Ethereum 2.0 to be classified as securities by the SEC? Lawyers say it is highly likely

Note: The original author Grant Gulovsen is a legal consultant for blockchain projects. He is a practicing lawyer in Illinois and has previously provided legal advice to multiple blockchain project parties. In this article, he analyzed in detail how the Proof of Stake (PoS) used by Ethereum 2.0 would involve securities law, and CFTC Chairman Heath Tarbert also mentioned earlier that the CFTC and SEC are analyzing the Ethereum 2.0 platform, which he believes the It is likely that Ethereum 2.0 will be judged as a security.


Thanks to Gabriel Shapiro and Adrian Cortez for their valuable suggestions during the drafting of this article.

I. Background

In June 2018, William Hinman, director of the U.S. Securities and Exchange Commission's Corporate Finance Supervision Department, stated:

"From my understanding of the current state of Ethereum and its decentralized structure, Ethereum transactions do not constitute securities transactions."

On October 10, 2019, Heath Tarbert, chairman of the US Commodity and Futures Trading Commission (CFTC), issued a similar statement, saying:

"As Chairman of the CFTC, I think Ethereum is a commodity."

As of November 12, 2019, CFTC Chairman Heath Tarbert revealed that both the CFTC and the SEC are carefully analyzing the Proof-of-Stake (PoS) model used by Ethereum 2.0.

As the forthcoming Ethereum 2.0 platform will use the Proof-of-Stake (PoS) model, the two major regulators, CFTC and SEC, have decided to re-examine. This may determine the new PoS verification transaction for Ethereum 2.0 as a securities transaction, and It could have a significant impact on the upgrade plan for the Ethereum network, as well as the wider cryptocurrency market.

What is PoS?

Unlike proof-of-work (PoW) mining, PoS mining usually requires a verification node (ie, a verifier) ​​to deposit a specified amount of cryptocurrency in their digital wallet and keep the wallet online so that it can automatically broadcast its network to the network Balance.

In addition, PoW mining relies on computing power (computing power), while PoS mining depends on the rights pledged by the verifier.

In the case of Ethereum 2.0, users can use ETH as collateral, and can obtain financial returns under the condition of verifying and proving the validity of the block. The requirements for becoming an Ethereum validator are as follows:

  1. Configure and run a validator client;
  2. Pledge 32 ETH in the wallet;

To collect pledge rewards and transaction fees, the validator must also perform the following operations:

  1. Keep a balance of 32 ETH in the validator's wallet;
  2. Make sure you use the latest software;
  3. Ensure that clients stay online and can communicate with the network;

(Note: The above are the requirements for self-operation, and the situation of entrusting a third party is different)

3. How does the Ethereum 2.0 PoS model involve securities laws?

Under U.S. law, the starting point for determining whether something is "securities" is to look at the legal definition of "securities", which can be found in Section 5 of the Securities Act of 1933 and Section 12 (g) of the Securities Exchange Act of 1934 turn up. The purpose of Congress's enactment of securities laws is to regulate investments, regardless of their form and name. To this end, it promulgated a broad definition of "securities", which is sufficient to cover almost all instruments that may be sold as an investment.

In both regulations, the term “investment contract” is included in the definition of “securities”.

As the PoS model of Ethereum 2.0 involves digital assets, the "investment contract" analysis is also applicable.

In the groundbreaking SEC case against WJ Howey (Note: U.S.J.C. 328, p. 293 (1946)), the U.S. Supreme Court announced:

"For the purposes of the Securities Law, an investment contract is a contract, transaction or plan in which a person invests his funds in a common enterprise and obtains profits only through the efforts of the promoter or a third party."

This is what is now known as the "Howey Test". The definition of this investment contract reflects a principle of flexibility rather than staticity, a design that can be adapted to meet the needs of those who use other people's money in their commitment to seek profit. And variable scenarios.

The Howey test requires that a "contract, transaction, or plan" must have the following elements in order to be considered an "investment contract" (ie, a security):

  1. Use money for investment;
  2. Exist in a common cause;
  3. Have reasonable profit expectations;
  4. Rely on the efforts of others;

Each of these elements is related to the PoS protocol proposed by Ethereum 2.0, let's analyze it in detail below:

1.Use money for investment

The first question that needs to be answered when applying the Howey test is whether this arrangement involves "investment in funds". According to the latest Ethereum 2.0 GitHub repository, users must hold 32 ETH to operate the verification node, so the answer is obviously "YES". The fact that whether to invest in cash is not relevant to this part of the Howey test;

2. Exist in a common cause

The second question that needs to be answered when applying the Howey test is whether the arrangement involves a "common cause". The U.S. federal court system recognizes three different tests that vary according to the jurisdiction of the Federal Circuit Circuit in this matter:

  1. Horizontal commonality (horizontal commonality refers to the wealth of each investor is linked to the wealth of other investors through asset concentration);
  2. Broad vertical commonality;
  3. Strict vertical commonality

However, if it is the SEC's "careful analysis" of Ethereum 2.0, this is actually an unquestionable problem. This is because in the digital asset “investment contract” analysis framework announced on April 3, 2019, the SEC ’s Center for Innovation and Financial Technology Strategy (FinHub) issued the following statement:

"The SEC itself does not require vertical or horizontal commonality, nor does it treat 'common business' as a unique element in the term 'investment contract'."

FinHub states in its framework:

"In evaluating digital assets, the SEC has found that 'common ventures' often exist."

Whether the federal court will agree with the SEC on this issue is beyond the scope of this article, but given the above circumstances, we have every reason to believe that at least the SEC will find this in the Ethereum 2.0 case.

3. Have reasonable profit expectations;

Of all the questions that need to be answered when applying the Howey test, the third question "whether there is a reasonable profit expectation" is the most prominent question involved in Ethereum 2.0, and the answer is also obvious. This is because Ethereum 2.0's own specification explicitly mentions:

"The verifier is a user-selectable role. Users can mortgage ETH and seek financial returns while verifying and proving the validity of the block."

As mentioned by the U.S. Supreme Court in the SEC lawsuit Edwards (Note: U.S.C. 540, p. 389 (2004)):

"In the Howey test, a common-sense understanding of 'profit' is simply 'financial return on investment'."

Therefore, the third element of the Howey test is also satisfied.

4. Rely on the efforts of others

The fourth question that needs to be answered when applying the Howey test method is to consider whether the reasonable profit expectation of the arrangement "depends on the efforts of others" or "completely from the efforts of the sponsor or a third party".

Based on the clear language in Howey, we can make the argument that the arrangement to run a verification node on the Ethereum 2.0 network did not actually pass this part of the test because users must spend considerable effort to qualify for any "economic reward". As mentioned earlier, in order to receive pledges and transaction fee rewards, validators must do all of the following:

  1. Configure and run a validator client;
  2. Pledge 32 ETH in the wallet;
  3. Keep a balance of 32 ETH in the validator's wallet;
  4. Make sure you use the latest software;
  5. Ensure that clients stay online and can communicate with the network;

Failure to perform these tasks will result in the user losing the right to receive rewards (at least until the problem is corrected), thus demonstrating that the ability to obtain any financial return comes solely from the user's efforts, and not "only from [any] The efforts of the sponsor or a third party. "

Unfortunately, "given the remedial nature of [US securities] legislation," the federal court passed a more realistic test of whether efforts by people other than investors are of undeniable importance, and it is these effects The overall failure or success of the Ethereum network is the correct focus of analysis. In fact, this is the focus of the SEC Director William Hinman previously mentioned in his concluding speech, which believes that the current Ethereum It does not involve securities law.

If its operating platform has been fully decentralized, meaning that buyers no longer reasonably expect individuals or groups to carry out the necessary management or entrepreneurial efforts, assets may not represent investment contracts.

So, the ultimate question is whether the launch of Ethereum 2.0 means that the Ethereum network itself is not "fully decentralized" as the SEC previously believed.

What does "full decentralization" mean?

Since the announcement of Director Hinman's speech, the debate about the "fully decentralized" standard has been extensively discussed, and some commentators believe that "innovators should be pleased that this decentralized standard is properly understood", Others believe that "decentralization" as a legal standard is very problematic for a variety of reasons, from our inadequate understanding of the concept to its inevitable change in nature. "

In fact, it is cumbersome to focus only on these two words in Director Hinman's speech, especially considering that even in the context of blockchain protocols, the actual meaning of the word "decentralization" often has many confused. For securities law, whether a blockchain protocol or system is "fully decentralized" has a much smaller relationship with blockchain technology or even "decentralization", and it has a greater relationship with the basic principles of securities law Relationships, as Director Hinman puts it, mainly means "eliminating the asymmetry of information between promoters and investors."

"When the efforts of third parties are no longer a key factor in determining the success of a business, the substantial information asymmetry will disappear. As the network is truly decentralized, the ability to identify issuers or sponsors for necessary disclosure becomes Difficult and meaningless.

Of course, there will continue to be systems that rely on core actors whose efforts are key to the success of the business. In these cases, the application of securities laws protects investors who purchase tokens or coins. " Therefore, considering the launch of Ethereum 2.0 and the new specification of PoS, the question that the SEC may have to solve is whether Ethereum can continue to succeed without the participation of institutions such as Vitalik Buterin and the Ethereum Foundation. If the answer is yes, then it may still be considered "fully decentralized" so that it can pass the Howey test, otherwise it will fail.

Based on the above reasons, if for the purpose of the Howey test, Ethereum 2.0 is no longer "fully decentralized", the SEC may conclude that the implementation of Ethereum 2.0's PoS involves US securities laws, which requires the Ethereum Foundation to implement Section 12 (g) of the Securities Exchange Act of 2015 is registered, and this is the result that it does not want much to see.

V. Is Ethereum 2.0 sufficient for decentralization?

What judgment the SEC will make on this issue cannot be concluded at this time, but we can get guidance from the FinHub framework above. In particular, the framework provides several examples, which mention:

  1. The AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network, especially when the purchaser of the digital asset wants the AP to perform or supervise the implementation of the network or digital asset, or perform the tasks necessary for its intended purpose or function;
  2. The AP plays a leading or central role in the continuous development of the network or digital assets;
  3. The AP has an ongoing management role in determining or judging the characteristics or rights represented by the network or digital assets, for example, determining whether and how to compensate those who provide services to the network or one or more entities responsible for overseeing the network;
  4. Buyers can reasonably expect APs to work hard to promote their own interests and increase the value of the network or digital assets. For example, APs have the ability to realize capital appreciation from the value of digital assets. For example, if AP holds shares or equity in digital assets, this can be proven. In these cases, the purchaser can reasonably expect the AP to make an effort to promote its own interests and increase the value of the network or digital assets.

When we applied the above example to Ethereum 2.0, we found:

  1. It is generally believed that the specifications of Ethereum 2.0 were developed by a small team of the Ethereum Foundation, including Vitalik Buterin;
  2. Therefore, the Ethereum Foundation has a "leading or central role in the continuous development of the network or digital assets," and the buyers of Ethereum (or those who decide to become Ethereum 2.0 validators) obviously expect the Ethereum Foundation Perform or supervise the Ethereum network, or let Ethereum fulfill or maintain its intended purpose.
  3. The Ethereum Foundation provides funds to independent teams to establish specifications to meet the "determining whether and how to compensate people who provide services to the network", although it is currently unclear what the Ethereum Foundation does every year in its organization and funding How much it cost
  4. The Ethereum Foundation owns or controls the intellectual property of its network or digital assets, including the following trademarks: ETHEREUM, ETHER, ENTERPRISE ETHEREUM (Enterprise Ethereum), and ENTERPRISE ETHEREUM ALLIANCE (Enterprise Ethereum Alliance);
  5. The Ethereum Foundation retains shares or interests in digital assets, which can be proved from the facts: "The Ethereum Foundation's multi-signature wallet is known. As of October 4, 18, the organization holds 645,137 ETH, That's the equivalent of $ 118 million. "

All these factors indicate that Ethereum 2.0 has a large dependence on the Ethereum Foundation, which will mean that the SEC will change its previous position that the "Ethereum network is fully decentralized" and find Ether Will the current specification of Fang 2.0 involve "investment contracts" and then cause it to involve securities trading?

Certainly not determined, but as stated in the framework, "the stronger their existence, the more likely that digital asset purchasers will rely on the efforts of others", so the possibility of the network meeting "full decentralization" is also The smaller, therefore, the SEC's re-examination of Ethereum means that the results are likely to be reversed.

6. Conclusion

Please note that the purpose of this article is not for FUD, in fact, the purpose of the article is exactly the opposite: it is to encourage those who develop digital asset technology to accept the fact that "the law applies to what they do" and advocate for initiative and regulation Institutional contacts to ensure that their work does not conflict with applicable legal and regulatory frameworks.

Failure to do so or refusing to do so will have a serious negative impact on their ongoing projects, and Ethereum is no exception (second largest cryptocurrency).

Regardless of how this unfolds, anyone interested in this asset class needs to look at it very carefully.

We will continue to update Blocking; if you have any questions or suggestions, please contact us!


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