Ethereum 2.0, Staking, and the Howey Test

In the fast-paced and innovative realm of digital currencies, traditional financial regulatory frameworks are regularly tested and challenged. One such digital currency, Ethereum, sits prominently at this juncture of technology and law, especially with its monumental shift from a Proof of Work (PoW) to Proof of Stake (PoS) consensus mechanism, completed on September 15, 2022. This transition prompts a crucial question: Can Ethereum 2.0, and other similar Proof-of-Stake-based cryptoassets, be considered as securities under U.S. law? 

The Howey Test and the Fourth Prong 

To navigate this regulatory labyrinth, we lean on the Howey Test, a legal litmus test arising from the landmark U.S. Supreme Court case SEC v. W.J. Howey Co. (1946). The test determines whether a transaction constitutes an “investment contract” and thus qualifies as a security. It lays out four crucial criteria: 1) an investment of money, 2) in a common enterprise, 3) with an expectation of profit, and 4) derived solely from the efforts of others. However, with the intricacies of Ethereum 2.0 and similar PoS-based cryptoassets, the interpretation of the fourth criterion becomes highly contentious. Do the token holders participate in a non-trivial manner that leads to potential profits, or are the profits genuinely derived “solely from the efforts of others”? 

Ethereum 2.0’s PoS model sets itself apart through its active participatory structure. Token holders have the option to become validator nodes by staking their Ether (ETH) tokens, pledging them to the network to facilitate transactions, propose new blocks, and uphold the network’s overall security. Running a validator node isn’t a passive process; it necessitates active decision-making regarding transaction validation and active participation in the network’s consensus mechanism. 

This active participation by token holders represents a substantial contribution to the Ethereum ecosystem, directly influencing their return on investment. In contrast to traditional securities, the participatory structure places decision-making authority firmly in the hands of validators. As a contrasting example, it’s worth considering the ruling in Long v. Shultz Cattle Co., Inc. (2008), where despite investors’ participation, the critical decisions dictating the failure or success of the enterprise were solely in the promoter’s control. 

So it’s easy to see that ETH, and other staking tokens that require that one run a validator node, create a situation where significant contribution is added. Thus they are not securities. Now it is true that many PoS systems involve staking tokens without operating a validator node. But even in those instancs, the systems requiring tokens to be “locked” for a specific period, effectively reducing the supply in circulation. By electing to lock their tokens, investors actively influence the token’s price, contributing to their investment’s potential profitability. This strategic decision could again be interpreted as a significant contribution, further blurring the lines in the Howey Test’s “solely from the efforts of others” criterion. 

A Family Resemblance to Non-Securities 

What further complicates this analysis is the very nature of Ethereum as a functional utility token. As a central pillar of the Ethereum network, ETH is burnt or consumed to perform various functions, including paying for transactions and smart contracts on the network. In fact, Ethereum users are currently spending approximately 107.12 billion gas (the measure of computational effort in Ethereum) per day. At an average gas price of 21 gwei (0.000000021 Ether) and an Ether price of $1,869.10, this amounts to over $4.2 million spent on transaction fees every day. These tokens serve as the fuel powering Ethereum’s vast ecosystem of decentralized applications, and their consumption is integral to the network’s functioning. In this context, ETH could be better seen as a consumable commodity rather than a passive investment, subject to consumer protection laws rather than securities regulation. 

The role of Reves v. Ernst & Young (1990) and the “family resemblance” test deserves attention in the discussion surrounding the classification of utility tokens. The Supreme Court ruling established that certain notes could be exempt from securities regulations if they closely resemble instruments exchanged in ordinary business transactions, rather than traditional securities. The “family resemblance” test recognizes that not all instruments should be automatically classified as securities, especially when they possess characteristics more akin to non-security instruments. 

In the context of Ethereum 2.0 and similar PoS-based cryptoassets, the utility function of tokens becomes a compelling argument for exemption from securities regulation. While investors may have an expectation of profit, their primary motivation for using these tokens lies in their functional utility within the respective blockchain platforms. Users rely on these tokens to access and engage with various applications and services, akin to consumable goods in ordinary transactions. This utility-driven usage aligns more closely with consumer protection laws rather than securities regulations. 

Conclusion 

The transformation of Ethereum and the rise of Proof of Stake-based cryptoassets challenge the traditional boundaries of financial regulation. With their unique characteristics and structures, such as active participation through validator nodes and utility-driven purposes, these assets defy clear classification under existing frameworks like the Howey Test. The blurred lines surrounding the “solely from the efforts of others” criterion highlight the need to delve deeper into the specific functions and attributes of these digital assets. 

Moreover, the intrinsic utility of Ethereum and similar tokens, which serve as the foundation for decentralized applications and platforms, calls for a broader exploration of regulatory exemptions through the lens of the family resemblance test. Recognizing their usage and purpose, more akin to consumable goods rather than passive investments, suggests a closer alignment with consumer protection laws instead of securities regulation. 

Ultimately, Ethereum 2.0 — which is now simply Ethereum — serves as a catalyst for rethinking the existing regulatory landscape to accommodate the rapid evolution of digital assets. A comprehensive and adaptable approach is necessary to acknowledge the distinctive features of these emerging technologies while providing judicious investor protection and fostering growth within the industry. Rather than imposing traditional frameworks on an innovative space, regulators and policymakers must strive to create tailored, forward-thinking guidelines and legal interpretations that embrace the transformative potential of blockchain and digital currencies, or better yet, get simply get out of the way.