What would happen if the SEC classified ETH as a security?

Yesterday, news broke that the U.S. Securities and Exchange Commission (SEC) may consider reclassifying Ethereum’s native token, Ether (ETH), as a security. Not everyone is convinced that this is the case, and so far the SEC has not clearly answered whether the Ethereum Foundation is investigating — just as the agency has clearly stated that ETH is or is not Ethereum.

Many digital asset lawyers said the Ethereum Foundation’s “voluntary investigation” of its Github repository was not a cause for alarm. Subpoenas of cryptocurrency companies are a normal course of business in the industry. The Ethereum Foundation’s canary — which indicates whether a government has investigated a website — ultimately had to be taken down.

“ From what has been publicly disclosed to date, it is difficult to know the nature of the government inquiry issued to the Ethereum Foundation, or whether the Foundation is a target of the investigation ,” Preston Byrne, managing partner at Byrne & Storm, PC, told CoinDesk in an email.

Byrne said it was "unlikely" that the Ethereum Foundation would be a target of the investigation. However, given that the investigation is ongoing, some questions remain. For example, it is unclear why the SEC would sue the creator of Ethereum nearly 10 years after its launch and after the network has accumulated hundreds of billions of dollars.

Does the investigation involve Ethereum’s initial coin offering and token distribution, or does it involve a shift in the collateralized security model? How come the U.S. securities regulator has jurisdiction over an organization based in Zug, Switzerland? Will the Commodity Futures Trading Commission (CFTC), which oversees the burgeoning ETH futures market, fight back?

As for why the crypto firm was asked about its dealings with the Ethereum Foundation, Byrne offered two plausible reasons: Either the SEC is attempting to classify ETH as a security in order to force U.S. spot exchanges to delist the token or to bolster its case for rejecting a much-needed spot Ethereum exchange-traded fund (ETF).

Byrne added that neither motivation “necessarily requires the SEC to take enforcement action against the foundation.”

But there are lawsuits. Let’s say ETH is a security (although there are good reasons to say it isn’t). So what exactly happens? Ethereum is the second-largest blockchain by value ($414 billion at today’s prices) and the home of most of the digital asset industry’s most commonly used vehicle — classifying ETH as a security could cause confusion. With such a big move, where the shoe will ultimately fall is completely unpredictable.

Demerge​

One of the more unlikely responses is that Ethereum could revert to the mining model pioneered by Bitcoin, which switched to a proof-of-stake algorithm that rewards tokens to users who lock them up to secure the network. This in itself is unlikely — it took Ethereum developers inside and outside the Ethereum Foundation years to move to staking.

Vitalik Buterin came up with the idea for Ethereum in 2013, and even then he thought the blockchain might need to move to staking, a “consensus model” that was still in its infancy at the time. It wasn’t until 2020, five years after the network actually launched, that Ethereum staking took its first tangible steps with the launch of the Beacon Chain.

Ethereum developers deployed and rebuilt many testnets in an attempt to move to staking over several years, and the “de-merge” may take just as long.

Besides the scale and cost-effectiveness of staking, part of the problem is that mining is a process that purposefully consumes energy, something the developers would be happy to say goodbye to. After the “merge,” Etheruem’s energy consumption theoretically dropped by 99% — quelling critics of the cryptocurrency’s environmental footprint.

“I can’t see any outcome like the merger you’re pointing out leading to anything like that,” Paul Brody, blockchain leader at EY, told CoinDesk.

ETH PoW Launch

Ethereum is Ethereum and Ethereum Classic is Ethereum Classic, even if Ethereum Classic (ETC) actually maintains the “original, unaltered” history of the blockchain. Given that the network is already running, this is certainly an easier solution than “de-merging”.

Ethereum Classic, of course, has gone through multiple faith-breaking reorgs. So has Ethereum’s alternative: EthereumPoW (ETHW), a fork that was launched during the merger to preserve proof-of-work.

Neither ETC nor ETHW has surged on news of a potential SEC investigation, suggesting they are unlikely to be adopted quickly. But it’s not impossible. After all, Buterin did admit that ETC is “a very good chain.”

One notable drawback is that Etheruem’s founders could hold a large number of ETC or ETHW tokens, which reflects the state of their ETH holdings at the time of the two forks. It is unclear whether the SEC is concerned about Ethereum’s token issuance , which distributes valuable tokens to the founding team and the Ethereum Foundation. But the agency has said in the past that such expenditures are similar to investment contracts.

Did XRP win?

The XRP Army has been waiting for a moment like this for years. While not as overt a conflict as Ethereum vs. Solana, many in the XRP Army absolutely despise Ethereum. The history here likely stems from Bill Hinman, the former head of the SEC’s Division of Corporation Finance, who declared that ETH was not a security because it was “sufficiently decentralized.” The XRP Army, which supports its own project, sees this intervention as unfairly picking winners in the cryptocurrency market, granting special consideration to one project while suppressing others that look very similar.

For years, XRP advocates, including Ripple Labs CEO Brad Garlinghouse, have argued that Ethereum is “Chinese-controlled”; that Vitalik Buterin could be co-opted; and that the network itself was “hand-picked” by the United States. Of course, Buterin didn’t win any favors by calling XRP a “sh*tcoin” in response to these allegations.

One of the advantages of XRP is that, unlike most cryptocurrencies, the asset actually has some legal clarity after Ripple Labs fought back against the SEC in court and won some concessions from the presiding judge. The judge ruled that XRP itself is not a security, and exchange transactions with it are not securities transactions, although Ripple's programmatic sales to qualified buyers are investment contracts.

“What makes something an investment contract is the characterization of a sale or offer for sale, not necessarily which cryptocurrency. ETH is sold on public exchanges, with no advertising,” Christa Laser, a law professor at Cleveland State University, told CoinDesk. “The SEC may be targeting only staking rewards, but it would need to prove there is a core promoter.”

Gensler's reputation is damaged again

In fact, one possible outcome of the SEC going after ETH is another major loss for the agency in court. As former CFTC Commissioner Brian Quintenz said yesterday, the SEC has implicitly said that ETH is a commodity after allowing the launch of ETH futures and ETH futures ETFs in the United States. In addition, over the years, countless American investors, companies, and individuals have acted on the SEC's signals that ETH is not a security.

Moreover, there is a growing recognition that the Gensler-led SEC has been unfair in its legal battles with the crypto industry. Instead of developing comprehensive regulations that truly explain the differences between decentralized protocols and traditional business methods, it has filed lawsuit after lawsuit against companies that have added value to the U.S. economy (rather than taking away from it).

This “law” doesn’t always work for Gensler. Just recently, a U.S. federal judge accused the SEC of “gross abuse of power” and “deliberate lies” in its dispute with cryptocurrency company DEBT Box. This followed an unprecedented closure by a three-judge appeals panel that condemned the agency’s years of denials that the number of spot Bitcoin ETFs was “arbitrary and capricious.”

In short: if the SEC does try to build a case for rejecting a spot Ethereum ETF by going after the underlying asset, it better have a good case.