Ethereum’s Security Problem

Ethereum has ambitions to become the world’s first distributed computer running applications that accomplish a varied set of tasks on its platform. But the cryptocurrency will have to contend with SEC regulations before it reaches that goal.

According to a WSJ report, federal securities and commodities regulators are analyzing whether “widely traded cryptocurrencies” should be regulated as securities. “The inquiry includes a focus on ether,” Paul Vigna, the Journal’s reporter, writes.

While bitcoin has the largest market capitalization of any cryptocurrency, ethereum dominates in other measures. According to etherscan.io, there are 454 ethereum tokens trading in cryptocurrency markets currently. The list does not include ether, which has the biggest market cap owing to its status as ethereum’s native token. Others, such as EOS and Cardano, have made rapid gains in the last year.

Regulatory agencies have become increasingly vocal about their intentions to bring cryptocurrency tokens under the regulatory umbrella. While testifying during a Congressional hearing in February this year, SEC Chairman Jay Clayton reiterated his stance from earlier when he stated that most of the initial coin offering (ICO) tokens he had seen were security tokens.

Former CFTC Chairman Gary Gensler recently told audiences at the MIT Business of Blockchain conference that there was a strong case for Ethereum and Ripple to be considered securities. In making their case for cryptocurrency tokens to be classified as securities, the SEC is using the Howey Test as its basis. The test, which was formulated back in 1934, defines an investment contract as one that involves a person investing his or her money into a common enterprise with expectations of profits due to promotion efforts by a third party.

Ether’s ICO took place in 2014 and was a resounding success. But the Journal’s report quotes the SEC as saying that it was “probably an illegal securities sale.” Ethereum is backed by the Ethereum Foundation and its cryptocurrency, ether, has appreciated considerably since the ICO. While they have not explicitly promised profits in their whitepaper, other ICO tokens have also risen on the back of an ICO boom. For example, EOS, an ethereum token, rose by 199 percent in the last month.

Joseph Lubin, an Ethereum cofounder, told online publication www.thestreet.com that his team was “extremely comfortable” with their argument for ethereum not being a security. “We spent a tremendous amount of time with lawyers in the US and in other countries, and are extremely comfortable that it is not a security; it never was a security,” he told the publication, adding that they were “absolutely unconcerned” about current discussions. 

How Will A Security Classification Affect Crypto Tokens?

Classification as securities could affect the crypto tokens in several ways. First, it might clean up the ecosystem. Unscrupulous actors, who form an overwhelming majority of promoters, might become an anomaly under the SEC’s rules. The move might also end up in the delisting of several crypto tokens that are currently available on cryptocurrency exchanges based in the United States.

Second, it could cause also cause problems for existing tokens. To get around the SEC’s regulations, crypto promoters have devised the Simple Agreement for Future Tokens (SAFT). The agreement promises future tokens in exchange for investment today. At the time of a SAFT sale, tokens are generally under development or have not been issued. The agreement can be construed as promise of equity on a crypto platform at some future date, when the token has been completely developed. It is modeled after a similar mechanism used by seed and angel investors to fund in tech startups. The problem is that SEC is already said to be cracking down on SAFT tokens.

During a conversation at the MIT Business of Blockchain conference, Gary Gensler said that he doubted if utility tokens could evolve into securities (which is the promise of SAFT) at a future date. Filecoin is the most prominent example of a SAFT agreement. But there are other tokens which have not used SAFT and still raised money from the markets. For example, EOS, whose platform will be released on June 2nd, is currently the fifth-most valuable cryptocurrency.      

Third, it could cool down the red-hot market for ICOs. The SEC has strict disclosure requirements for ICOs, which include filing of documentation and divulging information about teams and governance. As of this writing, ICOs have no such requirements. Whitepapers are released to accompany an offering only as a courtesy to the community. It could also drive up costs for an ICO. Preparation of documentation for compliance with SEC regulations is already emerging as an industry.