The proof-of-stake-focused Ethereum 2.0 has gone live, seemingly without a thought paid to whether the network’s new system falls within the definition of securities for the purpose of the U.S. securities legislation.
Given the massive penalties that can be levied for the offering of unregistered securities, and given that the SEC has left the door wide open for a finding that Ethereum 2.0 does qualify as a security, this represents a massive liability for both the Ethereum network and anyone looking to participate in its new proof-of-stake consensus system.
What makes a security?
The offering of securities triggers the often onerous requirements of the U.S. securities legislation, including important investor protection obligations—not the least of which is the requirement to register the offering with the SEC. Being caught offering unregistered securities can mean the return of money to investors and fines running in the tens of millions. The SEC levied a US$18.5 million fine on Telegram and ordered the return of US$1.2 billion to investors after its “Gram” token was deemed to be an offering of unregistered securities.
So, whether or not an offering is a security or not is vitally important—not just for companies, but for the protection of their investors. In a market already filled with hopeful speculators, naïve investors, and rampant market manipulation, those protections are much needed.
The definition of ‘security’ is set out in the Securities Act of 1933. The definition includes “investment contracts,” which is typically most relevant when assessing digital assets. Whether or not a something qualifies as an investment contract, and thus a security, depends on the application of the U.S. Supreme Court’s “Howey Test.” The Howey test has three elements:
- There must be an investment of money;
- The investment must be in a common enterprise;
- There must have been a reasonable expectation of profits reliant on the effort of others
If an offering hits all three elements, it is an investment contract.
Various authorities have unofficially speculated that under proof-of-work, Ethereum does not constitute a security—William Hinman, then-director of the SEC’s division of corporate finance, said that based on his understanding, offers and sales of Ether are not securities transactions due to the Ethereum network’s “decentralized structure.” But he also emphasized that “the analysis of whether something is a security is not status and does not strictly inhere to the instrument.”
With Ethereum’s move to a proof-of-stake model, Hinman’s statement is an omen. If the SEC previously did not consider Ethereum a security, what about Ethereum 2.0?
Proof of Stake vs Proof of Work
Proof-of-work is a consensus mechanism in which miners may only create blocks after finding a solution to a complex cryptographic puzzle. The first miner to solve the puzzle receives a predetermined reward for that block, which is added to the chain. Proof-of-stake requires participants to put up a ‘stake’ (in Ether’s case), and the amount staked influences how likely the staker is to be chosen to propose a new block.
There is a solid case to be made that the Ethereum is already a security, contrary to the SEC’s stated view that it is a commodity. Though this issue has not been litigated in the courts, the SEC has said enough about ETH that we can understand their thought process in coming to this conclusion. The concept of ‘decentralization’ has been central to the SEC’s analysis on this subject, and has worked its way into the discourse surrounding the applicability of the securities legislation to Ethereum. Whether the third prong of the test—a reasonable expectation of profits reliant on the effort of others—is satisfied can turn on decentralization in that the SEC is more likely to consider there to be a reliance on the effort of others if there are ‘essential tasks’ yet to be done by an ‘active participant’ as opposed to a decentralized network of users.
Ethereum is by and large governed by the Ethereum Foundation. No matter how often it advertises that anyone can contribute to the Ethereum codebase, the reality is that a closely-knit group of developers are the ones proposing—and implementing—the most significant changes within Ethereum. Only 0.5% of the system stakes, which means a small elite controls the system. On top of that, virtually every non-code innovation in the Ethereum ecosystem can be traced back to the Ethereum Foundation and its developers.
Though this is by no means a legal test, ask yourself: if you were to take a position on the future value of ETH, would you bet against any member of the Ethereum Foundation? Of course not. Nobody would. Its founders, including Vitalik Buterin, have a sufficient stake to ensure control no matter how many users vote by staking. The actions they take are so central to Ethereum that you would never take such a position.
Nonetheless, despite plainly exhibiting all the characteristics of an ICO the likes of which the SEC has pursued as the offering of unregistered securities, Ethereum has escaped the same fate as those offerings.
With Ethereum 2.0, presumably, now is the time for the SEC to revisit the question. Hopefully they will make up for letting the raising of over US$100 million in exchange for ETH slide by without granting investors any of the protections that are normally granted to such issuances.
Regardless of what the SEC thought of Ethereum initially, the system proposed in Ethereum 2.0 undoubtedly satisfies the Howey test as an investment contract.
Under Ethereum 2.0’s proof-of-stake model:
- Users hoping to become validators must stake Ethereum in order to do so, meaning there is a clear investment of money;
- There is clearly a common enterprise (this almost always satisfied when applying Howey to digital assets); and
- There is a reasonable expectation of profits derived from the efforts of others (see below)
As is often the case in Howey analysis, the third prong of this test is the most worthy of discussion. It can be split into two elements: firstly that there must be a reasonable expectation of profits, and secondly that the expected profits must derive from the efforts of others.
The first element is clearly satisfied: validators post their stake with the expectation that their stake will both be returned to them and they will receive a reward proportional to that stake.
Is it derived from the efforts of others? This question is a little trickier. Though the original wording of the Howey test indicates that the expectations of profits must be derived ‘solely’ from the efforts of others, subsequent applications of the test have had the effect of rendering the word’s inclusion as ineffectual. This is particularly clear in the case of digital assets, where the focus in applying this test has been on decentralization. If the network supporting the coin is ‘sufficiently decentralized,’ then it can’t be said that the purchaser is relying upon the efforts of others.
The level of decentralization that would be considered ‘sufficient’ to fail the Howey test is not set in stone. However, the SEC released a Framework for the “Investment Contract” Analysis of Digital Assets in 2019 which elaborates on precisely this point. Though not a legal document, it does illuminate the SEC’s thinking in this area. In it, they ask whether the efforts being relied on are the “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”
If the SEC erroneously considered Ethereum as ‘sufficiently decentralized,’ the characteristics of Ethereum 2.0 provide the SEC with ample opportunity to right that wrong.
While it cannot be said that there is a reasonable expectation of profits deriving solely from the efforts of others, it certainly depends on the central machinations of the Ethereum network in order to set, assess and implement the rules of validation and the distribution of the profits, without which the network would not function: there would be no reward without the efforts, in large part, of Ethereum’s core developers. Here the myth of ETH decentralization falls apart. It is not necessary that the efforts of others be the sole catalyst for the profits expected.
Ethereum 2.0 likely satisfies the Howey test—now what?
What the SEC says about the Howey analysis is not law: what we know about the SEC’s position on Howey largely comes from oral speeches and non-authoritative frameworks. This is clear from the SEC’s approach to the original Ethereum, which should be caught by Howey if the SEC’s own published comments on the application of Howey are to be taken at face value.
However, it is clear that the factors which go into a Howey analysis under the third prong of the test are questions of degree. If the SEC didn’t find that Ethereum initially constituted an investment contract, then the circumstances of Ethereum 2.0 make it far further along the centralization continuum than Ethereum was.
So now what?
Well, considering that Ethereum has not registered itself with the SEC, Ethereum 2.0 represents an unregistered security. Looking to the Telegram fiasco, this would mean fines in the tens of millions and the potential repatriation of funds back to investors, leaving the Ethereum 2.0 network in the precarious position of having the financial rug pulled from under it at a moment’s notice. These penalties are likely to come in the form of a settlement which could include any number of stipulations and concessions for the Ethereum network, including the voiding of the tokens in question.
As it stands and until the SEC clarifies their position on proof-of-stake systems such as Ethereum 2.0, the new Ethereum should be approached by those looking to invest as though it is an extraordinary liability at the mercy of the SEC (and other regulators) who are becoming ever-more aggressive in pursuing non-compliance in this space.
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