Are We Quite Sure That Ethereum Isn’t A Security?

Andrew Throuvalas

@andrew

Crypto SecurityEthereumSECSecurity

The Securities and Exchange Commission (SEC) remains hazy on which cryptocurrencies are “securities'', versus “commodities”. Even Ethereum isn’t out of the woods. 

The SEC is notoriously slow at providing regulatory clarity for the crypto industry. Besides its strange hostility toward permitting a Bitcoin spot ETF, the commission refuses to classify which cryptocurrencies are securities.

Instead, SEC chairman Gary Gensler continues to make vague statements on the matter that shake confidence in every altcoin holder. In a September conversation with The Washington Post, he stated that “most” cryptocurrencies are securities, while only “some” are commodities. No specific designations were made.

Ah. But that’s just a small-cap problem! Large-caps like Bitcoin and Ethereum have already been designated as commodities, right?

Not exactly.

Gensler Sidesteps the Ethereum Question

On Squawk Box earlier this month, Gensler was directly asked for his view on whether or not Ethereum is a security. He completely avoided the question.

“I’m not going to speak to any one matter,” he said. “I’m the chair of a five member commission that’s also a civil law enforcement agency. We don’t get involved in these types of public forums talking about any one project.”

A fair answer, but hardly reassuring for Ethereans. While it doesn’t tell us that Ethereum is a security, it does clarify that debate on its classification is not over among regulators. After all, many in the crypto community had gotten the impression that it was.

In 2018, SEC Director of Corporation Finance William Hinman opined that neither Bitcoin nor Ethereum operated like securities. He said that given the current nature and decentralized structure of Ethereum, “sales of Ether are not securities transactions”. Indeed, Ether today functions much like a tool – the “digital oil” that powers various applications on the Ethereum blockchain.

The SEC chairman at the time – Jay Clayton – reiterated this viewpoint. Speaking with Congressman Ted Budd in 2019, he agreed that the nature of crypto transactions could evolve. For example, suppose a purchaser no longer expected any party to primarily carry out “managerial or entrepreneurial efforts” for a product. In that case, a digital asset may “not represent an investment contract under the Howey framework.”

But neither of these statements were concrete classifications. As Hinman emphasized in that same speech, the analysis of whether something is a security “is not static”. Both Gensler and Clayton have explained that such a classification essentially boils down to the Howey test.

The Howey Test

The Howey Test refers to the Supreme Court case SEC v. W.J. Howey Co. from 1946. Howey Company sold tracts of citrus groves to Floridian buyers, who would then lease back the land to Howey. The company then took sole responsibility for tending and selling the fruit they produced, from which both Howey and the landowners profited.

The problem? Howey did not register the relevant transactions with the SEC. The court would later determine that his leaseback arrangements were, in fact, investment contracts.

This case established the following criteria for determining whether something is an “investment contract” or “security”.

1. There is an investment of money.
2. The investment is in a joint enterprise.
3. There is an expectation of profits from said investment.
4. It will derive profit from the efforts of others.

Anything that meets these qualifications “passes” the Howey Test. It must be disclosed and registered under the Securities Act of 1933 and the Securities and Exchange Act of 1934.

The first act requires businesses to provide transparent financial statements for investors about their securities using a prospectus. The prospectus must include information about the business’s property, its executive management, and other things.

The second act governs securities transactions over secondary markets – including crypto exchanges. It requires registration and disclosure, margin trade limitations, and necessary audits. Generally, it is intended to bring transparency to the financial markets and reduce the potential for fraud.

Howey Test V. Ethereum

While he refuses to comment on specific tokens, Gensler has recalled the Howey test’s criteria numerous times when evaluating cryptocurrencies. He referred to this exact argument during his interview this week, following the Ethereum question.

“If you’re raising money from the public, and the public is in anticipation of profit based upon that promoter, sponsor, or group’s efforts, that’s within the securities laws.”

When these criteria are applied to Ethereum – particularly at initial offering – its ‘security’ argument grows stronger.

Ethereum featured an initial coin offering (ICO) in which buyers traded Bitcoin to a common blockchain address in exchange for Ether. That address belonged to the Ethereum Foundation – an organization aimed at marketing and supporting Ethereum and its infrastructure.

Led by whitepaper author Vitalik Buterin, the Foundation exerts vast – though not total – influence over Ethereum’s development. This was especially true in its earliest years when Buterin’s team of coders was the absolute backbone of Ethereum’s success.

Finally, though it deems itself a non-profit, Ether’s ICO was designed to raise money for the Foundation, anticipating Ether’s value would grow over time. In short, the details surrounding Ethereum’s inception tick every box that would make it a security under the Howey framework.

There already appears to be substantial agreement on that point. While teaching at MIT in 2018, Gensler stated that Ether “would have passed” the Howey test when launched in 2014. In 2019, Clayton suggested that almost all ICOs are securities. Even Hinman showed skepticism of Ethereum’s initial fundraising in his speech, arguing against its security status.

Therefore, the debate around Ethereum concerns whether it has become sufficiently decentralized to shake its security-like roots. While Hinman seems to think so, we don’t know if Gensler does.

Ripple V. SEC

More reason to doubt Ethereum’s “non-security” status comes from the ongoing Ripple V. SEC battle.

In December of 2020, the SEC charged Ripple and two of its executives with conducting unregistered securities offerings. In the commission’s opinion, XRP is, in fact, a security, while Ripple CEO Brad Garlinghouse maintains that it’s not. Garlinghouse’s main argument is that XRP does not constitute a stake in Ripple, nor does it rely on Ripple’s success to stay afloat.

During this lawsuit, Ripple has dug for internal SEC dialogues on what caused Hinman to view Ethereum as a non-security. As a result, they were recently granted access to internal SEC emails surrounding Hinman’s speech mentioned above. The company believes this evidence could help “rebuff the SEC’s claims about the nature of XRP.”

So far, however, their efforts have revealed unpleasant truths for both XRP and Ether. In October, the SEC had Hinman sign an affidavit confirming that his 2018 speech only reflected his personal views – not the commissions. What’s more, he even stated that the SEC has still not taken an official position on Ethereum.

“To the best of my knowledge, the Commission had not taken at that time, and still has not taken, any position or expressed a view as to whether offers and sales of Ether constituted offers and sales of securities,” said Hinman.

That’s not all: Last month, Charles Gasparino of Fox Business reported that the SEC had reversed its position on both Bitcoin and Ethereum’s “complaint” status during court testimony for the Ripple and SEC case. If true, it would be a total reversal on any indication from Hinman and Clayton that either Bitcoin or Ethereum are cleared as non-securities.

However, Bitcoiners generally have less to fear than Ethereans on this front.

What Makes Bitcoin Different

Current Classifications

Even if Gasparino’s claim applies to Bitcoin too, other regulatory bodies have quickly and decisively given it different classifications already.

For one, the Commodities and Futures Trading Commission (CFTC) has classified Bitcoin as a commodity. The classification lets the CFTC supervise Bitcoin futures trading on regulated exchanges. In turn, this is what made Gensler open to permitting Bitcoin Futures ETFs to launch in the US.

Meanwhile, the IRS has classified Bitcoin as property for tax purposes. As a result, any income earned due to Bitcoin increasing in value has been taxed like stocks and bonds since 2014.

Finally, Jay Clayton affirmed that Bitcoin was not a security during his term. He recognized that it is meant to replace sovereign money, calling it a “currency” and not a “security”. For El Salvador, Bitcoin has successfully become a national currency.

Among Bitcoin’s many classifications, “security” is not one. That’s because it differs from Ether and other cryptos in fundamental ways that cause it to fail the Howey test. These properties are collectively referred to as Bitcoin’s “Immaculate conception”.

The Immaculate Conception

Firstly, Bitcoin did not feature an initial coin offering. Instead, its proof-of-work consensus mechanism doubly served as a method for distributing the currency. As a result, the most competitive miners that provided the most cumulative “work” to the network were – and are – rewarded with all-new Bitcoin.

By comparison, Ethereum also uses proof-of-work but featured a massive pre-mine for its founders and early investors. So by this metric, even Dogecoin has a stronger argument for not being a security.

Bitcoin had no concentrated group primarily responsible for raising money or developing the protocol. Though there technically exists a “Bitcoin Foundation”, it was formed years after Bitcoin’s launch to clear it of various scandals. It is not integral to the protocol’s development, which has always been maintained by a decentralized group of developers worldwide.

Finally, the network’s founder – the anonymous Satoshi Nakamoto – has shown no intention to profit from Bitcoin’s creation. He is yet to sell a single Bitcoin from the network address that most presumed was his own. There is even evidence that he intentionally mined less Bitcoin than possible to give other miners a chance to earn in Bitcoin’s infancy.

Satoshi has now been missing from Bitcoin for over ten years and is no longer involved with the project in any capacity. With that, Bitcoin features no profit motive, trusted party, or fundraising activity that would suggest it passes the Howey test.

Regulatory Clarity = Investment

Whether or not the SEC ultimately goes after Ethereum, their mere threat is already driving investors away from the asset. Michael Saylor – whose company has invested billions of dollars into Bitcoin – has put nothing into Ether for precisely this reason.

“It’s universally acknowledged that Bitcoin is property,” he said in a recent interview with MMCrypto. “If you look at the entire crypto ecosystem, all the regulatory uncertainty and question marks are around securities. If there’s an ICO, a central organization, a premine, a foundation that has a treasury, and lots of hard forks that are happening every quarter, that starts to look more like a security in the eyes of a regulator.”

Conclusion: Ethereum is in Trouble

Some prominent crypto-community figures – including Global Macro Investor CEO Raoul Pal and Coinbase CFO Alesia Haas – believe current securities laws are outdated. They should either be updated to accommodate cryptocurrencies or have an entirely new regulatory framework.

However, both the former and current SEC chairman reject the idea, respecting the traditional definitions. Therefore, if Ethereum meets these classifications, it’ll have to adapt to time-tested securities standards. The law will most likely not bend to accommodate it or other cryptos.

Much of Ethereum’s fate likely still rests on the Ripple vs SEC case. When it filed the case, Joseph Grundfest – a former SEC commissioner – argued to Clayton that if XRP is a security, then Ether is no exception. He believed that no “material distinction” had been made by the SEC between the operations of each crypto.

Ethereum’s long-awaited transition to Ethereum 2.0 will likely only make things worse. As argued by attorney Jeremy Hogan, its new proof-of-stake functionality will strengthen the argument that holders expect a profit from Ether based on others’ efforts. In addition, issues about the network’s improvements due to a “semi-centralized entity” also came to mind.

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There’s a strong likelihood that Ethereans have an arduous regulatory battle to look forward to. Yet if Vitalik’s comments during Ether’s presale are anything to go by, he and other founders have probably spent years anticipating it.

“Ether is a product, NOT a security or investment offering… we make no guarantees of its future value.”