Ethereum is a Security: Is it a Controversial Absurdity from The SEC’s Tightening Policy

The SEC recently launched a new round in “Regulation by Enforcement” regulation of the encryption market. Kraken and its ETH staking service (Staking as a Services) were the first to suffer. This regulatory enforcement has created panic in the market and even the absurd claim that “Ethereum” is a security. To explain why “Ethereum” is not a security, ETH Solo Staking does NOT constitute an investment contract and Kraken’s ETH staking products is a security, we have compiled an article from Paradigm. It explains that POS cannot satisfy the conditions of “common cause” or “other people’s effort” in the Howey Test. Therefore, ETH Solo Staking will not constitute an investment contract, so it is not a securities transaction.Background introductionAfter Ethereum shifted from the proof-of-work( PoW) consensus mechanism to the proof-of-stake (PoS) consensus mechanism, some people, including SEC Chairman Gary Gensler, believe that Ethereum’s new equity model may lead to ETH being regulated by the US Securities Act are considered “securities.” The reasons are: (1) POS validators need to lock 32 ETH for “investment”; (2) participate in the “common cause” composed of various validators; (3) have profit expectations from obtaining staking rewards; (4) profit Efforts from other validators or other parties involved in the validation process.Leaving aside whether the verifier’s deposit of ETH into the smart contract is in line with “money investment,” the behavior of ETH or staked ETH is regarded as an “investment contract” because it cannot satisfy the second point (common cause) and the fourth point of the Howey test (other people’s efforts) and cannot be established. Additionally, no one on Ethereum has access to information that might need to be disclosed to public. The following analysis shows that Ethereum’s transformation to POS does NOT make ETH or ETH staking behaviour an “investment contract”. Unless an exemption is granted, the U.S. Securities Act requires all issuers to register with the SEC for the issuance or sale “securities.” Registering requires issuers enforce disclosure, ensures that investors can make informed decisions, avoids any information asymmetry and avoids agency problems. A contract, plan, transaction or agreement must meet all four dimensions in order to qualify. The court uses a flexible interpretation of the “investment agreement”, focusing on the “economic realities” between the promoters and investors. Many courts have used an “economic reality” interpretation in order to limit the scope and application of the Securities Act to “investment contracts”. The following analysis shows that ETH staking does not have “horizontal” or “vertical” commonality. Accordingly to the Howey test, POS cannot be considered “common cause”. Legal Basis. “Horizontal” is when investors are linked to each other by committing their funds to a pool (often agreeing in proportion to the profits). Promoters must combine investors’ funds and use them to promote a common cause. The court stated that “horizontal commonality” means that investors must be able to link their expected profits with other investors “through entrepreneurial efforts of the promoters.” This requires investors to give up any personal claim on profits in return for sponsorship. Individuals have proportional rights to the distribution of the profits. Some views incorrectly believe that there is “horizontal community” in ETH staking, as validators deposit ETH into a single smart address (a pool), or that there is some cooperation between validators. These views are misunderstood and a misunderstanding of the ETH staking system. First, 32 ETH must be deposited to a smart contract address (called a “deposit contract”) in order to become a validator. Depositing ETH into a contract to deposit ETH is not a way to deposit into a pool. The Ethereum network will never be managed by one person. ETH staking, on the other hand, is intended to create an incentive mechanism to ensure the functioning of the Ethereum network. To ensure that validators have a certain interest in it, the network must first be verified. Each validator’s ETH is deposited into the deposit contract. However, the ETH can still be distinguished and each validator will be able, after the network upgrade to the Ethereum network, to get their staked ETH back. Individual validators do not have the right of a pro-rata portion of the common cause’s profit. The rewards of validators vary depending on their individual efforts. Validator input is not affected by the success or failures of promoters. Courts should therefore find a lack in “horizontal commonality” when analyzing ETH collateral’s economic realities. Some courts believe that the condition of “common causes” in the Howey test may also be satisfied by “vertical mutuality,” which focuses more on the relationship between the investor and the promoter. This requires that both have a high level of wealth. However, since the Ethereum network has no initiator, there is no “vertical commonality.”Generally speaking, the smooth operation of the Ethereum network does not depend on any key party; it is “fully decentralized.” To ensure decentralization, Ethereum’s consensus mechanism allows validators to operate independently without relying on any third party. Validators are free to join or withdraw from the Ethereum network at their discretion. Validators can assume their roles according the rules of Ethereum without having to rely on others. Validators will be rewarded according these rules and not the efforts of initiators. A detailed analysis of the economic realities of ETH staking reveals there are no originators that validators must rely on.POS does NOT meet the “efforts of others” condition in Howey testLegal basis According to the Supreme Court’s statement in the Howey case one condition of an “investment agreement” is that the investor expects to profit only from the efforts or a third-party (solely from the efforts or a third person). The appellate court emphasized the importance of the promoter’s efforts in ensuring the cause’s success, and downplayed the “only”, (solely) test. According to the SEC’s guidance on these efforts, the court focused instead on whether the promoter was able to control the profitability and success of the investment. The lower the likelihood that an investment transaction will be classified as an “investment contract,” the greater the investor’s ability to control the earning power of the investment through his own efforts. In such cases, the Securities Act and disclosure requirements to the sponsor may not be required. The Schaden test was used to determine whether an investor is “able to control”. It includes (1) investor’s access and (2) investor’s contractual powers. (3) Investor’s time and effort. (4) Adequacy of financing. (5) The nature of business risk. (6) Some views believe that Ethereum’s transition to proof of work and proof of equity is a transition to a competition mechanism. This is because verification in proof of equity requires multiple parties to participate. This view states that validators can expect to rely on other validators when staking ETH to earn staking rewards. As you can see, Ethereum validators are less cooperative with POS than they are in POW. Validators are mainly rewarded based on their own efforts and funds. It is important to understand how validators are rewarded under Ethereum POS. Verifiers will be rewarded every epoch (6.4 min) under the POS mechanism. The base reward Solo is determined based on the total active stake (total active stake) and dynamically adjusted to encourage the required size validator set. The network’s total stake is the most important factor in determining the rewards for validating exchanges. Verifiers can be rewarded in the following ways: (1) correct source, (2) correct target, (3) correct block header. These 3 types of verification (voting), are collectively called “accurate reward” accuracy reward. (4) Include their validation (voting), in a block (“inclusion rewards”). The researchers found that the ETH balance of the validator, which is capped at 32 ETH, determines the amount of inclusion rewards. The rewards and penalties are proportional to the verified balance. The validation reward will depend on how often a validator receives a block of ETH randomly within a given time frame. After analyzing the economic reality of ETH staking the court should conclude that it does not meet the Howey test as “efforts by others”. Validators are responsible for determining the rewards for staking. They do not rely on administrative efforts from third parties. As stated above, validators’ rewards are largely determined primarily by the amount they stake and the chance they get to propose a block. These are both based on individual efforts, and are not dependent on any administrative efforts by third parties. The Schaden test shows that there is no information asymmetry within the control of the verifier. The reward is based upon an open-source protocol and the distribution is recorded on a public blockchain. The Schaden test shows that there is no information asymmetry in the control of the verifier. The reward is based on an open-source protocol and is recorded on the public blockchain. It is also unclear whether depositing ETH to an Ethereum address qualifies for a “money investment.” This means that the court should conclude that the ETH POS pledge does not satisfy the Howey test. Securities regulation was established to reduce the information gap between investors and promoters. If ETH staking is deemed an “investment contract,” then a disclosure requirement would be imposed upon the originator. As you can see, ETH is not identifiable when a validator deposits it as collateral. If we comply with the Securities Act’s disclosure requirements and allow the verifier to assume the role of “sponsor”, or “issuer,” it is not unreasonable for the verifier that they fulfill their obligations of securities registration and periodic reporting. Is the Securities Act a requirement that verifiers provide relevant disclosures? What information must validators disclose? How will this resolve any information issues and serve the public interest? These unrealistic questions show how flawed the logic of applying Securities Act to validators on Ethereum network is. They don’t present the risks that disclosure is intended. We encourage you to do your research before investing.Join us to keep track of news: NewsTags: ETHEthereumPoSSECsecurityStaking as a Service