Is Ethereum (ETH) a security under US law?

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A court would likely agree with the U.S. Securities and Exchange Commission (SEC) that Ethereum 2.0 amounts to an unregistered security, a comprehensive internal legal memo has warned.

Buffone Law Group issued the memo to venture capital firm Ayre Ventures, and warned that both Ethereum’s move to proof-of-stake and the Ethereum 2.0 staking programs offered by exchanges both amount to illegal securities offerings under the Howey test.

Ethereum is often held up as a kind of gold standard for digital assets that are not considered securities under the law. This is thanks to comments made by a former SEC director in 2018, which indicated his view that ETH was a commodity rather than a security. Though the speech was explicitly caveated as not being representative of the SEC’s official position, ETH holders have clung to his words ever since.

But a lot has changed since 2018—not least of all, regulators’ understanding of the digital asset industry. Look no further than the sweeping charges levied by the SEC against the two biggest digital asset exchanges for illegally listing securities in June or Gensler’s on-record comments that ‘only a few’ of the coins listed on exchanges were not securities.

This means Ethereum is also due for a revaluation—especially with this year’s move to proof-of-stake under Ethereum 2.0.

“Ayre Ventures commissioned the report so that it can continue to steer clear of illegal securities business,” said Calvin Ayre, founder of Ayre Group.

“I think the evidence is the only platform that is certain to not be a security is BSV.”

Recapping Howey

The memo, issued by Buffone Law Group, includes a summary of the Howey test for determining whether an asset offering is an investment contract and, therefore, a security. Under Howey, an investment contract exists if there is:

1. An investment of money;
2. In a common enterprise;
3. With a reasonable expectation of profits;
4. That expectation is based upon the efforts of others

The key element of the Howey test, as it applies in a digital assets context, is whether there was an investment of profits derived from the efforts of others. This test will be met when the development of a given digital asset project is centralized (meaning there are identifiable individuals with the power to govern the network).

It also canvases several cases (on top of the Binance and Coinbase [NASDAQ: COIN] charges) where the courts have examined Howey’s application in a digital assets context, showing that courts have been able to fit digital assets within Howey in a variety of contexts:

• SEC v Telegram: an enforcement case brought by the SEC over the issuance of Telegram’s Gram tokens, the court found that the offering amounted to an investment contract under Howey. In particular, the court said that Telegram’s execs “will be the guiding force behind the TON Blockchain [supporting the Gram token] for the immediate post-launch period while the [initial] purchasers unload their Grams into the secondary market” and, therefore, “the initial 175 purchasers possess a reasonable expectation of profit based solely upon the efforts of Telegram because these purchasers expect to reap whopping gains from the resale of the Grams in the immediate post-launch period.”
• SEC v Kik Interactive: this case concerned presales of Kik’s Kin token to private investors. The court held that this amounted to a securities offering, saying that the ‘common enterprise’ element of Howey could be established by showing “the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro rata distribution of profits.” It also clarified that under the ‘expectation of profits derived from the efforts of others’ limb, the expectation of profits need not derive solely from the efforts of others. The fact that the token was eventually intended to be used consumptively also did not save Kik, as the court held that such consumptive uses would only arise from the efforts of its managerial staff in the first place.

Ethereum 2.0

The memo says that Ethereum 2.0 represents illegally unregistered securities offering on two fronts:

• First, with the upgrade to Ethereum 2.0 itself; and
• Second, with regard to exchanges offering Ethereum 2.0 staking services

To begin, the memo sketches out the circumstances behind Ethereum’s transition to Ethereum 2.0 (a term that has apparently been ‘phased out’ by the Ethereum Foundation). Additionally and most pertinently to the securities analysis, the memo also examines how this upgrade was designed and implemented.

Ethereum 2.0 went through four distinct development stages, all of which were managed by Vitalik Buterin’s Ethereum Foundation. This included:

• The rollout of Ethereum 2.0’s proof-of-stake algorithm via the Paris upgrade
• The creation of shard chains for network “scalability”
• The activation of smart contract execution
• The implementation of miscellaneous features for 2.0, such as the April 2023 Capella upgrade to allow staking withdrawals

The Ethereum Foundation said these changes were ‘necessary to unlock Ethereum’s full potential.’

If Ethereum 2.0 is not a security, then these changes should have all been democratically designed, chosen, and implemented. Further, there would be no expectation of further changes to the network. This didn’t happen in the case of Ethereum, which is at all times exclusively managed by the Ethereum Foundation.

As the memo says:

“Under this arrangement, presumably the Ethereum Foundation developers will continue to administer improvements to the network and distribution of validator rewards post-launch, and will be responsible for the success or failure of Ethereum post-merge.”

It points out that the GitHub page for Ethereum 2.0 contributors shows that there are only five individuals with a ‘significant concentration’ of additions or commits—all of whom are employees of the Ethereum Foundation. These are:

• Danny Ryan (aka “djrtwo”)
• Hsiao-Wei Wang (aka “hwwhww”)
• Diederik Loerakker (aka “protolambda”)
• Justin Drake (aka “JustinDrake”)

Applying Howey to the Ethereum 2.0 upgrades

Was there an investment of money?

The memo advises that the courts have found that the investment of digital assets, as opposed to fiat currency, still amounts to an investment of money under Howey (BitConnect). It was a true investment, because the users staking their ETH were running the risk that the entire amount staked could be lost in the process, and users could not unstake or otherwise redeem their staked ETH until the Ethereum 2.0 network upgrade was completed in April of this year. Additionally, there was never any guarantee that the Ethereum 2.0 upgrade would be successfully completed.

Was there a common enterprise?

According to the memo, “the $325 million of ETH staked to launch Ethereum 2.0 would likely be considered a pooling of funds that would give rise to horizontal commonality.”

It cites the court’s decision in Kik, which held that the key feature of a common enterprise “is not that investors must reap their profits” in a specific form or at the same time, but that the “investors’ profits at any given time are tied to the success of the enterprise.” Further, “the nature of a common enterprise [is] to pool invested proceeds to increase the range of goods and services from which income and profits could be earned or, to increase the range of goods and services that holders of [the digital asset] would find beneficial to buy and sell with [that digital asset].”

For Ethereum 2.0, there are two factors that suggest a common enterprise exists:

1. Over 16,000 validators collectively staked $325 million, which was the threshold required for the launch of Ethereum 2.0 to take place.
2. The ETH created on the 2.0 network count not be sent back to the original Ethereum blockchain and could not be used on the 2.0 network until the Paris update and network merge. If the merge did not take place, the ETH held on the Ethereum 2.0 network had no consumptive use or value.

“Thus,” reads the memo, “these features lead naturally to the conclusion that the $325 million of staked ETH constitutes the pooling of funds to not just increase, but create, the goods and services that holders of the ETH on the Ethereum 2.0 network can use this asset for.”

Was there a reasonable expectation of profits?

This limb of the test is straightforward. The validators who staked their 32 ETH to the network begin earning rewards on their ETH in the form of annualized interest, which can reach more than 20% and is distributed around every 6 minutes (the time it takes to create a new block).

Earlier investors also stand to earn higher interest on their investment than later investors because the percentage interest earned over time decreases in proportion to the total number of validators.

Was that based on the efforts of others?

The memo identifies four facts relevant to the final and most frequently challenged limb of the test as it applies to digital assets.

1. ETH earned on the Ethereum 2.0 network was locked on this network until the merger with the Ethereum mainnet. Before that merge, the ETH could not be sent to the Ethereum mainnet.
2. No consumptive transactions or smart contracts could occur on Ethereum 2.0 until the merge took place.
3. The Ethereum 2.0 network did not have an existing marketplace where ETH tokens were accepted for consumptive use until the merge.

“Accordingly, the value of the Ethereum tokens earned as interest payments was entirely speculative, and the future value turned entirely on the Ethereum Foundation successfully executing on its four-phase plan leading to the merging of the Ethereum 2.0 network with the Ethereum mainnet.”

Now that the merger has taken place, those ETH tokens have increased in value thanks to the additional capabilities offered by the merged network, such as vastly increased scalability. If the merger hadn’t gone ahead, those tokens would be worthless.

That the upgrades were to increase the value of the network can be seen from the Ethereum Foundation’s promotional materials describing the merge. They said that the upgrades would “make Ethereum more scalable, more secure and more sustainable.”

“As Ethereum developers presumably continue to build out, improve, and administer updates to the network and distribution of ETH post-launch, a court is likely to find that Ethereum 2.0 validators are heavily reliant on the efforts of the Ethereum Foundation for their ETH token holdings on the Ethereum 2.0 network to have any value, let alone appreciate in value.”

The memo warns that there are ‘several’ aspects of the Ethereum 2.0 rollout that would likely cause the SEC or a court to find that it falls within the Howey test and thus amounts to an unregistered securities offering.

• Users that want to earn rewards for securing the network and processing transactions must deposit 32 ETH into a smart contract on the original Ethereum blockchain.
• An equal amount of that ETH is created on the Ethereum 2.0 beacon chain, which can be put up as collateral by the user in order to become a validator.
• The validators only received their 32 ETH existing on the 2.0 chain because the threshold of 16,000 validators was reached, which allowed for the Ethereum 2.0 network to launch.
• ETH could not be sent back to the original Ethereum chain.
• There was a risk that the 32 staked ETH could be lost to the user under the provision of the smart contract. Validators immediately began earning interest as high as 20% on their initial 32 ETH investment.

Exchange-facilitated Ethereum staking programs

The analysis also covers another significant implication of Ethereum 2.0’s status under Howey: the legality of exchange-offered ETH staking programs. These are programs facilitated by exchanges, which allow users to stake their held ETH (usually in amounts smaller than the 32 ETH threshold) in exchange for the payment of interest. The exchanges then pool those assets together and are responsible for staking them in 32 ETH increments to the Ethereum 2.0 blockchain. Validator rewards are then distributed back to the original users in proportion to the amount initially staked.

This is a particularly relevant topic given the SEC charges against Coinbase and Binance, both of which highlighted the digital asset staking programs offered by the exchanges as examples of unregistered securities. The SEC has also pursued other exchanges for similar arrangements, including the Gemini Earn lending program.

In the case of staking ETH to the Ethereum 2.0 network via exchanges, the memo warns that this, too, meets the Howey test for an investment contract.

• As discussed above, users are making an investment of money through the platforms.
• There is a common enterprise, as when users stake less than 32 ETH via the exchange, the exchange is pooling the funds to stake 32 ETH lots of assets to the network. The court’s ruling in the Kik case is instructive, as it said that “the nature of a common enterprise [is] top pool invested proceeds to increase the range of goods and services from which income and profits could be earned or… the increase the range of goods and services that holders of [the digital asset] would find beneficial to buy and sell with [that digital asset].”
• Several factors support a reasonable expectation of profits: exchanges offer rates of between 5 and 20 percent per year, with validator rewards being paid out to users proportional to the amount staked.
• The expectation of profits is derived from the efforts of others: the exchanges are providing the resources necessary to run a validator node, such as hardware and the finances to run it. The rewards ultimately received by the users depend heavily on the efforts of these exchanges to 1) provide the resources and hardware required to run the node, and 2) ensure that the validator does not stop validating or behave in a way that would lead to the forfeiture of the staked ETH.

The analysis of staking programs is interesting because it illustrates that a court finds that a given digital asset offering amounts to a security will have significant implications for all parties connected with the asset. This can be seen in the slew of charges now faced by Coinbase and Binance merely for listing digital asset securities (their liability arises from failing to register as securities dealers), and will be seen in the way other products based on securities (such as Ethereum staking services) will also be rendered illegal by the circumstances of the initial offering.

Does this analysis apply elsewhere?

Perhaps most alarming (to some) about this analysis is that it can be applied to a huge proportion of the digital asset market.

There is always going to be an investment of money. Any hope of escaping liability under this heading vanished with the confirmation that digital assets are considered money under this test.

There is practically always going to be a common enterprise. As the court said in Telegram, the key feature is not that the investors actually reap their profits in a specific form or at the same time; all that is required is that the profits—at any given time—are tied to the success of the enterprise.

There is an expectation of profits derived from the efforts of others: this is both the most obfuscated element of the test and the easiest to apply. It comes down to centralization: is the investors’ expectation of profits arising from the efforts of some management or entrepreneurial efforts of others? Crucial to this element is that the expectation does not need to derive solely from the efforts of others, so the fact that some of the profits can be accounted for by an increase in value arising solely from speculation is no argument against a finding under this heading.

Like ETH, BTC has often been held up as an example of digital assets which do not amount to commodities. As seen from the analysis above, the upgrade to Ethereum 2.0 looks a lot like an illegally unregistered securities offering, as do exchange-facilitated ETH staking programs.

BTC has also undergone significant changes designed and implemented by a core group of individuals with the power to affect the network. In 2017, the SegWit update drastically changed the way Bitcoin transactions are recorded: whereas the Bitcoin white paper made it clear both that signatures are an inextricable part of the system and that the network is scalable on-chain, SegWit removed digital signatures and broke them out into a separate data structure in order to (allegedly) help the network’s scalability issues.

Such a change has significant consequences. Not only is it a demonstration of power by the BTC Core developers (just as it was with the Ethereum Foundation employees shepherding in Ethereum 2.0) in demonstration of reliance on the efforts of others, each departure from the original Bitcoin protocol is a ‘fork’ of the network. This creates new coin issuances based on the new protocol whereby the new coins are ‘airdropped’ to the holders of the original.

ZeMing Gao describes the consequences of this in a securities context in his article, “Even BTC is a security according to the Howey test”:

“Every time when the actual underlying blockchain changes the base protocol that not only affects transactions but also affects the automated unilateral contract originally offered by Satoshi, the coin is no longer the original coin. From that point on, any coin that continues on the changed blockchain is materially a new coin offered under a new contract. Further, the continuous issuance of new tokens to miners is also under a new mining contract different from the original unilateral contract offered to miners by Satoshi. This makes the reissued tokens and new tokens both a security, collectively or separately, even though the original bitcoin was a nonsecurity. It does not matter what name or ticker it carries, nor what the market price it receives. This is because the market is not the factfinder for this matter; it simply votes according to whatever information it was fed, and in this case they were fed deceptive information.”

Howey can sound like a confusing and difficult-to-apply test, especially in a digital assets context. However, when you strip away the fluff, the core question is as simple as whether or not the underlying protocol is fixed and set in stone. If not, then centralized power exists somewhere in the system, usually resting with a few key individuals. Once that’s established, the conclusion that there is an expectation of profits reliant on the efforts of others—and is thus a security—is staring you in the face.

As it is with Ethereum 2.0, so it is with BTC.

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