Will the Upcoming Merger Turn Ethereum into a Security?

By Frederick Munawa, CoinDesk analyst

Compiled and edited by Amy Liu

Ethereum’s upcoming merger could make the second-largest blockchain greener, faster, and cheaper. But Georgetown University law professor Adam Levitin wrote on Twitter, “After the merger, there will be a strong argument that Ethereum will become a security. Any token in a proof-of-stake mechanism could be a security.”

If Levitin is right, and more importantly, if the U.S. Securities and Exchange Commission ( SEC ) agrees with him, then exchanges that list Ethereum (which is pretty much all exchanges) will be subject to stricter regulatory requirements. Like Bitcoin , Ethereum has so far been considered a commodity, outside the SEC’s jurisdiction.

Most discussions in the ethereum ecosystem concern the technical aspects of the merged proof-of-stake network, not such legal issues. Goerli is set to launch a software update on Wednesday, the last test before the second-largest blockchain fully transitions from the more energy-intensive proof-of-work to proof-of-stake.

Levitin’s argument is based on the Howey test — a test detailed in a 1946 U.S. Supreme Court decision that is often used to determine whether an asset is a security. To fully understand Levitin’s argument, it’s important to understand the concepts in Howey and proof-of-stake systems.

Staking

Proof of Stake is a consensus mechanism that allows all nodes on a blockchain to agree on the state of the network. It requires nodes called validators to propose and verify new blocks. Validators must invest funds to have a chance to participate in this process, and this capital investment is called staking.

The minimum staking requirement for Ethereum validators is 32 ETH, which is roughly equivalent to $53,000 at the time of writing. The incentive to stake and invest hardware and software resources in the network is to earn a return. According to the Ethereum Foundation, a nonprofit that guides the development of the network's software, validators can currently earn about 4.2% per year. In comparison, this is almost twice the rate of a regular U.S. bank one-year certificate of deposit (CD).

Validators are randomly selected to propose and verify blocks. The more ETH you stake, the higher the probability of being selected and receiving rewards. In other words, the more you stake, the more you earn.

William John Howey

Let's review the history and mechanics of Howey to understand Levitin's argument.

William John Howe was born in southern Illinois in 1876. He eventually moved to Lake County, Florida, where he became a successful real estate developer and politician. He specialized in growing and selling citrus fruits. Howey also sold land sales contracts for citrus groves. Half of his land was used for commercial purposes, and the other half was divided into small plots and sold to the public.

He founded the town of Howey, Florida, and became mayor in 1925 (later renamed Howey Hills). He built several hotels and an iconic mansion (now a popular wedding venue). Visitors to this resort town would stay at the Hotel Howey, which was located next to the citrus groves.

Part of the purchase agreement was for Howey's company to develop and service the acquired land in order to grow and sell citrus fruit for a profit. The profits would then be split between Howey's company and its investors. Howey died in 1938, but his company continued to grow.

A few years later, the SEC charged the companies with selling unregistered securities. The case ultimately went to the U.S. Supreme Court in May 1946. Justice Frank Murphy, writing for the majority, determined that Howey's land sales qualified as securities in the form of investment contracts under the Securities Act of 1933.

Howey Test

Justice Murphy himself defined the term “investment contract.” An investment contract is a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is directed to receive profits solely from the efforts of the promoter or a third person.

This definition has four distinct components:

1. Money investment

2. In a common enterprise

3. Expectation of Profit

4. Efforts solely from the sponsor or a third party

If an asset meets these four criteria, it is considered an investment contract and therefore a security. Even if an asset does not fully meet the criteria, it may still be considered a security based on economic reality.

Adam Levitin's Argument

Levitin argues that proof-of-stake systems like Ethereum require an investment (staking) in a common enterprise (ETH) with the expectation of profit (staking rewards) that comes primarily from the efforts of others (other Ethereum participants).

He used the phrase “resulting primarily from the efforts of others” rather than Judge Murphy’s “resulting entirely from the efforts of the promoter or third party.”

"The Court of Appeal interpreted 'entirely' to mean 'substantially' or 'significantly,'" Levitin wrote.

However, Levitin acknowledged the importance of the second half of Justice Murphy’s definition, which refers to a “promoter” — a third-party entity that fulfills the investment contract and is responsible for the majority of profit-making activities. Who would be in the Ethereum ecosystem?

Levitin tweeted, “None of this answers the much harder question of who the ‘issuer’ is when you’re dealing with decentralized systems. But it’s part of the broader question of how to fit decentralized systems into a human-centered legal system.”

Levitin noted that proof of stake allows stakers to invest in a validation pool. This goes back to his interpretation of the third and fourth aspects of Howey — the expectation of profiting from the efforts of others.

Tim Beiko, who runs protocol support for the Ethereum Foundation , countered on Twitter that ethereum has no “validation pools” at the protocol level and that it should not be categorized as “someone else’s effort.”

Validation of Levitin

Once a security, always a security?

Ethereum was funded by an $18 million initial coin offering (ICO). Hinman suggested in a 2018 speech that Ethereum might have been a security when it debuted, but by then it was sufficiently decentralized that it could no longer be an investment contract.

Hinman said, “It is my understanding that, leaving aside the fundraising that accompanied the creation of Ethereum… the current offers and sales of Ethereum are not securities transactions.”

This could strengthen Levitin’s argument that while Ethereum has achieved enough decentralization to be granted commodity status, a move to proof-of-stake could pull it back into the securities zone.

Does the Ethereum Foundation operate like a software company?

Recently, a popular Twitter account published a thread about how the Ethereum Foundation is using the so-called difficulty bomb to “force” developers to accept a hard fork initiated by the foundation. The “bomb” is a feature that makes it more difficult to successfully mine Ethereum on the original chain, until it is almost impossible to mine.

A hard fork is a network upgrade that is not backwards-compatible (you either accept the change or split onto a separate blockchain). A soft fork is a change to a backwards-compatible blockchain (you can continue to use the network whether you accept the change or not).

With the difficulty bomb hanging over their heads, miners have two options — follow the hard fork proposed by the foundation or start a new project (which also requires a hard fork).

This suggests that the Ethereum Foundation is controlling the direction of the network. If so, the foundation could be considered a third-party facilitator under the Howey test, supporting Levitin’s argument.

In an interview with CoinDesk TV, Levitin explained the potential consequences if ethereum were to become a security.

Essentially, smaller decentralized finance ( DeFi ) projects, especially those outside the U.S., are likely to continue operating. Even if these projects run afoul of U.S. securities laws, the SEC is unlikely to deploy its limited enforcement resources to convict them because large centralized organizations are easier targets, Levitin said.

The biggest change may lie in the regulation of centralized exchanges. Currently, exchanges only need to register as money service businesses at the federal level and obtain a money transmitter license in the state in which they operate to facilitate spot ETH trading. Designation as a security would subject them to additional authorization from the SEC. At a minimum, this would mean new exchange business models and more complex customer transactions. Many other downstream effects could emerge.

Today, cryptocurrency exchanges perform brokerage, clearinghouse, and exchange functions under one roof (an exchange is a marketplace for assets, brokerages facilitate trades by connecting buyers and sellers, and clearinghouses settle trades). If companies like Coinbase (COIN) and Kraken were regulated as securities exchanges, they would have to separate the three functions, Levitin said.

“If they have to register as a securities exchange with the SEC, they’re probably going to have to spin off these different businesses because there are too many conflicts of interest when you wear three hats,” Levitin said.