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Decision: Is Ethereum, a security or commodity?

 john Kreativ |
Technology & Gadgets

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Did you know that Ethereum is currently the second largest blockchain in the crypto space by market capitalization after bitcoin? As at 19th May, 2022, Ethereum’s market capitalization stands at 236.97B, and bitcoin 567.62B. The blockchain continues to hold promise for an inclusive and open financial system. Currently there is no regulation and no clear-cut classification as to whether Ethereum is a security or commodity, with the SEC Chair, Gary Gensler and Chair of Commodity Futures Trading Commission (CFTC) having divergent views on the subject matter.

Quick Overview
Gary Gensler before the Financial Services Committee
What makes an asset a security or commodity?
Is Ether a Security or Commodity?

Gary Gensler face-off with US Financial Services Committee

Gary Gensler appeared before the House Financial Services Committee hearing (18th April, 2023) was evasive when questioned about the status of Ethereum as to whether is a commodity or security.
The Committee Chair, McHenry accused Gensler on refusing to provide clarity to crypto firms on what constitutes an investment contract, whilst punishing companies for not complying with the law, but isn't providing clear rules. Republicans are advocating for Gensler to work with Congress on customized new rules for crypto.

Ethereum recently switched its consensus algorithm from proof-of-work to proof-of-stake last year September 2022. The proof-of-work algorithm, as also used by bitcoin, allows individuals or business to harness computing power to solve cryptographic puzzles for transactions to be added to the block (also know as mining) in exchange for newly issued crypto from the chain. With the proof-of-stake, individual holders’ stake or lock-up their crypto (Eth) in exchange for interest or reward in proportion to the quantum staked.

What makes an asset a security or commodity?

When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. W.J. Howey. This ruling has become the criteria used by SEC for classifying an asset as a security. In order for the test to hold, there should be an investment in a common enterprise with an expectation of profit derived from the efforts of others.
In the Howey case:
A hotel operator sold interests in a citrus grove to its guests and claimed it was selling real estate, not securities and the transaction was recorded as a real estate sale, also included was a service contract to cultivate and harvest the oranges. Buyers could have arranged to service the groove themselves but, in fact, most were passive, relying on the efforts of Howey-in-the-Hills Service Inc. for a return. In articulating the test for an investment contract, the Supreme Court stressed: “Form is disregarded for substance and the emphasis is placed upon economic reality.” So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.

Just as in the Howey case, tokens and coins are often classified as assets that have a use in their own right, coupled with a promise that the assets will be managed in a way that will cause them to increase in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network (specific group).

A coin, token or asset in itself may not be a security, just as the orange groves in Howey were not. What makes an asset or coin a security is how it’s being sold and the reasonable expectations of purchasers. When someone buys a housing for accommodation, it is probably not a security. But under certain circumstances, the same asset can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. For example, if the housing unit is offered with a management contract or other services, it can be a security.

Is Ether a Security or Commodity?

With this reasoning, digital asset in itself is not a commodity, however, the way an asset is packaged and sold to non-users by promoters to develop the blockchain with an expectation of profit, can be, and, in that context, most often is, a security.

With bitcoin, there is no central third party whose efforts are a key determining factor on the blockchain. The network on which Bitcoin functions appears to be decentralized from inception. Aside from the Initial Coin Offering (ICO) that was undertaken when the blockchain was being developed initially, the current state of Ethereum network and its decentralized structure thus current offers and sales of Ether do not seem to constitute a security transaction.

Finally
From this understanding, can a digital asset that was originally offered to mimic a security offering ever be later sold or classified in a manner that does not constitute an offering of a security? In cases where the digital asset represents a set of rights that gives the holder a financial interest, the answer is likely “no.” However, considering the fact that some aspects resemble that of a security and others a commodity, a clear regulatory clarity needs to be provided here, to bring confidence in the markets, since the crypto and regulated or centralized financial system are interlinked. that being said, the labelling of a transaction does not necessarily change its substance to make it exempt from the purview of the U.S. securities laws.




REFERENCE
The speech by William Hinman at the Yahoo Finance All Markets Summit, 2018



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