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Ethereum ETFs In Doubt? SEC Probe Targets ETH as Security

Last Updated March 21, 2024 9:31 AM
Teuta Franjkovic
Last Updated March 21, 2024 9:31 AM
By Teuta Franjkovic
Verified by Peter Henn

Key Takeaways

  • The SEC could find that Ethereum is a security.
  • The regulator’s focus seems to have intensified after Ethereum’s switch to a proof-of-stake model in September 2022.
  • The investigation casts a shadow on the approval of Ethereum-based ETFs.

The United States Securities and Exchange Commission (SEC) is actively pursuing a legal strategy  to define Ethereum, the world’s second largest cryptocurrency, as a security.

This information comes from American companies subpoenaed as part of an investigation.

SEC Scrutinizes Ethereum’s PoS: Could it be a Security in Disguise?

This development a setback for the cryptocurrency industry. In particular, it dampens expectations the SEC would approve proposals from BlackRock and others for an Ethereum-based Exchange-Traded Fund (ETF). This belief gained traction after the SEC’s approval of multiple Bitcoin ETFs in January.

The SEC’s investigation asks companies to provide any documents and financial records related to the Ethereum Foundation. The foundation is a nonprofit organization responsible for the governance and development of the Ethereum blockchain.

A source from one of the companies that recently received a subpoena revealed  the SEC’s examination of the Foundation, which is based in Switzerland, began soon after the blockchain transitioned to a proof-of-stake” governance model in September 2022. Someone from a different company said the request was narrowly focused on the Ethereum Foundation. They also said  that they received their subpoena in recent weeks.

The transition to a proof-of-stake model marked a significant shift for the Ethereum blockchain. It moved it away from the energy-intensive proof-of-work  to a system that depends on a network of trusted validators. This change has given the SEC a fresh basis to potentially classify Ethereum as a security. This is the view of people from three different companies who are familiar with the subpoenas.

Ethereum: Schrodinger’s Security?

The revelation of the subpoenas emerges amid a forceful effort by the SEC and the Biden administration to regulate the cryptocurrency industry. Cryptocurrency’s ambiguous legal standing has, however, hindered this, sparking legal disputes over the SEC’s authority over the sector.

At the heart of these legal battles is the question of whether cryptocurrencies fall under the SEC’s jurisdiction as securities. This issue remains unresolved by the courts. Although there is a general agreement that Bitcoin is a commodity and, therefore, falls under the oversight of the Commodities and Futures Trading Commission (CFTC), SEC Chair Gary Gensler says that his agency views the vast majority of other cryptocurrencies as securities, which should be registered with the SEC. He has reiterated this stance in various court cases, except when it pertains to Ethereum, whose legal status is particularly uncertain.

ETHGate: Ethereum Weathers Storm Despite Regulatory Cloud

The debate over Ethereum’s status as a security has been ongoing within the agency under the now infamous phrase “ETHGate”. For instance, at a conference in 2018, William Hinman, the then-Director of Corporation Finance, expressed the view  that Ether did not constitute a security. Moreover, emails disclosed  during the Ripple lawsuit showed that SEC staff debated the clarity of this position, with one official expressing the view that there was no need for the SEC to regulate Ethereum.

In the immediate aftermath, the controversy surrounding Ethereum’s regulatory status is unlikely to significantly affect, the world’s second-largest cryptocurrency.

Looking ahead, however, the dynamics may shift. The legislative landscape has already shown signs of change, with Congress introducing 35 bills focused on cryptocurrency in 2021 alone. Ethereum traders are well aware of the platform’s high transaction fees,  which can significantly inflate the cost of transactions. For example, acquiring $500 worth of Ethereum tokens or an NFT might incur over $120 in fees. Meanwhile, the trader would also lose up to 4% because of slippage.

Such financial burdens could fuel public demand for more stringent regulation. This could, in turn lead to a future where large-cap cryptocurrencies are treated as regulated assets. This shift towards stricter regulatory oversight could transform the operational and financial landscape of cryptocurrencies like Ethereum.

SEC Chief Tight-Lipped on Ethereum Despite Proof-of-Stake Stance

Under Gary Gensler, who assumed leadership of the SEC in 2021, the agency’s approach shifted, particularly following Ethereum’s transition to a proof-of-stake model in the subsequent year. Gensler indicated that crypto assets generated by blockchains using a proof-of-stake  model might be akin to investment contracts, thereby qualifying them as securities, though he did not refer to any specific cryptocurrency at the time.

In March 2023, he reiterated the possibility  that proof-of-stake tokens could fall under securities regulation, yet he has since refrained  from making specific comments about Ethereum, even during SEC oversight hearings held by the House Financial Services Committee.

BlackRock Bets Big, But Will SEC Fold on Spot Ethereum ETFs?

The complexity surrounding Ethereum’s regulatory status intensified in October when the SEC approved nine ETFs that track the Ethereum futures market. The CFTC regulates this market, so this implies ETH was actually a commodity. Indeed, CFTC Chair Rostin Behnam has repeatedly stated his agency views Ethereum as a commodity.

However, the landscape was muddled further last month when Prometheum, a controversial crypto firm authorized to act as a special purpose broker-dealer, declared its plans to provide custody services for Ethereum, treating it as a security under SEC regulation. This move has reintroduced ambiguity concerning Ethereum’s regulatory classification. One of the recent subpoenas recipients also speculated SEC Chair Gensler might be using Prometheum to categorize Ethereum as a security.

The rush by major financial institutions to secure approval for a spot Ethereum ETF has thrust this dilemma into the limelight. Indications are that the SEC is likely to deny these applications by the May deadline. This is partly based on observations from Bloomberg analysts. They noted that, unlike with the spot Bitcoin ETFs approved in January, SEC staff have not engaged in detailed discussions with applicants about the Ethereum ETFs.

Should the SEC officially classify ETH as a security, it could further complicate the situation. This would cast doubt on the CFTC’s jurisdiction over Ethereum futures markets. As a result, there would be yet another layer of uncertainty covering the regulatory framework governing cryptocurrencies.

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