ETH has eliminated mining as part of its effort to bring Ethereum towards an increasingly scalable future. Instead of mining, ETH owners can earn rewards by actively validating transactions through a mechanism called "staking." In this article, we look at the possible securities law implications coming from this change. Despite the strong arguments as to why ETH should not be considered a security, the Securities and Exchange Commission ("SEC"), has already signaled that to the extent ETH owners expect to generate passive income through staking, and expect to earn a return from the work of third parties, then this could push ETH closer to a security classification.
The Merge
Ethereum, issuer of ETH, the world's second largest cryptocurrency by market cap, recently underwent a "Merge" where its Mainnet transitioned from using a "proof-of-work" mechanism to "proof-of-stake" for purposes of validating the network. Ethereum expects that this single transition will reduce its energy consumption by roughly 99.95%1, and it has also been separately calculated that the world's total energy consumption will reduce by 0.2 – 0.5% as a result of the Merge. Beyond energy savings, Ethereum expects the Merge will improve network security and be a critical first step towards an increasingly scalable future for Ethereum.2
The Merge has been widely anticipated and supported by leaders in the blockchain and tech industries. Patrick Collision, the CEO of Stripe, for instance, described the Merge in a tweet as a "sustained, ambitious, [and] technically difficult open source development" endeavour.
Goodbye Mining, Hello Staking
One of the largest advancements from the Merge is that mining in the Ethereum Mainnet is now obsolete. Replacing the need for mining is a mechanism called "staking," which is a process of actively participating in transaction validation. Any individual who owns ETH can participate in the staking process by placing their ETH in a "node" that forms a part of the Ethereum blockchain. If that "node" is used to validate a transaction, that individual's ETH is used as collateral during the validation process, and that individual would receive a reward post-validation.
Each node is formed of 32 ETH – meaning that if any one individual or organization owns that amount of ETH, they can create a node that would be part of the Ethereum's proof-of-stake network. For those that own fewer than 32 ETH, they can still participate in a node by pooling their ETH with others to create validating nodes through third-party staking services. The rewards for staking ETH vary – at the time of writing, the reward for staking one ETH is between 3.86% to 4.8% annual percentage rate ("APR"), meaning that an individual, by the end of a 12-month period, would be rewarded with a return of roughly 1.5 ETH for running one validation node which, at the time of ETH's monetary value peak, would have been around $7,200 USD or currently around $1,950 USD.
What Does Securities Law Have To Do With Staking?
Gery Gensler, the Chairman of the SEC, noted on September 15, 2022 that any digital currency networks or intermediaries that allow users to stake their coins might be deemed securities using the Howey Test.3 The Howey test is the leading test used by U.S. courts in determining whether a particular transaction is an "investment contract" and therefore subject to securities laws, by examining, amongst other factors, whether investors expect to earn a return from the work of third parties. The Howey test is almost identical to the test used by courts in Canada for the same purpose, Pacific Coast Coin Exchange.
Despite strong reasons suggesting that ETH is not a security, regulators may nonetheless attempt to determine that intermediaries that allow holders to stake their ETH are offering a security under the Howey or Pacific Coast Coin Exchange tests. From a regulator's perspective, under the old proof-of-work protocol, ETH miners used their time and computation power to process transactions and produce blocks. Now, under a proof-of-stake mechanism, stakers park their ETH and expect flowing profits, a process that is arguably more akin to investing. At the very least, as stated by Gensler, "from the coin's perspective...that's another indica that under the Howey test, the investing public is anticipating profits based on the efforts of others."4
The Case Against ETH Being Classified as a Security
There remain compelling reasons as to why ETH, despite the Merge, should not be considered a security. Most notably, ETH is issued by a decentralized protocol, unlike the common shares of an operating company run by a centralized management team. In light of this, it can be argued that the "efforts of others" element of those tests involves the efforts of all ETH holders globally and therefore it is unclear whether the tests established by Howey and Pacific Coast Coin Exchange can be credibly applied to ETH.
Second, the rewards of one validator are not dependent on a "common enterprise" – a validator receives rewards when the node they maintain performs its job. In other words, the profits of one person's validator are not dependent on the success or failure of others.
A third point is that ETH holders, to receive rewards through staking, must maintain, at the very least, certain software configurations, maintain an internet connection, and ensure their validator node operates properly. This remains true even if an ETH holder is using an intermediary to stake. This is labour that holders of most stocks offered by a centralized management team do not need to complete. Arguably, stakers are performing a specific service rather than gaining profit from the actions of others.
Finally, Ethereum validators also run the risk of their ETH being "slashed", a process whereby the Ethereum network automatically takes a validator's ETH—sometimes up to the full node—to punish them for misbehaving, such as by running dishonest validations. This is another point bolstering the argument that Ethereum validators are earning rewards from their own efforts, and not the efforts of other investors or Ethereum developers.
Heightened Scrutiny Is Still a Risk
Both the SEC and Canadian securities regulators, including the Ontario Securities Commission (the "OSC"), have shown a willingness to regulate the blockchain space and classify certain cryptocurrencies as securities. Perhaps the most well-known regulatory action is the SEC's action against Ripple Labs. In this ongoing action, the SEC alleges that Ripple Labs has raised over $1.3 billion through an unregistered, ongoing digital asset securities offering. This lawsuit is only one of several actions that the SEC has undertaken in its attempt to regulate the cryptocurrency space. Another regulatory move by the SEC is its recent declaration that nine digital tokens are securities or could be classified as securities, chiefly AMP, RLY, DDX, XYO, RGT, LCX, POWR, DFX and KROM. The SEC made this declaration in its first inside-trading suit involving cryptocurrencies. The SEC is only increasing its capabilities to regulate blockchain companies, as evidenced by the regulator's announcement that it will be increasing the staff of its Cyber Unit from 30 to 50 employees and it will be renaming this department to the Crypto Assets and Cyber Unit.
The OSC is similarly regulating the blockchain industry in Ontario and setting precedents for other Canadian provinces in their attempts to regulate cryptocurrencies and blockchain companies. Ontario, for instance, banned its residents from using Binance, the world's largest cryptocurrency exchange. As of June 22, 2022, the OSC also announced the outcome of "two successful enforcement actions against non-compliant crypto asset trading platforms, [Bybit and KuCoin]."5
Despite compelling reasons as to why ETH should not be considered a security, regulators are nonetheless keeping a close watch of potential securities violations, and so, it may only be a matter of time before exchanges and other pooling services may see heightened scrutiny from the SEC or the OSC.
Footnotes
1. Ethereum, The Merge (September 15, 2022).
2. https://ethereum.org/en/upgrades/merge/Ibid.
3. Paul Kiernan & Vicky Ge Huang, "Ether's New 'Staking' Model Could Draw SEC Attention," Wall Street Journal (September 15, 2022).
4. Ibid.
5. The OSC, "OSC holds global crypto asset trading platforms accountable" (June 22, 2022).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
