What happens if Ether is a security?

Is ether (ETH), the original cryptocurrency of the Ethereum blockchain and the second largest by market capitalization behind bitcoin, an investment security?

The question has been a source of simmering speculation ever since last year Ethereum switched to a “proof-of-stake” blockchain network where investors can “stake” their coins in exchange for rewards – not unlike the interest paid out on bonds.

A recent claim Thursday by a New York state regulator could push the legal debate back to the front burner.

Ether has long been treated as a commodity by state and federal regulators, including the Commodity Futures Trading Commission (CFTC). Designating it as a security would have a massive impact on crypto markets, drastically changing how (and whether) the currency and others like it are traded in the US

Ethereum apparently drew extra scrutiny from regulators starting in 2022 when it switched from a “proof-of-work” system to a “proof-of-stake” system for operating the network.

The proof-of-work system, still used by Bitcoin, relied on “mining” to secure the blockchain – where computers scattered around the world raced to solve cryptographic puzzles for the right to earn newly issued crypto and write transactions to the chain.

The new system, proof-of-stake, waives mining for “staking”. Ether holders can now unlock their crypto with the network in exchange for interest, and as a way to secure transactions.

“By moving to proof-of-stake, ETH no longer relies on competition between computers, but instead relies on a pooling method that encourages users to own and stake ETH,” the suit explained. “The shift to proof-of-stake significantly affected the core functionality and incentives for owning ETH, because ETH holders can now profit just by participating in stakes.”

The specter of a security token has long hung over ether, which was originally distributed to early backers and investors in 2015 as part of an ICO — or initial coin offering.

In his case against KuCoin, James suggested that ether is a security due to the early distribution schedule, as well as the fact that the infrastructure is maintained by a relatively small group of contributors.

James’s case takes particular issue with the influence of Ethereum co-founder Vitalik Buterin and the non-profit organization Ethereum Foundation, arguing that they retain “significant influence over Ethereum and are often a driving force behind major initiatives on the Ethereum blockchain that affect the functionality and price of ETH.”

The suit further adds that Buterin and the “small number of developers” who control the Ethereum blockchain “stand to profit from the growth of the network and the related appreciation of ETH.” Buterin and its developers, the suit suggests, “promoted it as an investment contingent on the growth of the Ethereum network.”

“Buterin and the Ethereum Foundation also received significant amounts of ETH in the ICO and are believed to retain significant holdings of this ETH today,” the suit claimed.

Despite the NYAG’s claim in its case that ether can be a security, the decision is far from final.

What is clear is that the reasoning put forth in the case definitively reveals how at least one regulator—and possibly others, including the US Securities and Exchange Commission (SEC)—thinks about ether.

The SEC has “worked with [New York] more than they have with any other state that we know of, at least that I know of,” explained Collins Belton, a California-based crypto attorney and partner at Brookwood PC “Although you can’t just say this is a harbinger of things to come to happen in the United States, I think inevitably that’s a very strong indicator that this is the kind of argument” that SEC Chairman Gary Gensler “is going to think about trying to refine.”

Gensler – who has increasingly slammed the crypto industry of late – has previously suggested that Ethereum’s move to proof-of-stake brings it closer into compliance with the agency’s definition of a security.

The SEC defines securities based on the Howey test, which states that a security is “a contract, transaction or arrangement in which a person invests his money in a joint venture and is led to expect profits solely from the efforts of the promoter or a third party.”

Proof-of-stake, by this logic, could bring ether closer to a “security” because the interest payments require little work and rhyme with the Howey test’s “expectation of profit.”

Should Ethereum be officially classified as a security by courts, exchanges wishing to list ether would likely have to register as securities brokers with the US Securities and Exchange Commission (SEC).

“If you are already registered in New York, now you have a question – do you either remove ether and/or block your New York clients from being able to buy ether, or do you just register as a broker-dealer?” Belton said.

Belton also pointed out that James’ stance comes as a surprise because exchanges operating legally in New York (not including KuCoin, which was not registered as an exchange) offer ether, with the approval of the state’s financial regulator, the New York Department of Financial Services (NYDFS).

“It’s not like New York had no idea air was being offered. They knew that for years because to get a license and to register in New York, you actually have to have the assets you plan to offer to New Yorkers greenlisted by their financial regulator, Belton said.

“So it’s pretty insane that your attorney general said, ‘Oh, by the way, you’re selling illegal securities, despite the fact that our financial regulator has allowed you to operate with impunity for five years,'” he added.

It’s not just centralized exchanges that have something to worry about: Decentralized trading platforms—autonomous pieces of software that live on blockchains—could also face legal problems if ether is found to be a security.

“Technically the way the draft reads, if you offer a platform to people where they can engage in these types of transactions, regardless of whether it’s a commodity or a security, New York is saying, ‘Hey, we think you might have to be a broker-dealer — either a broker-dealer, or commodities BD,” Belton said. “If that’s true, this thing is much bigger than like, ‘Oh, hey, can exchanges continue to offer ether?’

There is already legal precedent for banning blockchain-based computer programs, called smart contracts – over the summer, the US government banned the Tornado Cash mixer program due to its links to money laundering.

An ether-as-a-security world would have major implications for large-scale cryptography.

James’ logic for classifying ether as a security – based in part on the network’s transition to proof-of-stake – raises questions about whether other tokens can also be classified as securities.

What the NYAG says “could extend far beyond just ether and implicate the rest of the ecosystem,” Belton said.

Outside of proof-of-work Bitcoin, most major blockchains use a stake-based system similar to Ethereum’s, meaning it’s possible regulators could put them in a similar basket.

The price of ether fell by around 7% in the wake of the NYAG’s announcement of the lawsuit against KuCoin.