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    Gate.io Blog After SEC investigation into insider trading, could Ethereum count as a security
    Industry Analysis

    After SEC investigation into insider trading, could Ethereum count as a security

    05 August 16:38

    TL: DR
    - Recently, the SEC conducted an investigation into insider trading that has revived debates about Ethereum's qualification as a security.
    - Ethereum's move to Proof of Stake (PoS), as well as its way of being launched, has led some to question whether ETH passes the Howey test.
    - Since ETH stakers make money validating blocks on the Ethereum network, there are lots of expectations that ETH investors will profit, thus validating the as security. However, it is unlikely - that the SEC will classify Ethereum as security.

    Keywords: Ethereum, ETH, SEC, security, Proof of stake, proof of work, crypto asset.

    Introduction
    The Ethereum Merge protocol could bring back ambiguity regarding whether Ethereum is a security. This is based on a recent development where the SEC began an insider trading lawsuit against two former Coinbase employees.

    In the lawsuit, two former Coinbase employees and a friend are accused of buying and selling 25 different crypto assets with insider information. They explicitly said that at least nine of those crypto assets qualified as securities.

    According to the lawsuit, security is more than just what is defined by the Howey test. It explained how the SEC views crypto assets that cannot continue functioning when the issuer removes itself from a project's development as security.


    SEC’s past view of Ethereum


    In nearly seven years since Ethereum began producing blocks, there has been a rancorous debate over the classification of the coin as security. The debate was built on doubts in the market about the ability of Ethereum to pass the SEC's Howey test. Howey's test determines whether an asset represents security by examining three criteria:
    - whether it is an investment of money,
    - whether it is part of a common enterprise, and
    - whether the transaction expects a profit.

    In July 2015, Ethereum's native coin, ETH, was sold via an initial coin offering (ICO) in exchange for Bitcoin. With the sale of 50 million ETH during the ICO, the Ethereum Foundation, which oversees the network's development, earned more than $18 million. By selling ETH directly to the public, the Ethereum Foundation met the investment requirement. In addition, we can probably consider Ethereum a common enterprise since the Ethereum network, for which ETH is the currency, required direct input from over 100 developers to launch. Finally, Ethereum launched in July 2015, 11 months ahead of its ICO in August 2014. Therefore, investors expected ETH to increase in value when Ethereum's developers launched the network. Consequently, a lawsuit against the Ethereum Foundation at the time would likely have deemed ETH as security.

    The SEC has clarified Ethereum's security classification since its early years of ambiguity. However, despite the fundraising that accompanied Ether's creation, William Hinman, former corporate finance director at the SEC, asserts that current offers and sales of Ether do not represent securities transactions. According to Hinman's assessment, the SEC would almost certainly not retroactively classify Ethereum as a security. At the time of his speech in 2018, he claimed Ethereum's token, ETH, was no longer a security under U.S. law since it had sufficiently decentralized.


    The Merge and fears of being a security


    Despite Hinman's remarks, concerns that ETH could be viewed as security have been reignited by Ethereum's upcoming transition to Proof of Stake (PoS). Due to the update, the Ethereum network will undergo a significant restructuring later this year (still poised at September 19, 2022). With the implementation of Proof of Stake (PoS), the existing Proof of Work (PoW) system will be replaced by a Proof of Stake (PoS) system, in which independent miners compete to solve complex equations and mine blocks. As a result, the specifics of how the new Ethereum validation system will work could affect Hinman's earlier assessment.



    Will the Merge make Ethereum a security?


    Understanding precisely how the Merge will impact Ethereum is key to understanding whether or not the SEC should consider it a security after the Merge.

    At present, Ethereum uses a Proof of Work (PoW) validation mechanism, which allows miners to propose and validate blocks by solving complex equations. As a reward for mined blocks, the network pays miners two Ethereum plus any priority fees included in transactions.

    Following the Merge, Ethereum will move to a Proof of Stake (PoS) validation scheme, replacing the current Proof of Work (PoW) mechanism. Under the Proof of Stake (PoS) protocol, any Ethereum user who owns at least 32 ETH can set up a full validator node, join the pool of validators, and validate blocks. In addition to the priority fees charged by transactions, eligible validators will earn a reward after each block is validated.

    Various discussions have arisen regarding the security status of Ethereum due to the upcoming technical changes that will be part of the Merge. As a result of the Merge, Adam Levitin, Georgetown University Law Center Professor, says Ethereum will have a "strong case" to be classified as a security. He explains that Proof of Stake (PoS) satisfies the Howey test by pooling validators' ETH in a "common enterprise."

    Stock offerings from registered companies constitute most securities under the SEC's purview today. For their holders to receive dividends, they do not need to perform any special tasks or labor.

    However, Ethereum staking profits are also refuted by the Howey test as a security. For Ethereum staking to work, Ethereum holders must acquire ETH-compatible computer hardware, install and configure the necessary client software, maintain an Internet connection, and ensure the validator node operates correctly and honestly. Since stakers must perform a specific service to profit from ETH staking, some have argued they should receive payment instead of profiting from another's actions.

    Furthermore, validators who fail to report transactions properly will see their stake "slashed" -- i.e., the network will automatically remove their ETH to punish them. The historical precedent indicates that Ethereum validators shouldn't be viewed as securities since they only earn their income from their efforts rather than those of investors and developers.


    Conclusion


    According to the Howey test criteria and precedent set by prior SEC cases, Ethereum is not considered a security. Even if the SEC attempts to expand its purview over crypto assets by declaring more of them securities, Ethereum seems less likely to end up in the crosshairs of the organization after the Merge to Proof of Stake (PoS) takes place.






    Author: Gate.io Observer: M. Olatunji
    Disclaimer:
    * This article represents only the views of the observers and does not constitute any investment suggestions.
    *Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.
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