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US court sets ‘crypto = security’ precedent, spelling trouble for Ethereum

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The U.S. Department of Justice (DoJ) is celebrating a fraud conviction that definitively labeled ‘crypto’ tokens as securities for the first time, leaving Ethereum bigwigs wondering when that axe might fall on them.

On June 25, the DoJ announced that U.S. District Judge Patricia Seiz had sentenced both Shane Hampton and Michael Kane to nearly three years in prison for “manipulating the price of a security and scheming to defraud investors in connection with the purchase of Hydrogen Technology’s cryptocurrency, HYDRO.”

The pair were among five individuals charged in April 2023 with wire fraud, wire fraud conspiracy, and securities price manipulation. Kane was the Florida-based Hydrogen Tech’s co-founder/CEO, while Hampton was its chief of financial engineering. Kane pleaded guilty last November, while a federal jury convicted Hampton on February 7. Two other co-conspirators, Andrew Chorlian and Tyler Ostern, pleaded guilty in May 2023.

The scam involved using trading bots to manipulate HYDRO’s fiat value on an unspecified U.S.-based digital asset exchange. Between October 2018 and April 2019, the scammers ensured their bots made around $7 million in ‘wash trades’ and placed over $300 million in ‘spoof trades’ to convince retail investors that HYDRO was a winner. The scam netted its principals over $2 million in profits.

Nicole Argentieri, Principal Deputy Assistant Attorney General and head of the DoJ’s Criminal Division noted that “in this case, for the first time, a jury in a federal criminal trial found that a cryptocurrency was a security and that manipulating cryptocurrency prices was securities fraud.”

Argentieri warned other would-be manipulators that the DoJ “will not hesitate to use all tools at its disposal—including the federal securities laws—to protect the integrity of cryptocurrency markets.”

In October 2022, the Securities and Exchange Commission (SEC) filed civil charges against Kane and Hydrogen Tech for violating U.S. securities laws’ anti-fraud provisions through the same manipulative efforts. The SEC won a $2.8 million judgment the following April, forcing a settlement with Ostern, the CEO of South African market-maker Moonwalkers, for participating in the scheme.

The SEC noted at the time that the HYDRO tokens issued by Kane et al. “were offered and sold as investment contracts, and therefore were securities whose offer or sale required registration with the SEC unless an exemption from registration was available.” No registration was sought, nor was any exemption granted.

Consensys v SEC

In a June 25 Bloomberg interview with Annmarie Hordern, SEC chairman Gary Gensler appeared unmoved by cries of inconsistency in his approach to regulating digital assets, saying, “There’s nothing inconsistent about crypto securities and the securities laws.”

Not everyone shares this view. Under Gensler, the SEC has brought numerous civil suits against ‘crypto’ operators, be they token issuers, digital asset exchanges, or decentralized finance (DeFi) platforms. This hasn’t endeared him to the sector’s leading lights, who tend to view any encroachment on their (allegedly) God-given right to do as they please as tantamount to heresy.

The sector also doesn’t buy Gensler’s consistency claims, so they were popping champagne corks earlier this month when the Consensys blockchain software firm announced that the SEC’s Division of Enforcement “notified us that it is closing its investigation into Ethereum 2.0 and will not pursue an enforcement action against Consensys.”

In late April, Consensys announced that it had filed a pre-emptive suit against the SEC over the regulator’s (alleged) plan “to regulate ETH as a security.” The complaint filed by Consensys sought to compel the SEC to declare that ETH isn’t a security and thus the company’s ETH sales weren’t violating any securities laws.

The SEC didn’t publicly respond to the Consensys complaint, but a June 18 letter written by SEC Enforcement Assistant Director Kristin Pauley to Consensys’s attorneys did indeed state that her office wouldn’t be recommending an enforcement action against Consensys at this time.

However, Pauley added that the SEC didn’t agree with Consensys’s “legal conclusions” (that ETH was a commodity) and that the letter “must in no way be construed” as a suggestion that Consensys “has been exonerated or that no action may ultimately result from the staff’s investigation.”

ETFs don’t make ETH a commodity

The day after Pauley’s letter, Joe Lubin, Consensys founder and co-founder of Ethereum, told Fox Business journo Eleanor Terrett that his company would continue its litigation against the SEC “because we are intent on achieving more legality for all.”

Lubin appears convinced that the SEC is still mulling legal action against Consensys based on the belief that its MetaMask Swaps software is an unregistered broker-dealer and its MetaMask Staking product involves the offer and sale of unregistered securities.

Regardless, Ethereum backers were cheering on May 23 when the SEC’s Division of Trading and Markets approved rule changes to permit eight ETH-based exchange-traded funds (ETF). Reuters reported this week that formal approval of the eight applicants could come as early as July 4.

Ethereum fans took the ETF policy shift as further evidence that the SEC now viewed ETH as a commodity rather than a security. However, approving an ETF doesn’t require a declaration that ETH is a commodity, and the SEC has made no such declaration, regardless of how furious Lubin might try to spin that into reality.

The SEC was simply following the same path as its January approval of BTC spot-based ETFs—namely, that since both tokens were already traded on the Chicago Mercantile Exchange futures market, there was sufficient data to ensure oversight of possible fraud or market manipulation.

But make no mistake about it: ETF or no ETF, ‘Ethereum 2.0’ is even more of a security than the original product. (And don’t just take it from us: here’s an epic video thread of Ethereum ticking the boxes on the Howey Test.)

All the tokens, all the time

Ethereum 2.0 refers to the network’s September 2022 transition from a consensus mechanism based on proof-of-work to one based on proof-of-stake (PoS). The latter requires individual validators to stake 32 ETH (currently ~US$108,000) to participate in the PoS system and earn additional ETH via block rewards and transaction fees.

This system was custom-designed for ETH whales, a clear case of the ‘rich getting richer.’ Given Ethereum’s origin story, it’s not hard to see how the members of the Ethereum Foundation decided this was the way to go.

The initial ETH pre-sale in 2014 saw as much as 40% of the available tokens go to a handful of insiders, as there was little to no policing of the purported 12.5% cap on tokens sold to any one buyer.

A couple of years ago, former Ethereum developer Lane Rettig estimated that as much as 60% of all ETH was still the product of this pre-mine. Rettig also fingered Lubin as “probably the largest holder” of ETH at the time of the pre-sale. Rettig eventually quit the project when he began to suspect that his primary role was “pumping Joe Lubin’s bags,” something he concluded was “just not what I want to do.”

For years, Lubin and other Foundation whales have relied on a 2018 speech by Gensler’s SEC predecessor, William Hinman, that claimed Ethereum started out centralized and thus qualified as a security but had magically decentralized over time and thus no longer qualified as a security.

Hinman was a deeply conflicted individual, having had meetings with Lubin and other Consensys executives prior to that 2018 speech. During his stint running the SEC, Hinman also received millions from a law firm that was a member of the Ethereum Enterprise Alliance, prompting concerns from the SEC ombudsman regarding Hinman’s “full financial conflict” with the firm, which Hinman promptly rejoined after leaving the SEC.

In other words, Hinman’s speech—which was never formally enshrined as SEC policy—wasn’t worth the paper it was printed on.

Consent of the governed

The ETH token is by no means the only aspect of Ethereum that’s overly centralized. A recent report by Mike Novogratz’s Galaxy (formerly Galaxy Digital) blockchain/AI-focused investment group sought to determine whether Ethereum’s end users have any say in the evolution of the network or if everything is simply dictated by a shadowy group of insiders.

Protocol changes occur off-chain, “spearheaded by the Ethereum Foundation, and conducted through online forums such as Discord, GitHub, Ethereum Magicians, and Zoom.” Rank-and-file holders of the network’s ETH token don’t get to vote on proposed changes, nor do decentralized autonomous organizations (DAOs).

Galaxy’s VP of Research Christine Kim notes that this off-chain scenario prevents (most) ETH whales from exerting undue influence via the size of their bags, nor can bad actors hijack governance-related smart contracts to skew the results. However, off-chain voting is “difficult to audit and objectively evaluate because processes are intentionally opaque, subjective, and unstructured.”

In an interview with CoinTelegraph, Kim appeared to suggest that Ethereum was in a bind, as “the risks of Ethereum being governed by off-chain forums and processes are not unlike the risks that exist even with on-chain forms of governance.”

This dilemma is compounded by the fact that many of the same whales are among the most important voices in making off-chain decisions. As Kim puts it, “I think some improvements can be made to Ethereum’s off-chain governance model, particularly concerning the Ethereum Foundation’s role in the Ethereum ecosystem.”

The Foundation, a ‘non-profit’ established in Switzerland a year prior to the network’s 2015 launch, cannot unilaterally dictate what changes are made to Ethereum’s protocol. But its founders include Vitalik Buterin, Lubin, and others who are deeply involved in many of the other entities that decide the network’s future direction.

The Foundation’s size and scope remain a mystery, as it hasn’t issued any reports regarding its operations or finances since April 2022. Its only three publicly identified members are Buterin, Aya Miyagushi, and Patrick Storchenegger.

Making the centralized sausage

Ethereum Improvement Proposals (EIP) can be proposed by anyone but the Galaxy report identifies four specific groups of stakeholders involved in the EIP vetting process: the Foundation; validator node operators, who process transactions under Ethereum’s PoS consensus mechanism; decentralized application (dapp) developers, who provide feedback on their users’ needs; and execution/consensus client software teams.

Kim calls the client teams “arguably the most important decision-making in the EIP process.” That importance potentially poses a major problem, as the dominant execution layer GETH is funded exclusively by the Foundation.

Several other clients have been the recipients of Foundation grants. Still other clients were developed by Lubin’s Consensys. Buterin funded another client, which also received a Foundation grant.

In other words, while there may be ten client teams, even those that aren’t currently controlled by the Foundation and/or Ethereum’s co-founders owe much of their origin story to those same parties. All of these suggest the ‘invisible hand’ of Ethereum’s inner circle appears capable of exerting greater influence over the EIP process than is immediately apparent.

Kim says that “in theory,” validators “have the final say over what code changes are implemented” because they have the “agency to implement or reject code changes that have been made to Ethereum software by client teams.”

Given the 32 ETH hurdle for participating in the PoS system and the tiny handful of whales who hoovered up all that ETH via the initial distribution, validators are yet another possible example of the few governing the many.

Kim summarizes that “while the interests of each focus group, that is client teams, validator node operators, and dapp developers, are distinct, the individuals that comprise these groups often overlap, making the stakeholders involved in the Ethereum governance process difficult to neatly categorize or define.”

You’ve tried the rest

Ethereum’s overly centralized model is the dictionary definition of an unregistered security while also subjecting the network to the whims of those who just can’t seem to stop tinkering under its hood. Ethereum has undergone so many backward-incompatible ‘upgrades’ that they actually had a dedicated hard fork coordinator (until he was drummed out by the mob for making a joke about the upcoming transition to PoS).

Ethereum’s primary challenge is scaling to handle a sufficient number of transactions to live up to its self-imposed ‘world computer’ designation. But rather than build a strong and secure main network, those governing its operations incessantly tinker with various bolt-on appendages in a failed bid to reduce its transaction bottleneck and lower its occasionally astronomic fees.

Contrast Ethereum’s Rube Goldberg-worthy dead-end detours with the BSV blockchain, which can not only handle a volume of transactions that Visa (NASDAQ: V) would envy, but can do so securely on its original layer, with a fee structure measured in fractions of a cent. And unlike Ethereum, BSV has a locked protocol that ensures all smart contracts will remain valid regardless of when they were established.

BSV was named the digital asset least likely to be labeled a security for these and other reasons. So go ahead and clean house, Gary G. It’s time to take out the trash. 

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