Ethereum’s Proof-of-Stake chain are not pooling their funds, thus calling into question whether running a validator constitutes a “common enterprise.” “You receive rewards when the node you maintain performs its jobs and you are slashed when it fails. Your node succeeding or failing does not impact the interests of others,” he stated, arguing that the profits of one person’s validator are not dependent on the success or failure of others.
Cochran, as well as others such as AllianceDAO contributor Jacob Franek, have also pointed out that because there is no identifiable ETH issuer today, it’s difficult to argue that the profits validators receive are securities relating to any entity. To reference back to the SEC’s definition of a crypto asset security outlined in the recent insider trading lawsuit, even if Ethereum’s developers stopped working on the protocol, validators would continue to add blocks to the chain, and stakers would still receive rewards. This weakens the argument that ETH could be a security.
A final point regarding Ethereum staking profits also helps refute the criteria for a security found in the Howey test. Today, most securities that fall under the SEC’s purview constitute stock offerings from registered companies. Investors who hold them do not need to perform any special duties or labor to ensure they receive the profits from the issuer in the form of dividends.
However, in the case of Ethereum staking, ETH holders must acquire sufficient computer hardware, install the necessary client software and configure it, maintain an Internet connection, and ensure their validator node operates properly and honestly. Due to the significant labor needed to profit from staking ETH, some have argued that stakers receive payment for performing a specific service rather than deriving profit from the actions of others.
Additionally, any stakers who fail to validate transactions properly face having their stake “slashed”—a process whereby the network automatically takes a validator’s ETH to punish it for misreporting transactions. Ultimately, because Ethereum validators are earning from their own efforts and not the efforts of other investors or Ethereum developers, historical precedent indicates it shouldn’t be as a security.
The Howey test criteria and the precedent set by prior SEC cases make it hard for the regulator to argue that Ethereum constitutes a security. While the SEC may attempt to expand its purview over crypto assets by declaring more of them securities, it looks less and less likely that Ethereum will appear in the organization’s crosshairs, even after the Merge to Proof-of-Stake takes place.
Additionally, the SEC’s ongoing case that seeks to determine whether Ripple’s XRP token sale constituted a securities offering will likely further dissuade the regulator from litigation, lest it is dragged into another long and costly lawsuit. Still, without a firm ruling, the question of whether Ethereum will be classified as a security will likely continue to crop up in crypto circles. While the SEC has made some progress, including its decision to classify Bitcoin as a commodity, rulings on other assets have been few and far between. However, as Ethereum and the broader crypto space grow, it will be hard for regulators to continue ignoring it. Therefore, the SEC may be forced to definitively weigh in on the crypto space’s second biggest asset sooner rather than later.
Disclosure: At the time of writing this feature, the author owned ETH, BTC, and several other cryptocurrencies.
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