The original intent of cryptocurrency inventors was to create a digital currency free from the government or any major entity’s control. However, as cryptocurrency becomes mainstream in transactions, it has continued to attract attention from government regulators.
The recently highly celebrated shift by Ethereum, the second largest cryptocurrency, from proof-of-work to prove-of-stake has attracted closer scrutiny by the Securities and Exchange Commission (SEC). As a result, this may have a massive effect on the future of digital currency in terms of government regulation.
What Is The Ethereum Merge?
To a layperson, “merge” could mean a coming together of two companies. But the merge in regards to Ethereum has nothing to do with coming together. Instead, it refers to an upgrade to Ethereum validation mechanisms for transactions.
Traditionally, Ethereum mechanisms of validation were proof-of-work. Following the merge, the Ethereum mechanism of validation is now proof-of-stake. It is this shift that has attracted new scrutiny from the SEC.
According to Gary Gensler, the SEC chair, the staking services coming with this shift are similar to security investment options warranting regulation.
What’s The Main Difference Between Proof-of-Work And Proof-of-Stake
The terms proof-of-work and proof-of-stake have been used extensively since the Ethereum “merger.” If you are new to the nitty gritty of cryptocurrency, these terms may not make much sense to you.
Both terms refer to consensus mechanisms that ensure that cryptocurrency users are honest with their transactions.
These mechanisms make it expensive and difficult for bad actors to engage in fraudulent activities while incentivizing honest actors, thus reducing the chances of fraud, such as double-spending.
They are the one reason cryptocurrencies have remained relatively safe while existing entirely on the internet, where fraud and cyber-crimes are rife.
Under proof-of-work, a user can only earn or create a token through mining. Mining involves cracking complex mathematical equations using computers to validate a transaction or create a token.
Under proof-of-stake, a user can only earn or get a token by buying an existing token and locking it to have a chance to be used as a validator to earn new tokens.
Under the new approach, mining on the Ethereum blockchain becomes absolute. The idea behind this move was to establish Ethereum as a stable cryptocurrency.
The Howey Test
The role of the Securities and Exchange Commission (SEC) is to regulate securities. The SEC relies on the Howey Test to determine whether an investment is a security. The Howey Test comprises a set of standards that an investment must fulfill to be considered a security.
The Howey Test originates in the mid-1940s SEC v. W.J. Howey Co supreme court case where Howey Co., a Florida-based company, sold plots of a piece of land with mangrove trees. The company then leased the land from the farmers, grew orange groves for sale, and shared some of the profits with the farmers as dividends.
The SEC filed a lawsuit against the company for failing to register the transaction with them, culminating in the Supreme Court ruling in their favor. The court ruling formed the basis of the Howey Test.
Under the Howey Test, an investment can be ruled as security if:
- It involves monetary investment
- It is a common enterprise
- The investors expect to make a profit
- And the profit is to be derived from the effort of others
How The Howey Test Applies To Ethereum’s Merger
According to the SEC, the proof-of-stake approach to transaction validation satisfies the Howey Test. First, Ethereum has a monetary value that satisfies the first test of monetary investment. Cryptocurrencies have also become commonplace, satisfying the second requirement.
With the merger, a user buys an Ethereum, locks it to be chosen to validate a transaction, and expects to profit from it, satisfying the third and the fourth element of the Howey test.
Most investors only need to know that they can make a profit, meaning that many can buy crypto alongside the stocks, which calls for the need for regulation. The involvement of the SEC is not a bid to curtail the growth of cryptocurrency but to ensure that the investor’s interests are protected.
Are All Cryptocurrencies Securities?
Not all cryptocurrencies are securities. According to the SEC, most cryptocurrencies are a replacement for sovereign currencies such as the dollar, euro, yen, and thus not securities.
According to Gensler, the Securities and Exchange Commission’s chair, it is only the cryptocurrencies or their intermediaries that allow investors and users to stake their coins pass the Howey test and thus fall under the category of securities and the purview of the SEC.
Ella Marcotte
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