The quantum mechanical properties of Ether
Superposition is a quantum property that effectively refers to the ability to simultaneously be in multiple states.Ether (“ETH”) appears to be in superposition as commentary suggests it is and isn’t a security at the same time. In 2018, William Hinman, then Director of the SEC’s Division of Corporation Finance, implied that Ether was initially offered through a securities offering but was no longer a security at the time.
Typically, a product that begins as a security remains a security so I see issues with Hinman’s analysis, which I will refer to as Hinman’s puzzle. Issues with the Hinman puzzle have recently been highlighted by former SEC Commissioner Joseph Grundfest in the context of the SEC’s complaint concerning XRP. Grundfest has stated that the SEC has not adequately delineated the difference between ETH and XRP in coming to the conclusion that XRP is a security and ETH is not. For example, both issuances were centrally issued, included premines and had continuing issuances.
Hinman’s reasoning seemingly hinged on his understanding of there no longer being any central enterprise being invested in, and thus purchasers no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts. In other words, Hinman’s position is that assets can transition out of security state through sufficient decentralization. As stated by Hinman, “when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.”
when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.
And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins.
Ethereum 2.0: Securities analysis
The last part of Hinman’s statement produced above is powerful: in systems that rely on central actors whose efforts are a key to the success of the enterprise, securities laws apply.
I won’t use this forum to delve into a debate regarding Hinman’s previous conclusion that there are not central parties whose efforts are a key determining factor in the enterprise with respect to BTC and Ethereum, as one need look no further than Blockstream / core developers / “co-owners” responsible for final publication authority in the case of BTC and the Ethereum Foundation / core developers / Vitalik Buterin in the case of ETH. The economic and technical control, power and influence over development, information asymmetries, experimenting, changes to protocols and conflicts of interest issues regarding these central parties should give the SEC and other regulators cause for concern and reasons to revisit the Hinman puzzle.
Notwithstanding the above, for the purposes of this article, with respect to Ethereum 2.0, I want to revisit the securities analysis based on Hinman’s emphasis that the determination of whether something is a security is not static. Therefore, as implied by Hinman, while a token like BTC or ETH could transition away from classification as a security, it can revert back into security status. If we assume ETH transitioned away from classification as a security, which as stated above is debatable, there are compelling reasons to conclude that Ethereum 2.0 brings it back to its state as a security—thus, as the title of this article implies, ETH’s journey from a security to a security.
Issuer Liability: Application of digital asset securities laws to Ethereum 2.0
There are, at present, compelling reasons to conclude that the SEC and federal courts are likely to decide that the launch and buildout of the Ethereum 2.0 network constitutes an investment contract under Howey. At the highest level, the transaction between the Ethereum Foundation and the initial validator investors bears resemblance to Telegram’s and Kik’s initial private sales to investors, which qualified as securities transactions (the SEC v. Kik Interactive, Inc. and SEC v. Telegram Group decisions applied the securities framework to token sales). As in both cases, the Ethereum Foundation promised to develop the Ethereum 2.0 network and deliver the ETH2 tokens earned as interest to the initial validators upon the successful launch of this platform. Likewise, as in both Telegram and Kik, there is no consumptive use for the tokens earned on the Ethereum 2.0 network in its present form. Notably, Telegram conceded that this transaction constituted an investment contract.
Bearing in mind that the Howey test is always highly fact-specific, an independent analysis likewise results in the same conclusion. As to the first element under Howey, a court would likely find that the validators have made an investment of money in the Ethereum 2.0 network because the validators are staking a valuable currency equivalent in exchange for the pledged interest payments. First, users that want to earn rewards for helping to secure the network and process transactions must deposit 32 ETH tokens into a smart contract on the original Ethereum blockchain. An equal amount of ETH is then created on the Ethereum 2.0 beacon chain, which is represented as a new token on that chain, and which the user can put up as collateral to become a validator. These validators only received their 32 ETH on the Ethereum 2.0 network because the critical mass validator threshold was reached, allowing the Ethereum 2.0 network to launch. Second, the ETH created on Ethereum 2.0 cannot be sent back to the original Ethereum blockchain. Third, validators will immediately begin earning interest—potentially as high as to 20%—on their initial 32 ETH investment.
As to the second element of Howey, a common enterprise, the $325 million of ETH staked to launch Ethereum 2.0 would likely be considered a pooling of funds that would give rise to horizontal commonality. As the court held in Kik Interactive, the “key feature” defining a common enterprise “is not that investors must reap their profits” in a specific form or at the same time, but rather is “that investors’ profits at any given time are tied to the success of the enterprise”. Specifically, “the nature of a common enterprise [is] to pool invested proceeds to increase the range of goods and services from which income and profits could be earned or, to increase the range of goods and services that holders of [the digital asset] would find beneficial to buy and sell with [that digital asset]”.
A court is likely to find that the ETH staked to the Ethereum 2.0 network satisfies this test. First, over 16,000 validators collectively staked $325 million, a threshold that was required for the launch of the Ethereum 2.0 network to occur. Second, the ETH created on the Ethereum 2.0 network cannot be sent back to the original Ethereum blockchain, and it cannot be used for any consumptive purposes on the present version of the new Ethereum 2.0 network. Rather, the future value of the staked ETH, if any, turns entirely on the Ethereum Foundation completing the four promised phases of Serenity leading to the merging of the Ethereum mainnet and the Ethereum 2.0 network. Absent a merger of the two networks, the ETH held on the Ethereum 2.0 network would have no consumptive uses and no real value. Thus, these features lead naturally to the conclusion that the $325 million of staked ETH constitutes the pooling of funds to not just increase, but create, the goods and services that holders of the ETH on the Ethereum 2.0 network can use this asset for. In addition, as the Ethereum Foundation has explained, the launch of Ethereum 2.0 is necessary to allow for the scaling and sustainability of the Ethereum mainnet. Thus, if the four-phase plan succeeds, once Ethereum 2.0 has smart contract capability and is merged with the Ethereum mainnet, this could result in an enormous increase in the range of goods and services for which the ETH token may be used.
As to the third element, a reasonable expectation of profits, there are several factors that would support a finding that the validators have acquired additional ETH tokens on the Ethereum 2.0 network (via interest payments) with investment intent. A court would likely find that the following facts weigh in favor of finding a reasonable expectation of profits. First, the ETH earned on the Ethereum 2.0 network is locked on this network until and unless there is a merger with the Ethereum mainnet, and cannot at any point prior to such merger be sent to the Ethereum mainnet. Second, no consumptive transactions or smart contracts can presently occur on the Ethereum 2.0 network. Third, the Ethereum 2.0 network does not have an existing marketplace where the earned ETH tokens are accepted for consumptive use.
Accordingly, the value of the ETH tokens earned as interest payments at present is entirely speculative, and the future value turns entirely on the Ethereum Foundation successfully executing on its four-phase plan leading to the merging of the Ethereum 2.0 network with the Ethereum mainnet. If the Ethereum Foundation does succeed in its plan, these token stand to have a greater value (potentially significantly greater value) than the current market value of ETH tokens, because the merged Ethereum network will have greater capabilities—most notably vastly increased scalability. That potential value is substantial. If the Ethereum Foundation fails, the tokens could ultimately be worthless. Investors understand this.