Is Ethereum a security? Expert analysis

Ethereum is an open-source, public, blockchain-based distributed computing platform and operating system featuring smart contract (scripting) functionality. It supports a modified version of Nakamoto consensus via transaction-based state transitions.

Ether is a cryptocurrency whose blockchain is generated by the Ethereum platform. Ether can be transferred between accounts and used to compensate participant mining nodes for computations performed. Ethereum provides a decentralized Turing-complete virtual machine, the Ethereum Virtual Machine (EVM), which can execute scripts using an international network of public nodes. “Gas“, an internal transaction pricing mechanism, is used to mitigate spam and allocate resources on the network. The SEC has declared that Ethereum and its digital coin ether, are not securities today, during the Yahoo Finance summit. The announcement led the price of ether to rise by over 8 percent, hitting a high of $520 per token.

William Hinman, director of the division of corporation finance at the SEC, explained at the summit: “Based on my understanding of the present state of ether, the Ethereum network and its decentralized structure, current offers and sales of ether are not securities transactions.”

Hinman also hints that other cryptocurrencies, or altcoins, might one day no longer need securities regulation. He says, “Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.”

In the past, the SEC has considered some digital tokens as securities, particularly tokens distributed through an initial coin offering. Last July, DAO tokens were found to be securities after an investigation, according to a public SEC report. Therefore, they were subject to federal securities laws and the issuers had to register all sales of DAO tokens with the SEC. The report cautioned investors against initial coin offerings, which can also violate securities law. Months later, SEC chairman Jay Clayton clarified that “every ICO I’ve seen is a security,” and many were illegal.

Ethereum is too decentralized to be labelled a security

In April, Clayton told Congress that the commission did not consider bitcoin a security, describing it as, ”a replacement for currency that has been determined by most people to not be a security.” Following that announcement, many experts anticipated that the commission would take a similar line on Ethereum. Is it a security?

Today’s declaration echoed arguments made by experts that ether is too decentralized to be labelled a security. In an April post, Washington, DC think tank Coin Center’s director of research Peter Van Valkenburgh wrote that ether shouldn’t be a security because no third party is behind the virtual coin providing us with profits.

Coin Center said in a statement to The Verge: “We are glad the SEC agrees with our long-held analysis of how securities law applies to decentralized cryptocurrency networks like Bitcoin and Ethereum.” It added that “With this guidance, the SEC is showing that taking a pro-innovation approach does not have to come at the expense of protecting investors.”

Regulators are concerned that the presale itself could be classed as securities sale, due to the fact that investors likely bought tokens in the hopes that their value would increase in the future. If this is found to be the case, the Ethereum Foundation should have registered ETH as a security before the token sale was carried out.

Ethereum co-founder refutes claims

At the beginning of May, Ethereum Foundation cofounder Joseph Lubin addressed the situation at a tech conference in New Orleans. Lubin confidently stated that there were no concerns that the cryptocurrency would be classed as a security:

Lubin believes that Ethereum does not need to be regulated because it does not meet the classifications of a security at all.

The Howey test:

In 1946, the US Supreme Court presided over a case between the SEC and WJ Howey Co. As Investopedia explains, the case laid the foundation for what is now commonly known as the ‘Howey test’.

“The scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

In layman’s terms, the Howey test is used to determine if the value of a transaction between two parties is dependent on one of the parties work. This very test has been the subject of much speculation when it comes to cryptocurrencies, and especially initial coin offerings (ICO).

Arguments against securities classification

In the case of Ethereum, Lubin is of the opinion that it is not a security for two reasons.

Firstly, Ethereum’s blockchain requires miners to validate transactions, create new blocks and unlock ETH tokens. Lubin believes the fact that many parties are involved in the work creating value rules out classification as a security:

“I think we already have a regulatory scheme; securities laws in this country govern securities. If you fail the Howey test, you’re not a security. This is a way of accessing a shared computing resource, so I’m not sure [ETH] needs to be regulated in any way.”

Secondly, the Ethereum Foundation refuted claims made by former CFTC chairman Gary Gensler last week, who said both Ethereum and Ripple should be considered as unregistered securities.

Ethereum Foundation head Aya Miyaguchi diffused any talk of the organisation’s influence over the value of the cryptocurrency in a letter to the New York Times. Miyaguchi stated that the foundations do no control the supply or issuance of ETH, and its own holding of ETH amounts to 1 percent of the total supply, which is, in fact, lower than amounts held by other users in the network.

Legal ramifications

If the SEC chooses to label Ethereum as a security, the foundation will likely take the matter to the courts. This could end up in a legal battle that could last a number of years.

There are a few eventualities that do need to be considered. If Ethereum is found to be a security, a number of things could happen.

First and foremost is that the price of the cryptocurrency would take a knock as American exchanges would be trading a security – which they would need to have registered for with the SEC. Trading would have to be stopped in order to do so. Secondly, as Steinbeck pointed out, “failing to comply with securities laws can have serious ramifications, including fines, penalties and civil litigation by “damaged” purchasers or sellers of the security.”

According to the Harvard Law School forum, the SEC can dish out monetary fines for parties infringing on regulations. Individual penalties range from $7,500 to $160,000 while companies or entities face penalties from $80,000 to $775,000.

A fine can then be compounded depending on how many investors were ‘misled’ by the party under scrutiny.

 

People or businesses found guilty of selling unregistered securities could face jail time, but that is highly unlikely, as lawyer Jason Somensatto told Quartz. In essence, if Ethereum is found to have violated SEC laws, the foundation, exchanges and other ICOs that were built on the Ethereum blockchain could face penalties at the very least.

Nevertheless, it seems unlikely that the regulators from the SEC or CFTC will be rushing to a conclusion in the case of Ethereum. The cryptocurrency has been running successfully for over three years and its market capitalization shows its worth as a revolutionary blockchain technology.

Comments (No)

Leave a Reply