Why Ethereum is not a Security

The U.S. Securities and Exchange Commission (SEC) has long grappled with the categorization of cryptocurrencies within its regulatory purview. And today, it seems that the SEC is solely focused on extending its regulatory reach by classifying as many cryptocurrencies as securities.

What can we say with a high degree of confidence at this stage? Well, a few things.

First, Bitcoin is something completely different and will almost certainly never be brought into this conversation.

Second, Ethereum is less likely to be deemed a security by the SEC, but given the SEC’s current modus operandi, it cannot be deemed entirely invulnerable. That is why we need to continually review the reasoning behind Ethereum’s current non-security status.

Third, it “seems” like other cryptocurrencies could benefit from the reasoning behind the non-security status of Ethereum.

But let’s focus on the Ethereum particularities.

By way of history, in 2018, William Hinman, the then Director of the SEC’s Division of Corporation Finance, declared that Ethereum was not considered a security under U.S. securities laws.

A key consideration in categorizing an asset as a security in the U.S. is the Howey Test. The Howey Test, named after a landmark Supreme Court case, outlines that an investment is a security if it involves (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit, (4) to be derived from the efforts of others.

While Ethereum’s initial coin offering (ICO) in 2014 might fit the criteria of the Howey Test (raising funds by selling Ether in exchange for Bitcoin, an investment in a common enterprise with profit expected from the efforts of the Ethereum developers), things have changed since then. Significantly. It is crucial to consider Ethereum’s present state.

As per Hinman’s 2018 remarks, the primary reasons for Ethereum not being classified as a security are decentralization and functionality. The Ethereum network has evolved beyond the control of a central authority, and the effort of one group is not key to the functionality or profitability of the network.

Ethereum’s network relies on thousands of nodes worldwide, each contributing to the maintenance, decision-making, and forward progress of the ecosystem. This level of decentralization diminishes the significance of a central party whose efforts could result in a return on investment, and consequently, Ethereum is less like a security and more like a commodity, similar to gold or oil.

This is a touchy point for many in the digital asset space. To clarify, Ethereum is not as decentralized as Bitcoin, nor is it decentralized in the same way that Bitcoin is. But for purposes of securities law, Ethereum is decentralized to such an extent that it is operating in a way completely unlike a public company. That is why Ethereum today is not a security. In this regard, today, Ethereum is “more like” Bitcoin than a security.

And it is important to note that the standard under securities law is not that a cryptocurrency be as decentralized as Bitcoin to be a non-security. The standard is, how decentralized is it compared to companies that clearly issue securities.

Furthermore, Ether, Ethereum’s native cryptocurrency, serves as a “fuel” or “gas” for performing transactions and executing “smart contracts” on the Ethereum network. It is integral to the system’s functioning, indicating that Ether is more of a utility than a security.

Of course, the SEC’s assessment is on a case-by-case basis, considering the specific characteristics and uses of each cryptocurrency. The fact that we are in a case-by-case world right now, and that the SEC has clearly tipped its hand that they want to classify everything as a security, some regulatory clarification would be very helpful. But the reasoning behind Ethereum’s non-classification as a security is solid.

Can the reasoning behind Ethereum’s non-classification be extended to other projects? I believe it can.

It’s a topic for another day, but my personal opinion is that XRP is also not a security. And the Ethereum reasoning helps drive that conclusion. Ripple Labs does not control XRP or the XRP Ledger—the decentralized blockchain technology upon which XRP operates. The ledger’s validation system is distributed among numerous independent validators. This decentralized nature undercuts the “common enterprise” criterion of the Howey Test. But like I said, that’s a topic for another day…..