Is Ether a security? How the merger raised questions about crypto regulation

As the Ethereum merger recedes into the background, and even the potential disruption caused by ETHPoW has seemed to fade away, several questions have come back to the fore; How should crypto be regulated? In addition to that, which regulatory body should have the authority to determine this, and how will the regulation come about?

In testimony delivered just hours after the successful completion of the merger on September 15, 2022, the head of the Securities and Exchange Commission (SEC) – Gary Gensler – delivered comments that immediately made waves in the crypto community. Chairman Gensler stated that under the Howey test – which determines whether an asset qualifies as an “investment contract” and is therefore subject to federal securities law, PoS cryptocurrencies may qualify as securities.

The fact that the Howey test was adopted into law by the Supreme Court in 1946—and that financial markets in no way resemble those when the law was written—continues to raise eyebrows when it is constantly cited as a leading test for determining regulatory jurisdiction.

Here’s what investors need to know about whether ether, and other PoS crypto, will fall under (to date) regulation-by-suit-and-edict from the SEC.

Does it pass the Howey test? The parts of the Howey test that have been cited as reasons for classifying PoS crypto as securities are 1) PoS investors pledge funds (in the form of tokens) to finance an enterprise with the intention of making money from their efforts, and 2 ) that the investing public expects profits based on the efforts of the others.

The fact that nearly two-thirds of staked ether, the unnamed (yet assumed by many) focus of these comments, is held by Lido, Coinbase, Binance and Kraken seems to reinforce this position. After all, retail investors and customers stake tokens on these centralized exchanges to generate returns, and these centralized exchanges accept these deposits for the benefit of the company’s operations and profits.

On the surface these positions look like reasonable enough assessments of PoS regimes, but it highlights an underlying fact that can be overlooked; changing from PoW to PoS does not always change the nature of how participants interact.

Economic realities are unchanged. The switch from PoW to PoS has generated much debate, but the underlying fundamentals of blockchain consensus methodologies have not changed. Under both PoW and PoS 1) validators/miners are an open and potentially unlimited group of participants, and that 2) the only prerequisite for participation is acceptance of costs. The cost under PoW is the financial investment required to mine, and under PoS the cost is primarily the opportunity cost associated with staking crypto versus using or using it.

Both consensus protocols allow anyone, at any time, to allocate these resources to these activities, helping to create open and transparent competition among market participants with virtually no other barriers to entry. Corrupt, unethical or otherwise disinterested participants will be replaced and replaced by those more interested in participating in a legitimate and ethical manner.

Based on these realities, the coordination and cooperation of efforts necessary to trigger the Howey test looks like a much weaker argument.

The concentration of staked ether ownership will inevitably fall as 1) lock-up periods expire, 2) investors look for higher returns as interest rates and inflation remain high, and 3) new options emerge as developers further digest the PoS pivot.

Classification remains unclear. Previous comments from both the SEC and the Commodity Futures Trading Commission (CFTC) agreeing that ether functioned more like a commodity, and the fact that the SEC – under former leadership and Chairman Gensler – has not issued a definitive checklist or guidance for what criteria crypto must have for securities classification, continues to create an environment of regulatory ambiguity and uncertainty. That said, enforcement actions against Ripple and others, 80 in total, and fines imposed on BlockFi ($100 million) and others totaling over $2 billion by the end of 2021 indicate how forcefully the SEC is willing to debate and regulate these points.

As the debate surrounding crypto classification continues to swirl, it is more important than ever for investors to follow due diligence, stay abreast of market developments and take reasonable precautions when investing.