Ethereum, the platform that enabled the rise of nonfungible tokens (NFTs), executed a major change last week. The blockchain switched from the energy-intensive proof-of-work consensus model to a proof-of-stake, cutting its carbon emissions by 99% overnight. The merge, as the change was called, transformed the system behind ether, the world’s second most valuable cryptocurrency.
Instead of relying on a network of massive computers expending the annual electricity output of the Netherlands, ethereum now uses a process in which users stake—or put up—ether in order to win the right to record new transaction data on the blockchain.
The merge is widely hailed as a win for the environment amid the climate crisis, but it could also be what pushes the network into the crosshairs of US securities regulators.
The SEC is watching ethereum
US Securities and Exchange Commission chairman Gary Gensler said in a statement on Sept. 15 that staking-based cryptocurrencies are very likely securities that should be regulated by the agency. This spells trouble for ethereum, which could be charged or strong-armed into compliance by the SEC in the near future. Registered securities must disclose their management team, give regular financial updates, and outline potential business risks.
Under proof-of-stake, users earn ether by locking up their coins and validating transactions. Gensler said that when validators stake their coins, it’s an indication that “the investing public is anticipating profits based on the efforts of others,”—just like when a stockholder invests with the expectation that a company with make money.
Gensler clarified that he was speaking about staking-based cryptocurrencies in general, not about ethereum specifically, but his comments came soon after ether became the largest crypto by market capitalization to use proof-of-stake.
Does ether pass the Howey test after the merge?
The SEC chairman said that staking-based cryptocurrencies likely pass the Howey test, a standard for determining whether an asset is a security under the SEC’s jurisdiction or a commodity, akin to precious metals or scarce natural resources.
Under the Howey test, which hails from a 1946 Supreme Court ruling, a transaction qualifies as a security if it involves an investment contract in which “there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”.
In a Sept. 8 speech, Gensler said that much of the crypto industry meets the Howey test and is therefore operating illegally by not registering with the SEC. “Of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities,” Gensler said. “Offers and sales of these thousands of crypto security tokens are covered under the securities laws.”
Crypto advocates have pushed for cryptocurrencies to be regulated under the Commodities Futures Trading Commission (CFTC), which they believe will be less demanding than the SEC. Gensler conceded that a small number of cryptocurrencies, including bitcoin, might fall under commodities law rather than securities law.