Ethereum 2.0 Proof of Stake A Regulatory Nightmare

For all the Blockchain enthusiasts, Proof-of-Stake (PoS) is the panacea to the core challenge of astronomical energy consumption of Proof-of-Work (PoW) based blockchain networks i.e. Bitcoin and Ethereum. There have been a lot of research and discussions to argue the technical and philosophical pros and cons of each approach. This article is not meant to highlight these details as there are excellent references (mentioned at the end of this article) available on the web dealing with that. However, there is another important aspect that gets overlooked in these discussions and that is “Regulations”.

Regulations and Cryptocurrency based businesses have the history of bittersweet friendship. These new economy businesses feel hampered by existing regulations, for being unsuitable to harness its potential. Yet, at the same time, well defined regulations are needed for these businesses, to be able to take firm roots and grow, creating a new financial paradigm.

Ethereum and PoS

There has been much conversation about moving Ethereum consensus to PoS. The main advantages are the reduction of energy consumption needed for the network to operate, and much higher throughput (transactions per second which is roughly 15 per second with the current design).

Regulatory Challenge

It has been well settled that Ether is NOT a Security. Bill Hinman, U.S. Securities and Exchange Commission Director of Corporate Finance stated in June 2018,

“Based on my understanding of the present state of ether, the ethereum network, its decentralized structure, we believe current offers and sales of ether are not securities transactions,” he said at the Yahoo Finance All Market Summit: Crypto. After bitcoin, ether is the second most valuable cryptocurrency in the markets today and is referred to as the “gas” that powers Ethereum’s blockchain. (See also: Joe Lubin Answers: Is Ether A Security?) . This view has been furthered by the CFTC’s chairman (Oct 2019) Heath Tarbert.

The question now is what happens when Ethereum moves to PoS consensus algorithm. The stakeholders (called Validators) manage the creation of Ether and thus it no longer could be considered mined by a decentralized network with widest possible set of nodes involved in creation of Ether.

The PoS mechanism brings to the front the contract between Ethereum network and the Validators, that promises certain Ethers in return for staking their tokens. This contract is a legal document and thus could be construed as ‘Investment Contract’. As per CFTC, the presence of Investment Contract necessitates it to review the status of Ether, as potentially a security.

As per the latest estimate, the validators are being promised 4.6% – 10.3% in annualized reward for joining the network. Please check out the #4 below in my references for more information on this.

There are numerous cases since the “Securities Act of 1933” that have clearly established (check out the #6 in references below) that even if the native product (in this case Ether) is a Commodity (not a Security), its coupling with the contracts that promises certain returns, the contract is treated as Investment Contract. In case of Ethereum, these stakeholders will further be enlisting investors, promising them returns in terms of Ether. It creates a complete ecosystem supported by trading of Ether. It is not surprising that the SEC and CFTC are actively looking into this development, and may change their view on Ether, from Commodity to Security. If that happens, many of the businesses based upon Ether will need to review their regulatory compliance.

This is a major challenge for Ethereum based businesses while preparations are being done for its move to PoS.