Is being classified as a security inevitable for the post-Merge Ethereum?

As Ethereum price soars in anticipation of the proof-of-stake transition, the threat of potential regulatory scrutiny from SEC is now closer than ever.

Speaking to Jim Cramer during CNBC’s Squawk Box, SEC Chair Gary Gensler reinstated his view about cryptocurrencies being a “highly speculative asset class” with many of them falling under the definition of security.

“Many of these crypto financial assets have the characteristics of securities,” he said, suggesting that they are thus subject to his agency jurisdiction. “The investing public is hoping for a return, just like when they invest in other financial assets we call securities,” added Gensler.

Whether a certain asset qualifies as a security is important, because it determines if the investment is subject to certain regulatory requirements. A company offering securities should disclose specific information about its business purpose, financial statements, and management. On top of that, selling unregistered securities is punishable by up to five years federal prison term.

Does Ethereum pass the Howey Test?

In a landmark case SEC vs Howey, the Supreme Court created a test that determines whether the investment falls under the definition of security. Under the said test, an asset is deemed security if it has all four elements:

  • An investment of money
  • In a common enterprise
  • A reasonable expectation of profit
  • Derived from the efforts of others

According to Adam Levitin, the law professor at Georgetown University Law Center, any token based on proof-of-stake consensus can be classified as security depending on the legal interpretation of the Howey Test.

“Howey speaks of an investment of "money," but that has always been interpreted just to mean an investment of value. Putting up a stake readily satisfies this element,” the professor wrote in his Twitter thread. “The common enterprise element is also readily met with staking: the whole validation system requires multiple parties. That's the pooling (i.e., the more demanding interpretation of common enterprise – horizontal commonality).”

“The expectation of profit is clear enough too – stakers get rewards,” Levitin added, pointing out that Ethereum passes three of four requirements to be considered a security.

The last element, however, leaves a wide latitude for interpretation. The profits are expected to be derived “solely from the efforts” of others, but Ethereum network participants perform some form of “work” in return for rewards by validating blocks. However, this particular “solely” is often disregarded by courts, at least for MLM pyramid schemes, Levitin said.

“Now none of this answers the trickier question (IMHO) of who the “issuer” is when you’re dealing with a decentralized system,” he added, pointing out that the legal framework for decentralized entities is yet to be worked on.

Meanwhile, Vitalik Buterin seems not to be bothered by the potential troubles with SEC at all. Recently, he clashed on Twitter with a Bitcoin maxi Nick Payton, responding sarcastically to Payton’s assumption that PoS voting proves that Ether is a security.

The future of Ethereum

Previous SEC administration maintained the stance that both Bitcoin and Ethereum are commodities. Gensler so far refused to comment on Ethereum’s regulatory status and its future. Nevertheless, his last statements suggest that Ether may eventually be recognized as a security, especially given the fact that the cryptocurrency was launched through the initial coin offering.

In 2018, former SEC director William Hinman declared that Ethereum was not a security due to the sufficient degree of decentralization. Obtaining evidence on how this decision was made became a key part of Ripple’s legal strategy since it could make the case that XRP is a commodity.

“Following Hinman’s speech, Ripple met several times with key officials at the SEC, believing that rational minds would all agree on XRP’s status as something other than a security,” Stu Alderoty, Ripple's general counsel, wrote in his opinion piece for Fortune magazine.

The ongoing legal battle between SEC and Ripple may explain why Chair Gensler is so reluctant to speak about Ethereum. However, compared to Ripple, Ethereum is in a more advantageous position, since Ethereum Foundation is headquartered in Bern, Switzerland. In fact, the only negative outcome of being deemed a security for Ethereum will be a wave of delistings from centralized exchanges working under the US jurisdiction.