After the approval of the Bitcoin spot ETF by the US SEC in early January, the market’s expectations for an Ethereum spot ETF quickly increased. However, an unresolved question is whether Ethereum is a security or a commodity. This article, written by Steven Ehrlich, explores this issue.
Title: Is Ethereum a Security?
Differences Between Bitcoin and Ethereum
Coinbase’s Letter to the SEC
The cryptocurrency world is experiencing an early spring. The trading price of Bitcoin has surpassed $60,000, rising over 167% in the past 12 months. Within less than two months of the listing of Bitcoin spot ETFs, over $7 billion has flowed into these new funds.
Following this, the market has high expectations for the listing of Ethereum spot ETFs. With a market value of over $400 billion, Ethereum is second only to Bitcoin, which has a market value exceeding $1.2 trillion. In May, the US Securities and Exchange Commission (SEC) may make a final judgment on nine applications for Ethereum spot ETFs. However, unlike the approval of the Bitcoin ETF in early January, the outlook for Ethereum is not as clear.
The most immediate concern is whether the SEC considers Ethereum a security. If so, it would be required to register and be regulated by the SEC under the Investment Company Act of 1940. Most ETFs, such as QQQ or SPDR S&P 500 Trust, fall under the jurisdiction of the 40 Act as they are composed of stocks or registered securities.
Although the trading and activities of cryptocurrencies appear similar to the securities market, the cryptocurrency community unanimously believes that the thousands of different cryptocurrencies behind this emerging industry, with a total value of over $2 trillion, do not fall under the category of securities. In fact, they are angered by the view that “cryptocurrencies are securities,” considering it a curse to the decentralized spirit that Bitcoin introduced 15 years ago.
While the SEC approved the Bitcoin ETF in January this year, confirming that the Bitcoin behind these funds is a commodity, it has so far avoided discussing whether Ethereum is a security. However, in a case against Coinbase in June 2023, the SEC claimed that many tokens, including those associated with blockchains such as Cardano and Solana (essentially clones of Ethereum), are securities. SEC Chairman Gary Gensler has remained silent on the question of whether Ethereum is a security.
During a congressional hearing in June 2023, Chairman of the House Financial Services Committee, Patrick McHenry, questioned Gensler about whether Ethereum is a security or a commodity. Gensler’s most common response at the end of a controversial discussion was, “I think you don’t want me to make a prejudgment…”
If the SEC determines that Ethereum is a security, it will insist on the issuer of the Ethereum ETF treating it as a security in their application for approval. While this may seem like a stack of legal documents, doing so would be an insult to insiders and idealists in the cryptocurrency industry and raise questions about the status of thousands of cryptocurrencies. However, considering the potential billions of dollars at stake in the emerging cryptocurrency ETF market, companies that can quickly gain market share like Blackrock, Invesco, and Fidelity may benefit from the SEC’s ruling.
An anonymous applicant stated:
Following Bitcoin, Ethereum, established by Vitalik Buterin and others in 2015, is the second most important blockchain in the world. Its key difference from Bitcoin is that it allows developers to freely build countless applications on top of it, often referred to as smart contracts.
Its success is crucial for the vast ecosystem of companies such as Nike, Circle, Uniswap, and Blur, whose businesses span from payments to decentralized finance, gaming, and NFT applications. In terms of market performance, the price of Ethereum has doubled in the past 12 months.
The origin story of Ethereum is significantly different from that of Bitcoin, which has piqued the interest of lawyers at the SEC. Bitcoin was launched in 2009, with its developer, known by the pseudonym Satoshi Nakamoto, mining the first block, and anyone could join the network as a miner to mine and acquire new bitcoins without any preallocated distribution to the founder.
In contrast, Ethereum conducted its first token offering in mid-2014 as a form of crowdfunding, while the founding team led by Vitalik Buterin retained a portion of the 72 million ETH created during the initial release. In many ways, the initial token offering of Ethereum is similar to the issuance of stocks by company founders in an initial public offering.
One determining factor in determining whether something is a security is centralized control. In the early days of Ethereum, this peer-to-peer network was controlled by a small group of developers. However, over time, Ethereum and its governance became increasingly decentralized.
Bill Hinman, who served as the SEC’s Director of Corporate Finance in 2018, stated:
Another conflicting signal comes from the Ethereum futures ETFs launched last fall, such as VanEck’s Ethereum Strategy ETF and ProShares’ Ether Strategy ETF. Greg Xethalis, General Counsel at crypto venture firm Multicoin Capital, stated:
On the other hand, Prometheum in New York is the only registered broker-dealer with special permission to custody and trade digital assets. Prometheum plans to launch custody and trading services for Ethereum as “cryptocurrency securities” this spring.
Aaron Kaplan, CEO of Prometheum, believes Ethereum is a security:
The potential profits for the first issuer of an Ethereum spot ETF could be substantial. In October 2021, ProShares launched the first Bitcoin futures ETF, named ProShares Bitcoin Strategy ETF (BITO), two weeks ahead of its competitors. On its first day of trading, it attracted over $1 billion in capital inflows and has since dominated the cryptocurrency futures ETF market.
BITO has $20 billion in assets and charges a fee of 0.95%, holding a 90% market share. GBTC, the pioneer in the Bitcoin fund space, despite its expense ratio of 1.5% (over four times that of its competitors in the Bitcoin spot ETF), still maintains market dominance with $26 billion in assets, while BlackRock, its second-largest competitor, has $9 billion.
If this potential advantage is not enough, there are additional incentives. Applications for spot commodity ETFs submitted under the Securities Act of 1933 have a deadline or approval period of 240 days for the SEC to carefully consider. These types of applications require the listing exchange (such as Nasdaq or NYSE) to submit a separate form called 19-b4 in addition to the S-1 form for the issuance of new securities. Giang Bui, Head of US Equities and ETPs at Nasdaq, stated that these filings are reviewed by two different departments at the SEC and follow different timelines. The S-1 is audited by the SEC’s Division of Corporation Finance, while the 19-b4 is audited by the SEC’s Division of Trading and Markets.
If the application for an Ethereum spot ETF is submitted under the Investment Company Act of 1940, the issuer only needs to submit Form N-1A as its registration statement, which is audited by the SEC’s Division of Investment Management. This streamlined approach means that applications under the 40 Act require 60 days instead of 240 days to become effective. On Wall Street, this shortened time can determine the success or failure of an initial public offering.
For the broader cryptocurrency industry, the approval of an Ethereum spot ETF under the Investment Company Act of 1940 could cause significant disruption to the market, especially in the Ethereum spot market. The pricing mechanism of this cryptocurrency may be questioned as many key exchanges that determine prices, including Coinbase and Kraken, are not registered or authorized to trade securities.
When Ripple’s token XRP was sued by the SEC in December 2020, several exchanges, including Coinbase and OKCoin, delisted the digital asset. Given the importance of Ethereum, few expect ETH to be delisted by exchanges, but it could harm market demand. The smooth execution of a deep and orderly market is a crucial component of any ETF application.
Coinbase is a prominent participant in this drama as it positions itself to provide custody and prime brokerage services for new cryptocurrency ETF products. In fact, the company’s Chief Legal Officer, Paul Grewal, sent a letter to the SEC at the end of February, pleading for the approval of the current application for an Ethereum spot ETF. In the letter, Grewal asserts:
There is nearly three months left until the SEC needs to make a ruling on the current application for an Ethereum spot ETF, making it difficult to determine which viewpoint will ultimately prevail. Annemarie Tierney, an attorney at cryptocurrency advisory firm Liquid Advisors, stated:
She also pointed out that the SEC notably excluded Ethereum in its securities enforcement actions against Coinbase, Kraken, and Binance.
Regardless, one should not expect potential issuers of Ethereum spot ETFs to be fixated on the ideals of the cryptocurrency industry. An applicant who has already launched a Bitcoin spot ETF in the market stated:
Related Reports:
– SEC Delays Fidelity’s “Ethereum Spot ETF” Decision, Bloomberg Analyst Reveals Key Timing
– SEC Delays BlackRock’s “Ethereum Spot ETF” Review for the Second Time, Gary Gensler: Approval for BTC Doesn’t Mean a Blanket Approval
– When Will the “Ethereum Spot ETF” Be Approved? 52% in Poll Predict by the End of 2024; TD Cowen, JPMorgan: Approval Won’t Come Soon.