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Will Ethereum Transition To Proof-of-Stake Lead To Regulatory Issues?


Unlike Proof-of-Work (PoW), which requires mathematical calculations with varying complexity to create blocks and validate/verify transactions, PoS mining, as a rule, requires that the operators of validator nodes store a certain amount of cryptocurrency on their digital wallet (staking). Besides, miners who successfully solve the mathematical problem get at their disposal a fixed amount of cryptocurrency along with the release of a new block, while in PoS, rewards for validators are distributed in proportion to their share in the total pool.

How Can Ethereum 2.0 PoS Model Be Interpreted In The Context Of Securities Laws?

The starting point for determining whether something is a “security” in the context of US law is the legislative definition of a security, which can be found in section 5 of the Securities Act of 1933 and section 12 (g) of the Securities Act.

“The goal of Congress when issuing securities laws was to regulate investments, whatever form they took and whatever name they used. For this purpose, a broad definition of “security” is introduced, sufficient to “include literally any instrument that can be sold as an investment”. ”

Both documents say that an “investment contract” is included in the definition of a security. As the SEC and at least one federal district court have previously stated, digital asset businesses are subject to analysis for their “investment contract”. Since the Ethereum 2.0 PoS model is associated with digital assets, this analysis also applies to it.

In the 1946 SEC case law case, the Supreme Court ruled: “An investment contract for the purposes of the Securities Act” refers to a contract, transaction or scheme in which a person invests his money in a joint venture and is guided by profit expectations solely from actions that offer party or third party. "

According to Howey test, widely used in American judicial practice, the definition of an investment contract “embodies a flexible rather than a static principle that can be adapted to match the myriad of different schemes created by those who seek to use the money of others against the backdrop of promises of profit.”

The Howey test requires the following elements to be present in the contract in order to be recognized as investment (i.e., security):

  • Investment of money;
  • In a joint venture;
  • With reasonable expectations of profit;
  • From the actions of third parties.
  • Each of these elements will be considered by the SEC in relation to the Ethereum 2.0 PoS model.

Money investment

According to the latest data in the Ethereum 2.0 repositories on GitHub, the user must stake 32 ETH in order to gain the rights of a validator node. Obviously, this event constitutes a "money investment." The fact that Ethereum is not a recognized form of money is not significant for the Howie test.

In a joint venture

The U.S. Federal Judicial System recognizes three tests that vary depending on the jurisdiction of a particular court.

This issue also is not difficult in the light of the interpretation of SEC securities laws. On April 3, 2019, the regulator published the “Framework for the analysis of the“ investment contract ”in the context of digital assets.” It states the following: “The SEC does not require horizontal or vertical commonality as such and does not consider a“ joint venture ”as a distinctive element of the concept of an“ investment contract ”.”

In addition, in the same document, the regulator states that, based on previous experience, he was able to establish that a “joint venture”, as a rule, exists. The question of whether the federal courts support the SEC position in this case is beyond the scope of this article. However, there is every reason to believe that at least the SEC will see a joint venture in Ethereum 2.0.

With reasonable profit

This is the easiest question. The Ethereum 2.0 specifications themselves state:

"The validator is an optional role for users, within which they contribute ETH as a guarantee and indicate the reliability of the blocks in anticipation of financial benefits."

In 2004 SEC v. Edwards, the Supreme Court ruled: “In accordance with common sense,“ profit ”for the Howie test should mean“ return on capital from investments ”.”

Actions of third parties

Howey test says, that expectations came solely from the actions of the offering party or third party. Thus, this item can be challenged, since the user will have to make some efforts to launch the validator node in order to receive “financial rewards”. The steps that need to be taken by the user to start receiving rewards in Ethereum 2.0 have already been described above. Deviation from any of the points will lead to the fact that the user will not be able to participate in the full cycle of staking. From this, we can conclude that the expectations of profit, in this case, are not exclusively associated with the actions of third parties.

Unfortunately, “in the light of the corrective nature of American securities law,” federal courts have adopted “a more realistic test to determine if the efforts made by a person other than the investor are certainly significant to influence the success or failure of the enterprise.”

Here it is necessary to return to the statement by Hinman, who said that the SEC does not see the security in Ethereum 1.0: “If the network on which the token or coin operates is decentralized, where buyers can no longer reasonably expect that a person or group will accept critical managerial or entrepreneurial measures, such an asset may no longer represent an investment contract. ”

So the main question is: will the Ethereum 2.0 network be “fairly decentralized,” which SEC does the Ethereum 1.0 network think?