How SEC Extends Net Over Ethereum

In mid-September, the Securities and Exchange Commission filed a complaint involving digital asset trades conducted on the Ethereum blockchain. The case, filed against US-based crypto influencer Ian Balina, provides even more evidence – if we needed anything – that the SEC takes a broad view of its authority to police crypto fraud.

The basic allegations in the SEC’s complaint differ little from other cases the agency has brought in recent years involving unregistered token offerings and pooled investments. What is new about the case is how the SEC chose to assert its jurisdiction over blockchain transactions carried out across decentralized networks and nodes, both inside and outside the United States

Specifically, the SEC claimed that ETH – a virtual currency – investments took place in the United States, in part because the Ethereum network’s “validation nodes” on which the ETH smart contract transactions were recorded are mostly hosted in the US.

As the SEC put it, “the ETH contributions were validated by a network of nodes on the Ethereum blockchain, which is clustered more closely” in the United States “than in any other country.“ A “node” is any instance of Ethereum client software connected to the Ethereum network.

This understanding of the location of Ethereum blockchain transactions is significant, beyond the application of ETH, because most token issuance is generated on the Ethereum blockchain in the form of ERC tokens, and many smart contract implementations rely on the Ethereum network.

Transactions involving these ERC tokens and smart contracts are all validated by the Ethereum network and recorded on the Ethereum blockchain by Ethereum network nodes. As a result, if accepted as a basis for SEC jurisdiction, the new “node cluster” theory of the location of Ethereum transactions would apply to more than half of the digital asset landscape.

Transactional Geography Theory

The presence of a node at any location is the product of the geographic location of the node’s servers and data centers. Many protocol systems and node systems are programmatically supported by hosted and centralized server and host systems that maintain server and infrastructure farms in different locations.

A strictly geographic interpretation of a node’s location will effectively place all cloud services in the geographic area where their servers and infrastructure are maintained. However, the network nodes used to validate ETH transactions, which are integrated into each ETH transaction, may still be located outside the United States.

For this reason, blockchain transactions cannot accurately be said to take place where the commercial hosting providers are located, but rather where the network nodes are located – which for a single ETH transaction can be in seven or more different locations across the Globe.

Due to the network decentralization inherent in every ETH transaction, the Ethereum network is properly thought of as existing at every network node location and simultaneously at none of them, because no single location or group of nodes can be assumed to interact with every single transaction in execution.

Furthermore, most blockchain networks, validation systems, and protocols do not allow users to select the particular nodes that will be used to validate a transaction. US-based transactions can be validated using any number of non-US nodes, and vice versa, without user input to choose which nodes to use to complete them.

Coupled with the fact that ETH transactions are validated, executed and recorded on nodes in different jurisdictions simultaneously, the SEC’s new theory would allow the agency to claim US jurisdiction based on some very tenuous US connections – inadvertently sweeping many primarily foreign transactions into the US regulatory orbit .

A problematic theory

The fundamental problem with the SEC’s theory is its assumption that the relevant ETH transactions necessarily “took place in” the United States simply because blockchain nodes “are clustered more closely in the United States than in any other country.”

Although the Ethereum network nodes are primarily hosted using commercial hosting services, the network itself is not majority located in any one country, nor does the United States account for an absolute majority of total nodes worldwide.

The SEC’s jurisdictional allegations assume that, given that most nodes are US-based, it would be unlikely that any ETH transactions could be executed without at least some nodes being located in the US. But this is just an inference, and not necessarily a strong one.

Nothing in the SEC’s complaint clarifies how the SEC intends to prove which nodes were used to execute and validate a given ETH trade, or how the functionality of each node in relation to a particular transaction will be classified.

Ultimately, the crypto community’s fears of the SEC’s jurisdictional grab may turn out to be overblown. Much depends on whether the agency can get some federal judges to accept its theory.

As Whale However, the case shows that virtual currencies continue to present burning questions of regulatory interpretation that require a new synthesis that combines classic regulatory concepts with unprecedented technological innovation.

In some cases, the synthesis has been successfully completed, or will be soon – for example, crypto issuers and the Commission are slowly moving towards détente on the application of the registration provisions in the Securities Act of 1933 to digital assets.

In other respects, such as identifying the jurisdictional boundaries of amorphous digital technologies that were intentionally designed to have none, the SEC still has a ways to go.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Katerina (Katie) Mills is an associate at Barnes & Thornburg assisting with a range of financial services and regulatory matters for digital assets, transactions, compliance and licensing.

David Slovic is a partner in the Financial Regulation and Enforcement Group of Barnes & Thornburg. Previously, he spent nearly a decade at the CFTC and SEC where he led numerous administrative investigations and federal litigation involving a wide range of conduct in the derivatives and securities markets.