Jul 27, 2022 - Economy

The regulatory risk in Ethereum's new security model

Illustration of a gavel hovering over Ethereum's logo.

Illustration: Shoshana Gordon/Axios

Ethereum, the world's second-biggest blockchain, is switching to a new security model that at least one legal expert claims could raise an issue with profound repercussions for the cryptocurrency market.

Why it matters: If ether (ETH), the coin that runs Ethereum, is found to be a "security" by the Securities and Exchange Commission, it's hard to imagine how the blockchain even functions in the United States.

  • First of all, the places where people buy and sell ether (the exchanges) would need to de-list it, so in the immediate term it would be hard to say where people could even acquire the ether they need to use Ethereum.
  • Lots of lesser blockchains would be on notice with the same concern, though as every attorney will tell you: every case has to be assessed on its own "facts and circumstances."

Driving the news: The question was raised last week, when Georgetown University law professor Adam Levitin tweeted that any token in a "proof of stake system" is likely to be a security.

Context: Proof-of-stake is a security model for blockchains, defining the process by which all transactions on it are verified.

  • Ethereum will soon switch to it, a system where lots and lots of people check all transactions on the network and earn rewards in fresh ETH for doing so.
  • Those doing the checking and earning rewards will need to put a stack of ether at risk (that's the "stake" in proof-of-stake), and those funds could be taken if any are caught attempting to manipulate the ledger.
  • Once Ethereum makes the switch, any holders of ether will be able to stake them to one of these companies checking the blockchain and share in their earnings.

The big picture: The fact that ether can make money for itself when Ethereum reboots could potentially raise red flags.

  • Financial instruments become securities under U.S. law via a test described by the Supreme Court in SEC v. W. J. Howey Co. of 1946
  • The court then described four features that make something a security. "The expectation of profit" is one of them, and that's the issue Levitin raised.

Yes, but: With proof-of-stake, ether won't exactly work like that. If ether just sit in a personal wallet, the balance in ether won't change.

  • Users looking to grow their balance would need to stake them with a validator company (and they could also lose that stake if the validator screws up).

So the question is, does that option make all ether a security?

  • Prof. M Todd Henderson of the University of Chicago Law School doesn't think so. "Money does not become a security just because there's this opportunity for someone to make money," he tells Axios.
  • If a user posts some ether with a validator to earn money, that arrangement could be construed as a security, he said, but that doesn't make ether doing nothing into securities.
  • As Henderson explains it: stocks are obviously securities, and people use dollars to buy stocks, but that doesn't make all dollars into securities.

Of note: Henderson co-wrote a paper in 2018 where he attempted to sketch out an actual rule that the SEC could deploy to help founders issue tokens within the rules (rather than just getting sued later).

What others are saying: Stephen Palley, a long time attorney serving crypto clients, with the firm Anderson Kill, tells Axios that he could maybe see Levitin's point in the abstract, but no good reason for agency staff to pursue it.

  • "Would the SEC really push exchanges to treat ETH as security and either delist it or register as a national securities exchange?" he said over text message. "Why take this fight on where lower hanging fruit is abundantly available?"

The intrigue: Going back to the question we raised earlier, it seems like the laws as we know them haven't grappled yet with how to get a handle on decentralized systems where no one is really in charge.

  • As Levitin tweeted, "Now none of this answers the trickier question (imho) of who the 'issuer' is when you're dealing with a decentralized system. But that's part of the broader problem of how to fit decentralized systems into a person-based legal system."

Editor's note: This story has been corrected to include the accurate name of the University of Chicago Law School.

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