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Home Crypto Ethereum

What Happens if Ether is a Security?

News Room by News Room
March 12, 2023
in Ethereum
Reading Time: 5 mins read
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www.coindesk.com

09 March 2023 23:59, UTC

  

Reading time: ~6 m

Is ether (ETH), the native cryptocurrency of the Ethereum blockchain and the second-largest by market cap behind bitcoin, an investment security?

The question has been a source of simmering speculation ever since Ethereum switched last year to a “proof-of-stake” blockchain network where investors can “stake” their coins in exchange for rewards – not too dissimilar from the interest that’s paid out on bonds.

A fresh allegation Thursday from a New York state regulator could push the legal debate back to the front burner.

In a lawsuit filed against Seychelles-based crypto-exchange KuCoin on Thursday, New York Attorney General (NYAG) Letitia James alleged the firm broke the law by selling unregistered securities. Among the unregistered securities listed in the suit was ether.

Ether has long been treated as a commodity by state and federal regulators, including the Commodity Futures Trading Commission (CFTC). Designating it as a security would have a massive impact on crypto markets, drastically changing how (and whether) the currency and others like it are traded in the U.S.

The case for ether (ETH) as a security

Ethereum apparently drew extra scrutiny from regulators starting in 2022 when it switched from a “proof-of-work” system to a “proof-of-stake” system for operating its network.

The proof-of-work system, which is still used by Bitcoin, relied on “mining” to secure the blockchain – where computers scattered around the world raced to solve cryptographic puzzles for the right to earn newly-issued crypto and write transactions to the chain.

The new system, proof-of-stake, forgoes mining for “staking.” Ether holders can now lock up their crypto with the network in exchange for interest, and as a way to help secure transactions.

“By shifting to proof-of-stake, ETH no longer relies upon competition between computers, but instead now relies on a pooling method that incentivizes users to own and stake ETH,” the suit explained. “The shift to proof-of-stake significantly impacted the core functionality and incentives for owning ETH, because ETH holders now can profit merely by participating in staking.”

Concentrated influence

The specter of a security designation has long hung over ether, which was originally distributed to early supporters and investors in 2015 as a part of an ICO – or initial coin offering.

In her suit against KuCoin, James suggested ether is a security due to its early distribution plan, as well as the fact that its infrastructure is maintained by a relatively small group of contributors.

James’s suit takes particular issue with the influence held by Ethereum’s co-founder, Vitalik Buterin, and the non-profit Ethereum Foundation, claiming that they retain “significant influence over Ethereum and are often a driving force behind major initiatives on the Ethereum blockchain that impact the functionality and price of ETH.”

The suit further adds that Buterin and the “small number of developers” that control the Ethereum blockchain “stand to profit from the growth of the network and the related appreciation of ETH.” Buterin and the developers, the suit posits, “promoted it as an investment that was contingent on the growth of the Ethereum network.”

“Buterin and the Ethereum Foundation also received significant quantities of ETH in the ICO and are believed to retain significant stakes of that ETH today,” the suit claimed.

What happens if ether is a security?

Despite the NYAG’s assertion in its suit that ether may be a security, the decision is far from final.

What’s clear is that the reasoning laid out in the suit reveals definitively how at least one regulator – and possibly others, including the U.S. Securities and Exchange Commission (SEC) – are thinking about ether.

The SEC has “worked in tandem with [New York] more than they have with any other state that we know of, at least that I know of,” explained Collins Belton, a California-based crypto attorney and partner at Brookwood P.C. “While you can’t say just this is what portends what’s going to happen in the US inevitably, I think it’s a very strong indicator that these are the types of arguments” that SEC Chairman Gary Gensler is “going to be thinking about trying to refine.”

Gensler – who has increasingly cracked down on the crypto industry as of late – has hinted previously that Ethereum’s switch to proof-of-stake brings it closer in alignment with the agency’s definition of a security.

The SEC defines securities based on the Howey Test, which says a security is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

Proof-of-stake, by this logic, might bring ether closer to a “security” because its interest payouts require little work and rhyme with the Howey Test’s “expectation of profit.”

Impact on industry

Should Ethereum officially be classified as a security by courts, exchanges wishing to list ether will likely need to register as securities broker-dealers with the U.S. Securities and Exchange Commission (SEC).

“If you’re already registered in New York, you now have a question – do you either delist ether and/or block your New York customers from being able to buy ether or do you just simply register as a broker-dealer?” Belton said.

Belton also pointed out that James’ stance comes as a surprise because exchanges operating legally in New York (not including KuCoin, which was not registered as an exchange) offer ether, with the approval of the state’s financial regulator, the New York Department of Financial Services (NYDFS)

“It’s not like New York had no idea that ether was being offered. They knew for years because to get a license and to register in New York, you actually have to have the assets that you plan to offer to New Yorkers green-listed by their financial regulator,” Belton said.

“So it’s kind of insane that their attorney general was saying, ‘Oh, by the way, you guys are selling illegal securities, despite the fact that our financial regulator has been letting you operate with impunity for five years,’” he added.

It’s not just centralized exchanges that have something to worry about: Decentralized trading platforms – autonomous pieces of software that live on blockchains – could also face legal troubles if ether is found to be a security.

“Technically the way that the draft reads, if you’re offering a platform to people where they can engage in these types of transactions, regardless of whether it’s a commodity or a security, New York is saying, ‘Hey, we think you might have to be a broker-dealer – either a securities broker-dealer, or commodities BD,’” Belton said. “If that’s right, this thing is much bigger than like, ‘Oh, hey, can the exchanges keep offering ether?’”

There is already a legal precedent for outlawing blockchain-based computer programs, called smart contracts – over the summer, the U.S. government banned the Tornado Cash mixer program for its links to money laundering.

Beyond ether

An ether-as-a-security world would have major ramifications for crypto writ large.

James’s logic for classifying ether as a security – based in part on the network’s switch to proof-of-stake – raises questions about whether other proof-of-stake tokens might also be classified as securities.

The lawsuit impacts other proof-of-stake networks, Belton said. What the NYAG is saying “can expand way beyond just ether and implicate the rest of the ecosystem.”

Outside of proof-of-work Bitcoin, most major blockchains use a stake-based system similar to Ethereum’s, meaning it is possible that regulators may put them in a similar basket.

The price of ether dropped by around 7% in wake of the NYAG’s announcement of its lawsuit against KuCoin.

Read the full article here

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