December 2, 2021 | Max Atallah

Cryptos & Fintech

#2 Legal Analysis of Ethereum (ETH)

Since the beginning of this year, we have been publishing articles on different cryptocurrencies and their legal framework within the EU and the U.S. Last month we wrote about USDT, and this month we assess Ethereum’s native token ether (ETH) – the world’s second largest cryptocurrency by market capitalization rate.

Ethereum in a Nutshell

Ethereum is the world’s leading decentralized open-source blockchain network with smart contract functionality, initially described by Vitalik Buterin in Ethereum’s whitepaper in 2013. The network went live in 2015 allowing practically anyone to deploy permanent and decentralized applications on to Ethereum network. The users can interact through the applications, for example, by lending cryptocurrencies to each other. The Ethereum network is also suitable for, and currently widely used for, creation and exchange of non-fungible tokens (NFTs).

The network’s native token is ETH, with a current circulating supply of just over 118,5 million tokens. ETH is typically, amongst other things and besides usual trading and payments, used to cover transaction fees and mining rewards, deploy smart contracts, tokenize real-world assets as well as for NFT and stablecoin minting.

Ethereum’s nature as an immutable and transparent platform makes it ideal for a range of application fields, and it is today the most popular platform for decentralized finance (DeFi) application developers. The platform, i.e., the Ethereum Virtual Machine, has so far been used to launch over 10 000 decentralized applications.

U.S. Regulation of ETH

As we have already mentioned in our earlier articles, it is hard to find a uniform regulatory approach to cryptocurrencies in the U.S, where each State has their own regulation on money transmission and cryptocurrency. As cryptocurrency exchanges are usually involved in fiat-money transmissions, they are obligated to follow money transmission regulations. In addition, New York and Louisiana have their own cryptocurrency licences, which are a stricter way of regulating cryptocurrency exchange operations.

The different interpretations of U.S. authorities do not in this situation pave the way for regulatory clarity. For example, the Internal Revenue Service (IRS) sees cryptocurrencies as property and has issued tax guidance on the matter, whereas the Commodities Futures Trading Commission (CFTC) encompasses cryptocurrencies to be commodities as described in the Commodity Exchange Act. Meanwhile, the Securities and Exchange Commission (SEC) has been indicating that it considers certain cryptocurrencies to be securities by applying the so-called Howey Test, despite its origin in traditional investment contracts, e.g., securities. Under the Howey test, the following questions determine the legal nature of a transaction:

  1. Did purchasers of a financial instrument contribute money (or valuable goods or services)?
  2. Did purchasers invest in a common enterprise?
  3. Were purchasers reasonably expecting to earn profits through that enterprise?
  4. Were the expected profits derived from the efforts of others (e.g., a third party)?

Based on these four (4) criterias, it is clear that the test is constructed around centralized activities, whereby its overall applicability regarding decentralized cryptocurrencies can be rightly questioned from a legal perspective. It is easy to state that the Howey test with its origin in year 1946 is outdated in the assessment of crypto transactions anchored in blockchain networks such as Ethereum.

This being said, it is important to note that currently ETH is not considered a security by the relevant U.S. authorities. This position was first confirmed by the SEC in 2018 when the former director of the SEC, William Hinman, announced that the SEC will not treat ETH as a security. The direct quote of Mr. Hinman based on Reuters article was: “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.”

In a more recent event, the current CFTC Commissioner, Brian Quintenz, reaffirmed in his Tweet on 14 August 2021, that the CFTC considers ETH to be a non-security commodity.

Therefore, it can be claimed that currently ETH is not regarded as a security within the U.S. legal regime.

EU Regulation of ETH

Within the EU, ETH has a clearer regulatory situation than in the U.S. due to the more coherent nature of the EU cryptocurrency legislation. As other altcoins, ETH falls within the scope of the EU Fifth Money Laundering Directive (5AMLD) and is considered a cryptocurrency. As described in the 5AMLD, cryptocurrencies are defined as a digital representation of value i) that is not issued or guaranteed by a central bank or a public authority, ii) is not necessarily attached to a legally established currency and does not possess a legal status of currency or money but is accepted by natural or legal persons as a means of exchange and iii) which can be transferred, stored, and traded electronically. Therefore, entities offering exchange services in regard to ETH, and other cryptocurrency service providers are obligated by the EU Member State’s implementation of the 5AMLD and other national regulation, being subject to conventional EU regulation on customer due diligence, risk assessments, Fit & Proper as well as other applicable national legislation.

Based on the 5AMLD certain Member States have established a stricter license system for cryptocurrencies, whereas other Member States just require entities to follow general money laundering regulations. However, from a longevity standpoint it is recommendable to comply with the stricter Member States cryptocurrency legal frameworks as a planned and upcoming EU legislation package is going to make the EU-wide cryptocurrency requirements quite similar to those of the stricter legal frameworks. You can find more information on the planned EU cryptocurrency regulation in our previous articles.

Stay tuned for our next article, which is also going to be the last one of this article series and cover the undisputed king of the cryptocurrency world: Bitcoin (BTC).

02.12.2021 MAX

Nordic LawPioneer in Web3 and Fintech law