ETH Unlikely a Security
March 2024 Commentary
“March comes in like a lion, out like a lamb” is often used to refer to the passage from winter to spring in the northern hemispheres, but the same can be said of the cryptoasset market this past month. One can blame it on lower inflows to spot Bitcoin ETFs in the second half of March or lower expectations for rate cuts by the US Fed for 2024, but much can be placed on the speculation that the US SEC is trying to classify ETH as a security. How this plays out for the second largest Layer 1 will have repercussions for the cryptoasset industry and for many investment portfolios including ours.
In March, Fortune reported that the SEC has been investigating U.S. companies for their dealings with the Ethereum Foundation (EF) and Coindesk observed that the EF’s Github repository was updated to indicate that there may be an inquiry from a “state authority”. This spooked the markets, causing Ether’s price to drop by 11% from its peak on March 13, underperforming Bitcoin, which had dropped by only 2.7%. According to predictions market Polymarket, the likelihood of a spot Ether ETF approval by May 31 has declined to 18% from 40% at the end of February.
Source: Polymarket
Is ETH really a security?
Since its creation, Ether was most vulnerable to be classified as a security when the Ethereum Foundation conducted a public token sale in 2014 – people could buy 2000 ETH for 1 bitcoin. The foundation raised US$18 million from this ICO to fund the development of the Ethereum blockchain. Since the blockchain didn’t exist at that time, the ETH token had no utility, like being a currency to pay for on-chain transactions. Thus, the buyers were expecting that a small number of developers funded by the foundation could increase the value of Ether if the developers could build the network successfully.
That initial bit of funding sparked a wave of development and innovation on the smart contract platform. A network of miners formed to secure the network. DeFi primitives, including Maker DAO and Augur, were created. The first NFTs were minted (recall CryptoKitties?)
By 2018, there were indications that the SEC wasn’t viewing Ether as a security because the Ethereum network had become sufficiently decentralized. Bill Hinman, then the SEC Director of Corporate Finance stated as much in his comments to the Yahoo Finance All Market Summit: Crypto in June 2018. Several months later, Mr. Gary Gensler, then a professor at MIT during his lecture on smart contracts and DApps, pointed out that “in 2018, the Securities and Exchange Commission has said regardless of what it [ETH] might have been in [20]’14, it’s now sufficiently decentralized that we’ll consider it not a security.”
Is the staking process an investment contract?
So far, the U.S. Securities and Exchange Commission (SEC) has never specifically named Ether as a security in any of its official enforcement actions or statements. Nor has the SEC Chairman Gensler said as much publicly. However, around Ethereum’s transition from a Proof of Work consensus mechanism to Proof of Stake (the Merge) in September 2022, Gensler has hinted on a few occasions that the staking process may be construed as an investment contract. This started as far back as September 2021 with Gensler’s testimony to the Senate Banking Committee and continued after the Merge (here and here).
The Howey Test is a framework used in the US to determine if a transaction qualifies as an investment contract, and thereby should be subjected to US securities regulations. It consists of four elements:
Investment of money: The transaction involves putting money into an asset.
Common enterprise: The investment is part of a collective enterprise or project.
Expectation of profits: There is a reasonable expectation of earning profits from the investment.
Efforts of others: The profits are primarily derived from the efforts of others involved in the enterprise.
We believe that the SEC would face an uphill battle to argue that the staking process of Ethereum would constitute an investment contract under the Howey Test. First, the regulator may argue that the Ethereum validators constitute a common enterprise as they collectively secure the Ethereum network, and their actions impact the overall network. However, validators rely on their own expertise to set up and run their own validator nodes. The amount of staking rewards a validator can earn is not uniform but a function of their validator nodes’ performance like speed and uptime. Validators have to compete with each other to become the block proposer. This process is adversarial and can dramatically affect the amount of staking rewards a validator can received. It would be hard to argue that validators constitute a common enterprise of a network.
Second, the SEC may argue that staking rewards are expected profits to the validators. However, like the Bitcoin miners, the Ethereum validators provide security and data integrity services to the blockchain. Staking rewards are the compensation for such services, not a yield on a loan nor a dividend on a stock. The staked tokens are a security deposit for validator’s good behaviors. If a validator were to act maliciously against the network’s interests, his/her staked Ether would be slashed. Thus, the staked ether is not invested capital nor a loan principal.
CFTC calls Ether a commodity
While the SEC has never explicitly named Ether a security, its sister regulator CFTC has explicitly called Ether a commodity and claimed its jurisdiction over it. As pointed out by CoinTelegraph, “In its lawsuit against Sam Bankman-Fried, FTX, and sister company Alameda Research, the CFTC on multiple occasions referred to Ether, Bitcoin and Tether ‘among others’ as ‘commodities’ under United States law.” Coindesk similarly noted that, CFTC “Chairman Rostin Behnam reiterated [in March 2023] at a congressional hearing that he believes ether is a commodity”, and “that belief [was] driving the case against Binance”.
Furthermore, the SEC had also implicitly accepted Ether as a commodity with its recent approval of the ETH Futures ETFs in October 2023. These ETFs are based on Ether Futures contracts, which derive their value from the underlying commodity (Ether).
Ether could’ve have been considered a security during its public sale in 2014. By 2018, however, the SEC appeared to have accepted that the Ethereum network is sufficiently decentralized, and that Ether is not a security. While Chairman Gensler has hinted that the staking process could constitute a security, it would be difficult for the SEC to argue that validators are a common enterprise and staking rewards are expected profit. The CFTC’s classification of Ether as a commodity and the SEC’s approval of Ether Futures ETFs further strengthen the arguments for Ether being a commodity, not a security. We agree with the CFTC’s classification of ETH as a commodity and look forward to a spot ETH ETF approval, if not by May, then later in 2024.