Food for Thought: Will Ethereum’s Shift to Proof of Stake, from Proof of Work, Turn it Into a Security?

Here is an interesting thread I was following recently on Twitter.

As we all know, Ethereum is planning to change from Proof of Work (PoW) to Proof of Stake (PoS). There is no need to dive into the pros/cons .. shoulda coulda debate now, but an interesting discussion regarding its status as a non-security came up in the virtual discussion.

To step back a bit, in June this year, Bill Hinman, the Director of CorpFin at the Securities and Exchange Commission (SEC), pronounced at a Yahoo conference that Ethereum will not be considered a security. To quote;

“… 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.”

The crypto industry breathed a collective sigh of relief.

This appears to be hardening as policy as SEC Chair Clayton has referenced this understanding as recently as this past week.

But in clarifying the “decentralization test,” Hinman raises other questions. What if a non-security crypto becomes less decentralized?

Recently, someone more knowledgable on the topic than I, explained the decentralization test;

“Hinman basically indicated that tokens might avoid securities regulation if the platform is sufficiently decentralized.   What that means is likely to be debated for some time unless the SEC gives concrete guidance.  However, most initial coin offerings (ICOs) I see are substitutes for VC funding where the issuer plans / needs to have a very active role for quite a while / forever.  Even if you read Hinman to allow for the possibility of converting securities into non-securities, I don’t see the majority of ICO projects getting close to an Ethereum / bitcoin like level of decentralization.”

Thus ICOs are, pretty much, always a security.

But taking this debate a step further, would a more centralized Ethereum morph it back into something the SEC would take more interest in? Can you put the Genie back into the bottle?  I am not quite sure.

We reached out to Dan Rice, co-founder and CTO of Sagewise – a legal dispute remediation site for smart contracts, and posed the question;

“Ethereum’s planned move to Proof-of-Stake changes the control dynamics of the network. Right now under Proof-of-Work, miners control network block creation, but under Proof-of-Stake that responsibility shifts to coin stakeholders,” says Rice. “Given that the SEC comments around Ethereum related specifically to it being “decentralized”, the question is, how did they determine it was “decentralized”?

While it is still opaque, there is a chance that Ethereums move could cause the SEC to revisit the current non-security;

“Did the existence of miners play a role in that opinion?  Proof-of-Stake design has some additional commonality with publicly traded company structure in that shareholders/coin-holders have voting power over aspects of the entity,” adds Rice. “The significant difference is that cryptocurrency coin-holders are generally pseudo-anonymous. I don’t believe that pseudo-anonymity makes it more decentralized, but it certainly makes it hard to tell who has control of the network.”

Rice says it would be fascinating if this type of consensus affected the SEC opinion on decentralization.

“I suspect people would shy away from Proof-of-Stake if the SEC suggested that made it more likely to fall under their jurisdiction. For Ethereum, Proof-of-Stake could mean that they voluntarily converted to a system that invited additional regulatory concerns. At some point we probably do need to come up with standardized ways to measure and define “decentralization” and that may clear things up.”

Of course, a bit more clarity, and less circumspection from the SEC would help to clear things up. Perhaps, at some point in the near future, the Commission will offer better guidance but for now, it is certainly food for though.

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