Key Contact: Andrew Tzialli – Partner
The world’s second largest cryptocurrency, Ethereum, recently hit the headlines in a highly publicised upgrade of its blockchain mechanism in an event known as ‘the Merge”. With a sizeable reduction in global energy consumption and lowering of transaction fees on the Ethereum network, the Merge has been hailed as a huge success by most commentators. From a legal and regulatory perspective, however, the update poses fresh questions as to the treatment of Ether under securities laws.
What was the ‘Merge’?
For those familiar with the crypto and blockchain space, the ‘Merge’ was an event that had been talked about for many years. In a nutshell, Ethereum has upgraded its system by moving from a proof of work consensus mechanism (where ‘Miners’ compete to validate transactions on the blockchain) to a proof of stake mechanism (where validators stake their Ethereum and are assigned to validate transactions). One of the biggest reasons for this shift in technology, if not the main reason, is linked to the reduction in energy usage (circa 99% reduction according to the Ethereum Foundation) as miners are no longer competing to solve mathematical problems and validate these transactions (which was extremely energy intensive given the computer processing required to sole such mathematical problems).
Instead, with the proof of stake model, Ethereum is ‘staked’ by users (i.e., locked away) and they are randomly selected to validate transactions, although the longer they have deposited their stake, the more likely they are to be selected. The minimum staking requirement for Ethereum validators is 32 ETH (circa €44,000 at time of writing), which is a sizeable amount for some of the ‘smaller players’ in the market. However, other options are available to ETH holders such as validator pools, where stakers can ‘pool’ together to reach the 32 ETH mark and run a validator. Larger crypto exchanges such as Kraken, Gemini, Coinbase and Binance also offer staking services for customers with minimum requirements.
Ethereum as a security?
Regulation in the digital assets sector has been a contentious issue in recent years as lawmakers globally try to grapple with the so called “wild west” of financial and asset markets. Europe is gearing up for a single licensing regime across the European union with the introduction of the Markets in Crypto Assets (MiCA) Regulation, the UK are launching a new financial services and markets bill tackling crypto and in the US, the Biden administration has just released its first-ever framework on crypto regulation. Whilst each of these jurisdictions may vary on the specifics of their crypto & blockchain policies, they all share a common approach to the area of securities.
If a digital asset is classified as a “security” this likely means registration with the local regulator and the token/coin is usually dealt with under existing financial services laws. In the EU for example, crypto assets are not specifically included in the list of financial instruments under the Markets in Financial Instruments Directive (MiFID), but they can come within the scope of MiFID where they meet the criteria for a ‘financial instrument’ (which includes securities). In turn, this classification as a ‘financial instrument’ can open up a whole host of obligations under securities laws. Whilst registration requirements might be seen as a positive for both consumers and investors, this additional ‘red tape’ can cause huge financial problems for fledgling crypto asset businesses with serious consequences if procedures are not followed.
Until now, crypto asset firms working on Ethereum related projects did not need to worry about these additional registration requirements – as Ethereum is generally not considered a security. The SEC had determined that the offer and sale of ether is not the offer and sale of securities under the Howey test (the test often used as the baseline for determination of security vs utility status) as the SEC’s former Director of Corporate Finance, William Hinman announced that ether was not a security given the decentralized state of the Ethereum network. Likewise in the EU, as a decentralized network with no central issuer, Ethereum did not fulfil the necessary requirements under the MiFID “transferable security” test.
However, with the move to a “proof of stake” mechanism, questions are now being asked as to whether this will prompt a change in the SEC’s opinion on the Ethereum model, particularly as the act of “staking” ether could now be viewed as an investment.
Staking as an Investment
Under the Howey test, an “investment contract” is found to exist when there is (i) an investment of money; (ii) in a common enterprise with; (iii) an expectation of profits derived from the entrepreneurial or managerial efforts of others. Whilst an Ethereum model based on a proof of work mechanism was not captured by this definition, with the new proof of stake model it is less clear, especially given the process of (i) staking could be seen as an Investment, with (ii) Ethereum as the common enterprise and (iii) receiving staking rewards as the expectation of profits derived from the entrepreneurial or managerial efforts of others.
This ‘return on investment’ has certainly piqued the interest of regulators, with the current SEC chairman Gary Gensler stating, “from the coin’s perspective […] that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others”. These ‘profits’ are set to amount to 4 – 5% annually (some reports estimating this may reach 10%) and it’s this potential of high returns which is attracting large scale institutional investment. Gensler has also questioned some of the big crypto exchanges, who as intermediaries offer staking services to customers, commenting that staking “looks very similar – with some changes of labelling – to lending”.
Similarly, from a European perspective, the concept of receiving rewards from staking Ethereum certainly ‘muddies the water’, particularly as previous guidance from ESMA (European Securities and Markets Agency), highlights that attaching ‘profit rights’ to a crypto asset brings it more within the scope of financial instruments listed in MiFID. That said, whilst developments in the US will no doubt have an influence on European decisionmakers, the classification of a crypto asset as a financial instrument is ultimately the responsibility of individual EU member states and any fresh analysis of Ethereum, or any digital asset for that matter, will need to be read in line with MiCA.
Post merge, the ability to earn passive income through staking is gaining popularity and is no doubt something regulators will keep a close eye on. Gensler’s comments may ultimately lead to nothing, however formal action by the SEC could have huge knock-on effects for the industry, given the use of Ethereum in a large number of blockchain projects. Moreover, if Ethereum was deemed a security, it would inevitably mean that a huge host of other tokens and DEFI platforms would need to reconsider their own model, which would certainly cause problems against the backdrop of an already shaky market, but for the time being, it is a case of ‘watch this space’.
For more information in relation to this article, please contact partner Andrew Tzialli.