The Merge may be complete, but the battle for legally defining Ethereum 2.0 is just beginning.
Hours after Ethereum completed its historic transition to Proof of Stake technology, a top U.S. regulator said cryptocurrencies that use this approach should probably be defined as securities.
Onerous at Best
This is no small matter. If authorities deem Ethereum and its ilk securities or investment contracts like stocks and bonds the decision would activate a slew of obligations, including registering cryptocurrencies with the U.S. Securities and Exchange Commission.
Fearful this move would be onerous at best and fatal at worst, the crypto industry has steadfastly fought the idea that most digital assets are securities.
“Only the bluest of blue-chip revenue-generating corporations can afford this,” Gabriel Shapiro, general counsel at Delphi Digital, tweeted last week. “This won’t be compliance, it will be extinction.”
Speaking to reporters on Thursday, Gary Gensler, the SEC’s chair, said PoS cryptocurrencies like Solana, Cardano and now, Ethereum, may be considered securities under a precedent known as the Howey test. Since the inception of U.S. securities laws in the 1930s, the Howey test has been used to determine whether an investment is also a security and subject to reporting requirements.
“The investing public is anticipating profits based on the efforts of others,” Gensler said, according to The Wall Street Journal.
Ethereum’s move from energy-hungry Proof of Work technology to the greener PoS system was oft-delayed and years in the making. It was Ethereum’s biggest upgrade in its seven year history and the most anticipated event of the year among crypto die-hards.
The Merge is already reducing the blockchain’s power consumption by 99.98%, according to the Ethereum Foundation. The hope is that the shift will accelerate mass market adoption by attracting climate-conscious investors, users, and entrepreneurs eager to build new projects on the network.
The industry is worried regulatory interference may derail this trajectory. Crypto lawyers cried foul in the wake of the Journal’s report.
Jake Chervinsky, head of policy at industry lobbying group the Blockchain Association, said it was unclear how staking — as opposed to the mining used to maintain Proof of Work blockchains such as Bitcoin — made a cryptocurrency more of a security. Users who stake their crypto lock it into the network, helping to secure it while earning rewards in the process.
“The general idea seems to be ‘if you squint hard enough, staking sort of looks like a dividend or interest, & some actual securities have those, so maybe staked assets are securities too,’” he wrote on Twitter.
But the notion that profit expectation is what distinguishes a security from other assets is wrong, he continued. “People hold all kinds of assets with an expectation of profit. Gold, cars, watches, etc. … Whether that profit comes in the form of an increase in market price, a staking reward, or any other mechanism should make no difference to the securities analysis.”
Brandon Ferrick, general counsel and co-founder at crypto firm B+J Studios, told The Defiant in a message that staking “has nothing to do with the efforts of ‘others.’”
Such efforts, Ferrick said, “should really only mean the core or initial development teams involved in the initial public sales of tokens. It doesn’t make sense for ‘others’ to mean literally anyone else (who isn’t you) that is providing efforts to produce a return.”
Adam Levitin, a professor of law at Georgetown University who has paid close attention to the crypto industry, doesn’t believe it is so clear-cut, however.
In response to Chervinsky’s tweets, Levitin said securities are assets that require “an investment of money in a common enterprise with an expectation of a profit to be derived from the efforts of others.”
Miners Are Competing
“Investment of money: in PoS [proof-of-stake], the validators have to purchase a stake. That’s not a controversial prong,” he wrote. “Common enterprise: in PoS, the validators have to work cooperatively with other validators. A single node has to work with 127 others in a committee in ETH. That’s different than in [proof-of-work], where miners are competing, not cooperating.”
Gensler has become a crypto industry villain for arguing most existing laws can be applied to the nascent crypto industry. The White House seemed to endorse that point of view in a news release issued Friday.
It detailed the Biden Administration’s long-awaited “whole-of-government” approach to crypto, informed by a series of reports prepared by federal agencies at President Biden’s request.
“The reports call on agencies to promote innovation by kickstarting private-sector research and development and helping cutting-edge U.S. firms find footholds in global markets,” the White House announced. “At the same time, they call for measures to mitigate the downside risks, like increased enforcement of existing laws and the creation of commonsense efficiency standards for cryptocurrency mining.”
Crypto proponents said the White House seems fixated on the industry’s supposed risks rather than its benefits.
“Today’s reports and summaries from the Biden administration’s executive order on digital assets are a missed opportunity to cement U.S. crypto leadership,” said Kristin Smith, the Blockchain Association president, in an emailed statement. “While intended to be part of a broader government and stakeholder effort to bring better regulation to crypto assets, these reports focus on risks – not opportunities – and omit substantive recommendations on how the United States can promote its burgeoning crypto industry.”
The White House plans to ask regulators to step-up enforcement against “unlawful practices in the digital asset space”; create public awareness campaigns to educate the Americans on the risks of digital assets; invest in competing payments technologies like FedNow; create a “Digital Assets Research and Development Agenda” to boost research in crypto; and provide companies in the industry with regulatory guidance.
In an emailed statement, Congressman Ted Budd (R-NC), a proponent of crypto, said the administration “needs to view digital assets as a uniquely American innovation that should be allowed to flourish free from heavy-handed regulations.”
“The Biden administration’s report does not fully embrace this view,” Budd said, “and therefore risks pushing this new industry out of our country.”
Ferrick, the B+J Studios lawyer, said the administration’s position was “a lot of fluff” and would have little impact on the industry. “There are definitely calls out there for regulatory clarity,” he said. “But I’m not seeing any indication we’re going to get it any time soon.”
Miller Whitehouse-Levine, policy director at the DeFi Education Fund, called the White House’s announcement a “let down given the hope that I shared with many others that the administration was ready to create a healthy environment for US [crypto] industry and users.”
“That said,” he told The Defiant, “there have been substantial developments in crypto since [Biden’s] executive order in March that have not painted the crypto industry in a positive light, and I think everyone’s paying for that now.”