Ethereum PoS Is Not a Security, Here Is Why

The second largest cryptocurrency, Ethereum, may be under the tight scrutiny of the SEC after it shifted to the Proof-of-Stake model. Is ETH PoS security?

The Securities and Exchange Commission is closely examining the cryptocurrency market. They are already fighting a legal battle against Ripple Labs, the company behind XRP. 

The SEC alleges that the Ripple labs sold XRP tokens worth $1.3 Billions between 2013 and 2020 through illegitimate means because XRP wasn’t registered as a security, yet it was offered to investors globally. The curtains could soon fall on the Ripple Labs vs. SEC case, which could set a precedent for future instances in which the crypto’s status as security is being questioned. But before the XRP vs. SEC case can come to a conclusion, there are various speculation if ETH PoS is a security.

Is Ethereum the new target of the SEC?

The SEC Chairman Gary Gensler told reporters from The Wall Street Journal that certain cryptocurrencies that allow staking facilities to their investors might pass the Howey test.

“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,” Gensler told reporters after a congressional hearing. However, he didn’t name any cryptocurrency specifically.

The Howey test is a crucial criterion used by courts to decide whether an asset should be considered a security under US laws. Investment instruments such as stocks and bonds are classified as securities.

How is the Howey test applied to prove an asset, a security

According to The Securities Act of 1933, an investment contract should have three prongs. A contract should satisfy all three prongs. If an instrument does not meet even any one of the prongs, it cannot be considered security.

1. An investment of money
2. In a common enterprise
3. With reasonable expectations of profits derived solely from the efforts of others

The prong one states, “An investment of money” The validators depositing their ETH in the smart contract to validate the transactions and keep the Ethereum blockchain secure is not necessarily “an investment of money.” They are putting ETH as collateral to participate in the PoS mechanism. They are not making a purchase or an investment.

However, this argument may be valid technically. Still, it cannot be considered a solid argument because the ETH deposited as collateral can be viewed as a “risk” and may fall under the investment criteria. 

Does Ethereum satisfy the second prong?

Under the second prong, “In a common enterprise,” there are two tests of Commonality:

1. Horizontal Commonality means the individual’s capitals are tied to each other by “pooling of funds.” It is combined by pro-rata distribution of profits. Some believe that staking ETH qualifies horizontal Commonality because the fund is staked in a “common” smart contract, which means “pooling of funds.” It is not pooling because no promoter or central authority has direct control over the staked ETH. The validators stake 32 ETH in a common smart contract, but the staked ETH remains distinct and bound to their node. Validators are incentivized to validate the transactions or slashed if they are involved in some malpractice. There is no impact on all the other validators based on the successful actions or failures of a single validator. Hence there is no pro-rata distribution of profits. Thus the Horizontal Commonality is irrelevant.
2. Vertical Commonality: The vertical Commonality focuses on the relationship between the investor and the issuer/promoter. It is irrelevant in the case of Ethereum because there is no promoter. Ethereum is a decentralized and open-sourced project. Anyone can join the Ethereum network as a validator. They are rewarded or slashed based on their actions through the codes of smart contracts. The rewards they receive are not due to the efforts of any promoters or issuer.

Hence Ethereum fails to satisfy both the test of Commonality. Failure of even one of the prongs proves that Ethereum cannot be considered a security as per the Howey test.

Does Ethereum satisfy the third prong?

The third prong states, “With reasonable expectations of profits derived solely from the efforts of others.” 

The staking reward in Ethereum is determined by the validator’s own efforts, as explained earlier. It does not “solely depend on efforts of others.” The validators are putting efforts into maximizing their up-time and remaining connected to the network.

Ethereum fails to satisfy, if not all, but 2 out of 3 prongs. Hence ETH PoS is not a security.

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