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Ethereum Regulation
For the crypto market, regulation continues to be a large gray area. As the crypto market continues to grow in popularity, so too does the attention being paid to it by governments and regulating agencies. In the U.S., crypto is at the mercy of the Financial Services Oversight Council (FSOC) and its 10 voting members. There’s the Federal Reserve (Fed), the Department of Treasury, the Commodities & Futures Trading Commission (CFTC), the Securities & Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Commission (FDIC), the Consumer Financial Protection Bureau (CFPB), and a couple of others that are less directly relevant to crypto.
The FSOC’s duties include identifying risks and emerging threats to the financial system. This gives the FSOC the authority to organize a policy response to emerging tech like cryptocurrencies. The committee is led by Treasury Secretary Janet Yellen and aims to create and enforce a “proper” U.S. financial regulatory framework. As the U.S. makes up ~40% of the world’s financial market, the FSOC’s impact is far-reaching and critically important to the global economy.
The SEC has previously commented on Ethereum (twice) – in conjunction with Bitcoin – saying that it is not a security. In addition to those preliminary comments, the CFTC Chairman publicly stated in October 2019 that ether is viewed as a commodity by the U.S. regulatory body. Ethereum will likely still be subject to any blanket regulation imposed on cryptocurrencies but regulatory restrictions that target Ethereum specifically are unlikely. As such, Ethereum will not be subject to as much intense regulatory scrutiny as the many ICOs that were launched on its platform. A recent landmark case by the SEC sets a precedent for them to evaluate ICOs as securities retroactively, but this does not affect Ethereum itself, even though it had an initial token sale in 2015.
The SEC's laws on the marketing and sale of securities are intended to prevent a certain mischief: insiders and promoters of a business will have more information than investors (information asymmetry). This is remedied by the SEC requiring truthful and comprehensive disclosure in a regulated format.
The Howey test, the main case law on the features of a security', remains the best measuring stick despite its many shortcomings when applied to crypto assets. For the purposes of this analysis, understand that the degree of decentralization of a protocol is a significant factor in determining which, if any, United States securities regulations apply.
“When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the [Howey] test is met.
There are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users(commonly known as a “decentralized” network).”
-SEC guidance “Framework for ‘Investment Contract’ Analysis of Digital Assets
In August 2021, current SEC Chairman, Gary Gensler, gave a speech suggesting The Securities and Exchange Commission will "regulate cryptocurrency markets to the maximum extent possible" using its existing authority. Gensler continued the speech stating the asset class is fraught with “fraud, scams, and abuse.” The comments and aggressive language suggest the SEC is likely to become more active in policing cryptocurrencies in the future.
ETH can be deemed a security if it satisfies certain properties based on the common definition and interpretation of the Howey Test, the most common legal test applied to securities. The four-component questions of the test are listed below:
- Is there an investment of money?
- Is there an expectation of future profits?
- Is the investment of money in a common enterprise?
- Do any profits come from the efforts of a promoter or third party?
Many digital assets lack clear utility and thus have no purpose other than for retail investors to speculate on price (i.e. invest). ETH has a clear-cut utility case on the platform in the form of gas. Gas performs the role of a utility in the form of an internal pricing mechanism for allocating computational resources on the network. Since it is derived from but not the same thing as the native token Ether, discerning the functionality of Ether on the network is difficult to tease apart.
Recent lawsuits filed by the SEC against various crypto exchanges for listing digital assets deemed securities highlight the nuanced and selective enforcement strategy of the agency. These actions have targeted tokens from various Layer 1 blockchains, yet notably absent from this list is Ethereum. This exclusion raises critical questions about the criteria used by the SEC in classifying digital assets as securities and the implications for investors and the broader crypto market.
The distinct treatment of Ethereum by the SEC is evident in the agency's previous decisions, particularly its approval of Exchange-Traded Funds (ETFs) based on Ethereum commodity futures contracts in October of the previous year. This approval signals a clear demarcation of Ethereum's status as a non-security in the eyes of the regulatory body. Such a stance not only differentiates Ethereum from its counterparts but also influences investor perception and market dynamics.
The landmark case of SEC vs. Ripple Labs Inc. plays a pivotal role in understanding the SEC's current position. This case established a significant legal precedent, indicating that digital tokens do not inherently meet the criteria of the Howey Test – a benchmark for determining whether an asset constitutes a security. The ruling clarified that digital tokens are considered securities only when sold as investment contracts.
This precedent bears relevance to Ethereum, particularly regarding the yield generated from staking. Concerns have been raised about whether this aspect of Ethereum could be construed as an investment contract, thus falling under the purview of securities law. However, the Ripple case suggests that such concerns may be unfounded, as the mere ability to generate yield does not automatically categorize a digital token as a security.
Regulations could also play into Ethereum’s status as the preferred status for launching ICOs. Security token offerings are potentially going to replace ICOs as the next big token offering, but it is unclear what the medium or context for launching them will be.
