The Wall Street Journal reported that regulators and agencies of the US government were debating if a number of popular cryptocurrencies fall under the definition of securities under US federal law. The agencies involved are the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). This debate has attracted attention precisely because it is now examining the status of a number of cryptocurrencies, not just initial coin offerings (ICOs), most of which the SEC has made itself very clear that it does, in fact, consider them to be securities. Particularly noteworthy in this debate is the status of Ethereum, about which concerns have been raised, not least by Gary Gensler, a former head of the CFTC, who told the New York Times that a case could be made that both Ethereum and Ripple were noncompliant securities.
In essence and very broadly, a security is a financial instrument that investors buy for money and whose future value depends on other people to put in the work. Definitions of securities vary by jurisdiction, but in general, a security offers ownership of either assets or debts in a way that is both fungible and tradeable. Securities offer their issuers (such as corporations and governments), the possibility of raising money in ways more attractive than a bank loan. In the US, the agency responsible for regulating securities is the SEC. The SEC was set up in 1934 as one of the responses to the Great Depression. The goal of the SEC is to regulate the securities market to keep issuers honest and to protect investors. The SEC determines if a public offering is a security by employing the Howey Test. The offering is deemed a security, and therefore comes under the US security legislation if it meets all four of the following conditions:
According to current laws, almost all ICOs meet this test and are therefore considered securities by the SEC, meaning that they have to be registered with the SEC and conform to US security law. Such ICOs that do fail to meet these requirements are banned from trading on US Exchanges and cannot be offered to US citizens.
The SEC has been cracking down on ICOs for quite a while, and, in fact, US citizens cannot participate in most ICOs or trade them on exchanges. But the growing interest of the SEC in cryptocurrencies and Ethereum is new. Cryptocurrencies are peer-to-peer digital currencies that are regulated and verified by cryptographic methods, and decentralised by a blockchain that is essentially a distributed ledger. The first cryptocurrency is Bitcoin, which was released in 2009. Since then, many other cryptocurrencies, many of them based on Bitcoin itself, were released. Eventually, some of these other cryptocurrencies, known as altcoins, began to evolve features that took them far out of the parameters that define currencies. Probably the biggest and most important of these altcoins is Ethereum.
Released in 2015, Ethereum is not a cryptocurrency according to the aforementioned definition. It is an open platform based on its own blockchain (a distributed ledger) that enables developers to build and deploy decentralised smart applications, including smart contracts. So the Ethereum blockchain permits the execution of software of any decentralised application. To pay for transactions and computation on the Ethereum blockchain, “gas” is required. Gas is simply the unit that measures the amount of computation that is needed to execute certain operations on the Ethereum blockchain. To pay for gas, “Ether” (ETH) is required. ETH is a type of cryptocurrency that enables individuals to buy gas to use the computation power needed to run their smart applications on the Ethereum blockchain. But since it is a cryptocurrency, it can be used as such and traded or exchanged.
Since Ethereum is an environment that offers the facility to build and execute Turing-complete smart contracts, it has immense potential to revolutionise many areas of contemporary commerce and life. One use that has caught the SEC’s attention is the ability of anyone to build tokens on the Ethereum blockchain and use them to raise money through an ICO. The difference between a token and cryptocurrency is that cryptocurrency is a digital form of currency, which is a pure medium of exchange, while a token is not a currency but allows access to its own blockchain. However, tokens can function as media of exchange since they have value that is affected both by the current demand for access to their own blockchain, as well as by the dynamics of speculation.
Given Ethereum’s ability to allow anyone to build smart applications upon its blockchain, anyone can use it to build their own tokens. Ethereum’s immense potential is barely scratched but increasingly recognised to point at which Ethereum is currently the second largest Distributed Ledger Technology asset by market capitalisation. Worth around $80 billion, only Bitcoin is bigger than Ethereum.
The power of Ethereum to create smart applications with their own tokens has given rise to a new phenomenon for the generation of funds without the need to resort to banks for a loan, or to an Initial Public Offering (IPO), which, of course, has to conform to the SEC’s regulations. This new way of fundraising is through an ICO, the sale of tokens for a new venture, or rather, the exchange of these new tokens typically for Bitcoin and/or for ETH. Since this is seen to be getting around regulatory protections, this has not gone down very well with agencies such as the SEC, which has indeed put severe restrictions on ICOs.
Now the SEC appears to be examining the case for Ethereum as a security. The essence of its concern is if Ethereum is somehow a corporation and if its creators exert any significant effect on the value of Ethereum, and by extension of ETH, in the same way that a company’s value is affected by its managers and their performance. Moreover, the first batch of ETH was sold through a presale that may amount to an ICO. Finally, the regulators are likely to be concerned that Ethereum is the very platform that single-handedly created the token and ICO phenomena.
Nonetheless, it is difficult to see how Ethereum can be declared a security. Ethereum is a decentralised and open source platform with no official representatives, owners and any other feature of a private company or corporation. For this reason, ownership of ETH does not give an investor ownership of an asset or debt but only access to the computation power needed to run an application on this platform. Moreover, the first sale of ETH in 2014 took place in Bitcoin, not in money, failing the first criterion of the Howey Test. Finally, although ETH can be used as a medium of exchange, this is only as a side effect of the value it acquires by granting access to the Ethereum blockchain, which is not a private company or a corporation.
The rapidly evolving world of cryptocurrencies and decentralised blockchains is posing an increasing challenge to regulators. The Ethereum platform is exceptionally innovative and has immense potential to give rise to hitherto unimaginable applications. Meanwhile, Ethereum’s power to create decentralised smart contracts has given rise to tokens and ICOs as non-regulated way of raising money. The SEC, in its mission to regulate these activities and to protect investors, is now considering the case for Ethereum as a security. However, due to Ethereum’s open source and decentralised nature, it is highly unlikely that the SEC will come to this conclusion. If the SEC does come to that conclusion, it risks hampering the ability of US investors and businesses to harness the exceptional potential that Ethereum offers.
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