If ETH Isn’t a Security Then Nothing Is

Ethereum tokens (ETH) are often considered commodities but not securities, like Bitcoins. [1] But I think that ETH meets any common sense definition of “security” and that the ETH ecosystem needs to be closely examined by securities regulators. I’m not a lawyer, and not the right person to be making this argument, but it seems important and urgent — so I hope you’ll forgive any errors. [2]

Ethereum’s Announcement

The Ethereum Project was announced on the bitcointalk.org forum in January 2014 by cofounder Vitalik Buterin. The announcement solicited “investors and evangelists” who would be protected by a “fiduciary team,” and linked to an announcement blog post titled “Ethereum: Now Going Public,” which said:

We will be able to develop fully functional and robust Ethereum clients with as little as 500 BTC funding… To that end, we would like to be able to invest a large quantity of funds into securing top-notch talent for improving the security and scalability of the Ethereum network itself, but also supporting a robust Ethereum ecosystem

An archived snapshot of Buterin’s announcement (taken weeks later) commits the “fiduciary team” to certain trading restrictions, and contains fragments of the planned “IPO and Money Supply of Ethereum”:

The goal of our IPO is to endow an organization, collection of contributors and strategic partners with enough funding to ensure both the Ethereum protocol and the Ethereum ecosystem are bootstrapped to a point of critical mass. We also seek to develop a new type of venture capital

Their whitepaper similarly says:

The issuance model will be as follows:

Ether will be released in a currency sale at the price of 1000-2000 ether per BTC, a mechanism intended to fund the Ethereum organization and pay for development that has been used with success by other platforms such as Mastercoin and NXT. Earlier buyers will benefit from larger discounts. The BTC received from the sale will be used entirely to pay salaries and bounties to developers and invested into various for-profit and non-profit projects in the Ethereum and cryptocurrency ecosystem.

Definition of a Security

In its order halting the Munchee ICO, the SEC stated:

An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

Investment contracts are securities in the US.

The ETH “IPO” is obviously a security by this definition. But there are signs that Ethereum sought legal advice and changed their model. [3] Buterin’s final pre-offering announcement says:

Ether is a product, NOT a security or investment offering… The Terms and Conditions of the Ethereum Genesis Sale, and the Ether Product Purchase Agreement, are the only authoritative documents regarding the sale. Any statements that we have made up to this point are null and void. The ethereum.org website, the blog posts since Taylor Gerring’s recent howto and other posts we have made on various forums including our forum and reddit are to be treated as informal communications designed to keep the community updated on what is happening with Ethereum.

It’s reasonable to let people change their minds after seeking legal advice, provided they haven’t done much yet. Ethereum insiders though, had aggressively marketed the sale as a securities offering beforehand. [4] If they later changed their minds, they seem to have made little effort to correct the public’s perception that ETH would be an investment contract. And the offering documents themselves continue to describe a securities offering [5]:

Parties may be interested in purchasing ETH… to support the development of the Ethereum Platform.

The ETH offering was also not an unregistered SAFT. A SAFT is an untested structure that could fund a coin’s development with a securities offering, and later delivers a finished coin. A coin initially funded by a SAFT *might* not be a security, if “entrepreneurial or managerial efforts” truly do cease after the coin is distributed. When ETH officially launched, the foundation specifically said that it would continue developing Ethereum using funds raised from ETH sales. [6] The foundation’s entrepreneurial and managerial activities continue today.

So Ethereum entities made a cursory effort to claim that ETH isn’t a security, but before, during, and after the offering, they made it otherwise clear that ETH is a security.

ETH’s Flow of Funds

The following is just my general impression from reading ETH documents, and may have errors.

The initial offering raised around 30k BTC, which I believe went to a variety of entities controlled by the Ethereum Foundation. Most of these BTC have been distributed to individuals or sold.

Approximately 6M ETH were retained by the foundation’s treasury, some of which were later sold into the secondary market. As of January 2016, 2.3M ETH were still held by the foundation, with the remainder sold to fund operations or “distributed to its rightful owners”. [7]

Another 6M ETH were “gifted” to early contributors. Some of these “gifts” have been sold into the secondary market. [8]

Economics of ETH Ownership

ETH may be a security, but it is clearly not equity or debt. Normal equity gives owners exposure to all of a corporation’s unencumbered property. ETH gives owners exposure only to the project’s intangible property. Since the project is open source, it probably has limited intellectual property (though it does own trademarks). So, the majority of ETH’s value is derived from its brand, platform, and network.

Parts of the crypto community may argue that this model is fundamentally new to markets. It doesn’t feel that way to me. Many of the most successful companies in the world derive their value from intangible assets.

Even under the modern securities disclosure regime, valuing intangible property can be quite difficult. Market history is littered with the bodies of roll-up companies, and there are indications that ETH could be in this category. As far as I can tell, the biggest use of ETH is to fund ICOs, many of which are themselves platform “companies.” [9] This usage of ETH appears to have been intended from the beginning. In an illuminating interview (promoted by Ethereum) one month before the ETH ICO, Vitalik Buterin described his ideal types of Ethereum-powered platforms — gambling and unregulated fundraising:

Danaylov: If our viewers and listeners were to take a single message from our one hour conversation with you today — like the most important thing that you’d like them to remember — what would that be?

Buterin: Yeah. I would say it really boils down to this idea that Ethereum is not a currency… You can use it [decentralized consensus methodology] for so much more, and I think now is actually the time when we’re starting to move away from ‘Oh, let’s have a decentralized currency for decentralized currency’s own sake.’ And actually realize that there’s all sorts of these different applications where you can actually do so much that you can’t even do in the existing paradigm at all… One of the examples that I always like to bring up is actually gambling. So in 2006, if you wanted to make a gambling site, it would be extremely difficult… In 2012 it got a bit easier, because you got Bitcoin. And with Bitcoin, you can actually do all the currency part without most of the security, without the payment processing, and so forth. In 2014, guess what the gambling sites of the future are going to look like? They’re just going to be Ethereum contracts in 15 lines of code: write them once, click compile, click ‘push to blockchain,’ ‘push to blockchain’ returns to you an Ethereum address, paste the Ethereum address onto a forum, and bam, anyone can gamble.

Danaylov: Well, well, I can see how the casinos are going to love you for that. But I’m personally one of those crazy people who believe that it’s good that it’s hard to get involved into gambling — online or offline.

Buterin: It’s an example, alright. The idea is that you’re taking this industry — it’s actually very bad for consumers right now — because it’s very easy for gambling sites themselves to cheat… Gambling is such a nice example because it’s this sort of pure financial service.

Danaylov: It’s not my favorite example. So let’s do one better than that…

Buterin: So, a good example might be Kickstarter — is another one. So Kickstarter — once again, it’s a great idea — you can actually grab funding together from thousands of different people. People can start these large, well-funded projects without having to go to a VC. It’s good. But at the same time, it’s also inefficient… All the other sites take a pretty good cut too. And at the same time, they’re also geographically limited. There’s a lot of countries I’m sure you can’t really access them at all, right?

So, ETH is supposedly valuable because it’s a platform for other platforms (some of which are, also, platforms for other platforms). It is perhaps more of a roll-down than roll-up. Regardless, the danger of this model makes it doubly important for market gatekeepers (e.g. lawyers, brokers, and exchanges) to do their jobs and ensure securities they help sell are reasonable and compliant.

ETH Brokers and Exchanges

The SEC has made it clear that cryptoexchanges must be registered as ATSs or national securities exchanges if they enable exchange-like trading of securities. That is, if ETH is a security, every major American cryptovenue may be in violation of the law. [10] I don’t know what the penalties would be for violating these (well-known) rules, but they might be higher for venues that understand ETH is a security. Coinbase is potentially one such example.

Coinbase, in marketing ETH, pointed to its active developer community and leadership. [11] Even a casual inspection would have revealed that ETH’s developers and leaders are partly funded through ETH sales. [12] So, either Coinbase didn’t do the most basic diligence before helping retail investors purchase ETH, or they had good reason to believe that ETH was a security.

Update: It appears that Coinbase did recognize that ETH development was financed by ETH sales from the primary offering and later sales in the secondary market. Coinbase also explicitly described ETH fundraising as analogous to traditional securities offerings. This history is particularly interesting in light of Coinbase’s recent Congressional testimony.[13]

We Still Need Securities Regulation

It is easy to get frustrated with our regulatory regime. In one view, unethical participants ought to be deterred by markets’ self-policing mechanisms, so why should we burden ethical participants with all this red tape? It’s been nearly a century since the Great Depression — maybe humans have gotten smarter. Maybe we don’t need post-depression rules anymore.

Cryptocurrencies have been a fascinating natural experiment on the consequences of a complete rollback of regulation. So far, the results are frightening. Perhaps the cryptomarket would eventually learn to police itself, but it increasingly looks like there’d be unacceptable carnage on the way. It’s time to end the experiment before too many people get hurt, and make cryptocurencies follow the same rules as everybody else. Then we can let the market determine their value.

[1] Peter Van Valkenburgh of the Coin Center says:

They [The SEC] have also begun an important process of drawing a distinction between “initial coin offerings” that are securities on the one hand, and decentralized cryptocurrencies on the other, which don’t fit the bill and are more suitably regulated as digital commodities such as digital gold (bitcoin), digital fuel (ether), or digital real estate (filecoin/storj).

[2] This post contains no advice to buy, sell, or trade securities, commodities, virtual currencies, derivatives, or other financial instruments.

[3] Ethereum cofounders Joseph Lubin and Stephen Tual, 3 months before the offering:

We have done even more work on the legal front. We have been working, and continue to work with lawyers in different countries to structure the pre-sale of ether so that it is not seen by securities regulators as an offering of securities. We believe that selling ETH, a fuel that powers applications on the Ethereum platform, does not constitute sale of a security, be we hope to achieve more certainty before starting the sale.

[4] A small sample of times when ETH was described as an investment contract before the offering:

In January 2014, Vitalik Buterin responded to questions on reddit:

Q: Why will these coins [founder grants] be spendable after one year and not immediately?
Buterin: To prove to the world that we are not a pump and dump and are interested in Ethereum for the long term.

Q: What benefits do you have of personally owning pre-mined coins?
Buterin: What benefits do we have? We get profit if Ethereum succeeds; this is obvious. What benefit do you have? The assurance that the five originators of the project are heavily incentivized to do everything in their power to make as high quality a product as possible and not abandon it.

Q: Why create a non-profit?
Buterin: To give fundraiser participants the assurance that they have legal recourse if we run away, and to prevent double taxation (ie. we want to only pay taxes at the point when we spend the money on salaries and bounties, not several times before that)

Q: Why use a fundraiser?
Buterin: To get funds to develop the protocol and applications around the protocol.

Buterin in March 2014:

Q: What’s to prevent this altcoin from developing the same benefits that Ethereum has?

Buterin: Absolutely nothing. We’re even handicapping ourselves, just because everything we do is completely open source. If you’re investing in Ethereum, I would say you’re investing in the team and the community to a large extent.

Joseph Lubin, in May 2014 (2 months before the offering, and 1 month after he stated [3] that ETH was not a security) :

People and businesses are interested in purchasing ETH to power their own business applications, to make use of business applications offered by other service providers, to trade on forthcoming exchanges, or to speculatively hold for future sale to people and businesses. ETH may be purchased in the Genesis Sale (details forthcoming, please watch this space), on forthcoming 3rd-party exchanges and ATMs, and on exchanges that are implemented as DApps on Ethereum.

When purchasing ETH in the Genesis Sale, the buyer is supporting the development of the product, just as with a kickstarter campaign.

[5] Employees and volunteers were to develop the ETH platform using proceeds from the offering and future sales in the secondary market:

The Ethereum Platform is being developed primarily by a volunteer contributor team — many of whom will be receiving gifts of ETH in acknowledgement of their dedication — and will continue to be developed on a volunteer basis by some developers as well as under a more formalized contracting or employment relationship for other developers. The group of developers and other personnel that is now, or will be, employed by, or contracted with, Ethereum Switzerland GmbH (“EthSuisse”) is termed the “Ethereum Team.” EthSuisse will be liquidated shortly after creation of genesis block, and EthSuisse anticipates (but does not guarantee) that after it is dissolved the Ethereum Platform will continue to be developed by persons and entities who support Ethereum, including both volunteers and developers who are paid by nonprofit entities interested in supporting the Ethereum Platform.

The “intended uses of revenue” included development, outreach, research, and an allocation to a non-profit foundation. Page 4 of the DevPlan also describes their plans for 2 non-profit entities, a short-lived for-profit corporation, and an SRO.

I’m not aware of any progress towards the SRO in the ensuing 4 years. It’s common in the cryptoverse to hear about SROs, but rare to actually see one.

[6] Immediately after the launch announcement, on the Ethereum blog:

The Ethereum Foundation is a not for profit (‘Stiftung’) organization registered in Switzerland, and has the purpose of managing the funds that were raised from the Ether Sale in order to best serve the Ethereum and decentralized technology ecosystem.

[7] I’m not sure, but I think that some of the foundation’s ETH allocation was distributed to employees as part of the “developer purchase program.” E.g. Buterin:

I received ~553,000 in the genesis premine and ~150,000 from the developer purchase program. I currently hold ~630,000 ETH.

[8] E.g. Buterin in 2016:

I’ve sold about a quarter of my ETH.

[9] And CryptoKitties.

[10] It’s especially important to determine the legal status of ETH trading if there are going to be ETH futures and ETFs. Cofounder Joseph Lubin predicted that ETH futures would soon launch, and ETFs would follow — in December 2017:

Q: When do you expect that we could see an Ethereum future out there?
Lubin: It’s… I don’t want to really…
Q: Months?
Lubin: I think months would be a long, long time.
Q: Weeks?
Lubin: We’ll see.

[11] When Coinbase began trading ETH, they recommended a blog post from cofounder and market professional Fred Ehrsam:

To learn more about Ethereum, please visit our Ethereum FAQ page and co-founder Fred Ehrsam’s medium post “Ethereum is the Forefront of Digital Currency”.

Ehrsam wrote:

Ethereum’s core development team is healthy while Bitcoin’s is dysfunctional
Vitalik Buterin, the creator of Ethereum, has shown early promise as the leader of an open source project. He seems both comfortable as a community and technical leader…
Meanwhile, the core development team in Ethereum is focused. This is evident from the Ethereum blog. When I started reading it, it was everything I found myself thinking about for the present and future of Bitcoin but didn’t see being discussed much: scaling the network, the viability of proof of stake, how to create a stable digital currency, what a blockchain based company (DAO) would look like, amongst other topics. These are very ambitious ideas and some won’t work. But some probably will work, and they will be important…
What is very real, though, is the possibility that Ethereum blows past Bitcoin entirely. There is nothing that Bitcoin can do which Ethereum can’t. While Ethereum is less battle tested, it is moving faster, has better leadership, and has more developer mindshare….

[12] Miners also perform a service for Ethereum in exchange for new ETH tokens. It is not so different from a company paying contractors with newly-issued equity. Perhaps mining is a business activity funded by Ethereum issuing and selling securities?

[13] In November 2016, after Coinbase listed ETH, Ehrsam said on the Coinbase blog:

And therein lies a key point in the early stages of protocol tokens. We have yet to hit a situation where the combination of funds set aside in the initial sale and tokens held back have run out — yet. This is a close equivalent to running out of cash and the options pool in a typical company. Ethereum, for example, hasn’t hit this bump yet because 1) it’s young and 2) the price of ETH vs every fiat currency has, more or less, been on the rise, making the ETH the Ethereum Foundation set aside last longer. As a result, we’ve never seen the idea of multiple fundraises as is common with startups. Running out of funds for future development seems likely, as work on these protocols is never really “done”, although they may mature and change less over time…

This model is new and largely untested. The most important question is whether or not it will be considered a security under US securities law…

Most groups who have raised funds through a token sale create some kind of entity to handle the funds raised. The most common structure at the moment is setting up an (often Swiss) foundation. This foundation has some governance, much like the corporate governance you’d see in a normal company, which determines both the initial and ongoing distribution of funds raised. This is what Ethereum has done, more or less.

A month earlier, Ehrsam made similar remarks:

If you want to make this analogous to kind of regular companies in the world, you can think about the proceeds — whether it’s Ether or dollars from the pre-sale — as like the cash that a company might raise. And then the tokens that they hold back as kind of like the options pool, more or less. One thing I think is interesting that we haven’t seen a whole lot of yet in the world is: (And this happens at companies and startups all the time) What happens when those initial funds from the initial fundraise run out? Right? There’s kind of this model at least so far — and these are all really early projects — of we just do one fundraise and hopefully that just funds the thing in perpetuity. I’m guessing that that will not continue forever. With Ethereum, one of the main reasons it’s worked so far is: just like a successful company, the Ether that the foundation holds have appreciated quite significantly in value — meaning they could continue to pay for development more and more and more. So one thing I’m quite interested in is: what happens in the future, when those initial funds that we held back start running out and we want to continue funding the development of these protocols.

In February 2017, Coinbase continued to give the impression that ETH was a security:

Raising Capital

Lastly, one of the major use cases for Ethereum is decentralized fundraising from a global network of investors. Crowdsales lower the barrier to entry for developers working on high risk projects. Since Ethereum launched in July 2015 we have seen unprecedented amounts of funds raised for decentralized applications through crowdsales. Ethereum itself was funded through a crowdsale that raised $18 million in bitcoin and a project called The DAO raised $160 million.

However, Coinbase testified in March, 2018:

Coinbase is very deliberate about which tokens it supports on the exchange. Currently, the exchange supports only four assets (BTC, ETH, LTC and BCH). Part of the reason we trade only those four assets is that each has been determined by regulators to be a virtual currency and therefore not a security. We are studiously avoiding listing tokens that could be determined to be securities because we are not currently licensed to trade securities and cannot take the risk of inadvertently trading an asset that is later found to be a security…

At Coinbase, we have worked to bring clarity to the issue of what assets we can support since 2016. To help potential market participants, we published our Digital Asset Framework to provide transparency about how we consider listing new assets. A key factor in our framework analysis is a determination that the potential new asset is not a security under U.S. law.