Ether ETFs in Jeopardy as March SEC Filing Raises Serious Questions

Scott Johnson believes the SEC’s request for public opinion about whether ETH ETFs should be considered commodities could indicate that the regulator intends to reject the applications.

The U.S. Securities and Exchange Commission (SEC) seems to be leaning towards classifying Ether (ETH) as a security, which could be detrimental for the approval of spot Ether ETFs. The classification between a commodity is still being debated by the crypto industry and regulators, which is very clear in the SEC’s legal cases against companies like Debt Box. Meanwhile, in Europe, the new MiCA regulations are making things very difficult for decentralized finance (DeFi) protocols. They might now have to choose between embracing full decentralization or adapting to a hybrid finance model to comply with KYC requirements.

SEC May Deny Spot Ether ETFs

The United States Securities and Exchange Commission (SEC) is currently reviewing the classification of Ether (ETH), but recent findings suggest that the regulator is seriously looking to label the cryptocurrency as a security. This surfaced from a March SEC filing by BlackRock who requested to list and trade a spot Ether exchange-traded fund (ETF) on Nasdaq. The filing not only postponed the decision deadline but also asked for the public’s thoughts on whether the ETF should be treated as a commodity.

Scott Johnsson, an associate at Davis Polk and Wardwell, shared in a post that the request for public opinion could indicate that the SEC actually intends to reject the application. He believes that these filings could be misclassified as commodity-based trust shares if they involve holding a security.

The SEC has been scrutinizing ETH despite previous public statements from SEC Chair Gary Gensler that Ether was not considered a security. Gensler is scheduled to speak at the Investment Company Institute summit in Washington, D.C., on May 23, which is also the deadline for the SEC to decide on VanEck's spot Ether ETF, which is the first among several pending applications.

Should the SEC deny VanEck's application, it could set a precedent that might affect the other spot Ether ETF applications from firms like ARK 21Shares, Hashdex, Invesco Galaxy, BlackRock, and Fidelity. Grayscale withdrew its application for a spot Ether ETF on May 7 without giving a reason, which only added to the uncertainty surrounding the ETFs. VanEck's CEO, Jan van Eck, is also doubtful about receiving approval from the SEC.

What is the Difference Between a Security and a Commodity?

A commodity is a tangible product that can be transformed into other products. These can be divided into hard commodities, like metals and energy products, and soft commodities, which include agricultural goods. Commodities are traded on markets and are usually recommended as a diversification tool in investment portfolios because they perform inversely to stocks and bonds and can act as a hedge against inflation.

Securities, on the other hand, are tradable financial instruments used by corporations and governments to raise capital. They can be equity, debt, or a combination of both, and include stocks, bonds, mutual funds, and ETFs. The definition of what constitutes a security was broadened by the Howey Test from a 1946 Supreme Court case, which set criteria based on investment of money in a common enterprise with expectations of profits primarily driven by others. Securities are heavily regulated by entities like the SEC to ensure market transparency and to protect investors.

As one can see from the SEC’s scrutiny of ETH over the years, the classification of cryptocurrencies as either commodities or securities is still a complex and heavily debated issue in the industry. Some people believe that cryptocurrencies should be seen as commodities because they operate as a store of value and are used for speculative investment, very similar to traditional commodities.

On the other hand, the way in which capital is raised in the crypto space, like through initial coin offerings (ICOs), shares similarities with securities offerings like IPOs, which then could suggest that some cryptos might be more appropriately classified as securities.

SEC's Ongoing Struggle with Debt Box

The SEC also currently has its hands full legally as it is actively trying to dismiss its case against cryptocurrency mining software company Digital Licensing, which operates as Debt Box, without prejudice. This will, however, allow the SEC to potentially sue again in the future.

This move comes after the U.S. District Court for Utah Northern Division previously dismissed the SEC’s attempt to end the case in a very similar way. This was unsuccessful as the court pointed out a "gross abuse of power" by the agency and ordered it to reimburse Debt Box for legal expenses.

Debt Box is fighting against the SEC’s request as it believes it is a strategy to evade a permanent dismissal of the case. The SEC, however, argues that allowing the case to be dismissed without prejudice could actually benefit Debt Box investors as it would give the new team of SEC attorneys a chance to thoroughly review and possibly continue the investigation before deciding on refiling the complaint.

The lead SEC attorneys resigned from the case after the court's sanctions. In its negotiations, Debt Box proposed 11 conditions should the SEC decide to refile the case, including the issuance of a Wells notice, which is a formal warning that charges may be filed, and the completion of the investigation.

While the SEC agreed to most of the conditions, it resisted requirements to provide Debt Box with all subpoenaed materials, have an agency representative present at all investigative interviews, and produce any information that could favor the defense.

The controversy all began with accusations that Debt Box defrauded investors out of $50 million and sold unregistered securities through licenses for its cryptocurrency mining software. The SEC temporarily froze the company's assets last August, but faced sanctions after the court determined the SEC fabricated claims about the company planning to move operations abroad.

Crypto Dad Joins Paxos

Meanwhile, J. Christopher Giancarlo, the former chair of the U.S. Commodity Futures Trading Commission (CFTC), has joined the board of directors at crypto firm Paxos. The announcement was made on May 14 and revealed Giancarlo's new role is part of Paxos's strategy to expand into regulated crypto markets and boost its stablecoin initiatives. Paxos is known for the Pax Dollar (USDP) and for issuing PayPal’s PYUSD stablecoin.

In the announcement, Giancarlo stated that he is looking forward to his new role and praised Paxos’s commitment to compliance and its mission to create a more efficient and inclusive financial system. His background includes serving as CFTC commissioner from 2013 to 2017 and as chair from 2017 to 2019. He also founded the Digital Dollar Project with the goal to create a U.S. central bank digital currency. Giancarlo also worked as an advisory board member for the Chamber of Digital Commerce.

However, Paxos has faced some regulatory challenges recently, including a Wells notice from the SEC in 2023 over issues related to issuing BUSD as an unregistered security and actions from New York’s Department of Financial Services that led to Paxos's decision to stop minting coins for Binance.

New EU Regulations Demand Tough Choices

Crypto regulations are also causing a stir in the EU. The European Union's new Markets in Crypto-Assets Regulation (MiCA) is set to hugely impact decentralized finance (DeFi) protocols by the end of 2024.

MiCA will require DeFi protocols with centralized elements, like front-ends or intermediaries, to meet the same licensing and Know Your Customer (KYC) requirements as traditional financial companies. This leaves DeFi protocols with a tough choice: either fully embrace decentralization to avoid the regulatory framework or adopt a hybrid finance (HyFi) model that aligns with the new regulations.

Legal experts like Oliver Völkel have taken a very close look at the regulation. Volkel pointed out that while smart contracts facilitate crypto services, their use does not equate to decentralization. True decentralization, as defined by the EU, involves no intermediaries, thus falling outside MiCA’s scope.

The looming regulations have stirred many debates in the DeFi community about the path forward—either pursuing deeper decentralization or embracing some form of regulation to maybe attract institutional investment. This pivot is crucial as regulators around the world, including the SEC, are starting to scrutinize DeFi protocols more intensely. In fact, Uniswap was recently issued a Wells notice by the SEC.