The Node Ahead 65: The SEC’s attempt to deny the Ethereum ETF

By Brett Munster

The SEC goes fishing

In 2013, the Winklevoss Bitcoin Trust filed the first ever spot bitcoin ETF application which was later rejected by the SEC. Between 2018 and March 2023, the SEC rejected more than 20 applications for a spot bitcoin ETF on the grounds that the proposals did not meet anti-fraud and investor protection standards. Then in August 2023, the courts unanimously ruled in favor of Grayscale in their lawsuit against the SEC thereby striking down the SEC’s rationale for its continued denial. All three-judges concluded that the SEC failed to provide a “coherent explanation” as to why it approved bitcoin futures ETFs but not the proposed bitcoin spot ETF, and therefore acted “arbitrarily and capriciously” and in violation of the Administrative Procedure Act.

Following the ruling and having been on the record saying bitcoin is a commodity, the SEC was backed into a corner in which it had no legal grounds to deny a spot bitcoin ETF any longer. On January 11, the SEC reluctantly approved 11 spot bitcoin ETFs. Since their launch, the bitcoin ETFs have accumulated over $30 billion in net new capital, shattered just about every record for ETF launches, and not had a single issue of fraud or manipulation.

The overwhelming success of the bitcoin ETF is a black eye for the SEC because it spent more than a decade denying application after application for reasons that have since been proven in court and in practice to be completely unwarranted. It turns out, the only thing the SEC “protected” consumers from was access to the best performing financial asset of the last decade. That’s not a good look for an agency whose job is to be a disclosure-based regulator, not a merit-based regulator. That means it’s the job of the SEC to ensure companies provide adequate and accurate information to the public so the public can make informed investment decisions on their own. It is not the job of the SEC to make a judgment as to what is or isn’t a good investment. And clearly, there is a lot of demand in the market for this product.

It’s important to understand this historical context because it sets the stage for the impending Ethereum ETF decision. Back in January, after the bitcoin ETFs were approved, we explained why many people close to the matter at the time expected an Ethereum ETF to be approved by May 23rd of this year. The quick recap is that all the same market structures that existed for bitcoin and led to Grayscale’s win in its lawsuit also exist with Ethereum. There is a robust futures market, the correlation between futures and spot for ETH is very high, an ETH futures ETF has already been approved by the SEC, and there are spot Ethereum ETFs operating in other markets. The SEC will not be able to deny an Ethereum ETF based on fears of market manipulation like it did for bitcoin for all those years.

Which once again, puts the SEC in a tough spot of its own making. If an Ethereum ETF were to be approved and garnered even a fraction of the demand the bitcoin ETF has gotten, it would once again make Gary Gensler look bad based on his anti-crypto rhetoric and actions in recent years. This probably explains, at least in part, why the SEC has thus far not engaged with the Ethereum ETF issuers to the same degree at this point in the process as they did with the bitcoin ETF issuers. At a similar junction during the bitcoin ETF approval process, there was a lot of back-and-forth communication between the bitcoin ETF issuers and the SEC. According to all reports, the SEC has been dead silent when it comes to the Ethereum ETF. That lack of communication is not a good sign. The SEC appears to be reluctant to let the same story play out twice in a row which is why many analysts who were once bullish the Ethereum ETF would be approved this year now give it only a 30% chance.

But as we alluded to earlier, it’s likely the SEC does not have a justifiable reason to deny the Ethereum ETF that would hold up in court. So, what do you do if you are Gary Gensler and you don’t have a reason to deny the Ethereum ETF? You try to go find one.

Recent reports from both Fortune and Coindesk suggest that the SEC has subpoenaed several U.S. companies for documents related to their dealings with the Ethereum Foundation in hopes of uncovering something it can use to justify classifying ETH as a security. If the SEC can classify ETH as a security, it can then file a lawsuit against the Ethereum Foundation for selling unregistered securities and use the lawsuit as justification for denying the ETF in May.

Even skipping over the fact that Gary Gensler, rather than doing his job, is choosing to go on a fishing expedition for evidence because he currently has no good reason to deny the ETF, the SEC is going to have a hard time proving in court that ETH is a security for several reasons.

First, to determine if a cryptocurrency meets the legal definition of a security, federal and state courts use well-established legal analysis known as the Howey Test. The U.S. Supreme Court adopted the Howey Test in 1946 to provide a uniform analysis when determining if an investment qualified as a security. An investment must meet all four requirements of the Howey Test to be considered a security. Because bitcoin and Ethereum are decentralized, there is no common enterprise and thus these assets do not meet the requirements under Howey. Even the SEC has publicly acknowledged this fact.

In 2018, SEC director of Corporate Finance, William Hinman gave a speech in which he

likened utility tokens to the oranges being grown on the parcels of land in the Howey case stating, “the token…all by itself is not a security, just as the orange groves in Howey were not.” He further elaborated that some digital assets progress to a point where there is “sufficient decentralization” of the network and that a digital asset that was once considered to be a security could be classified differently over time. Hinman specifically acknowledged Ethereum in his speech stating that despite the initial token launch the “current offers and sales of Ether are not securities transactions” largely due to its decentralization.

If the name Hinman sounds familiar, it’s because we covered the Hinman documents last year during the Ripple court case that the SEC lost. The hundreds of internal messages from high-ranking SEC officials showed that Hinman solicited and received feedback from numerous colleagues at the SEC in the weeks leading up to his speech. The multiple edits and comments reveal that those who worked on the speech believed the goal of the speech was to provide market guidance. The bottom line was Hinman was in no way a maverick who went rogue and espoused his personal views but instead, incorporated guidance from many high-ranking members of the SEC in his speech and many (if not all) believed Hinman was speaking on behalf of the agency.

And if the Hinman speech and documents weren’t enough, prior to becoming SEC Chair, Gary Gensler himself testified before Congress that ETH is not a security. In other words, if the SEC were to try and assert that Ethereum is a security, the SEC will need to explain to a federal court why its actions contradict its own public statements over the years.

Second, the SEC would be going against years of precedent set by the Commodities Futures Trading Commission (CFTC), the legal body responsible for regulating the trading of commodities. The CFTC has routinely called ETH a commodity both in public and in legal filings. Not only that, since 2021 millions of dollars of ETH futures per day have been traded on the CME (a US based and US regulated derivatives exchange). When the CME Group applied for permission to launch the first Ethereum futures contracts in 2021, it claimed ETH was a commodity and therefore it was not subject to regulation by the SEC. The SEC could have objected back then if it wanted to argue that Ethereum was a security but the SEC never did. If ETH were to be deemed a security today, then the CFTC-listed futures contracts would technically be illegal as would all the trading on the exchange over the past three years. By choosing not to object to ETH futures being traded on the CME, the SEC implicitly endorsed CME Group’s claim that ETH is a commodity.

Third, when the SEC allowed 9 different Ethereum Futures ETFs to trade it explicitly acknowledged the status of ETH as being a non-security. If the SEC had any doubt about the regulatory treatment of ETH in October 2023, it wouldn’t have approved the futures-based ETFs. It’s hypocritical of the SEC to try and argue that a spot-based ETF can’t be approved because ETH is a security when that very same argument means the futures-based ETF, which the SEC approved, is an illegal instrument. There is no way for the SEC to reconcile that contradiction.

It’s also important to note that the approval of the futures based ETF came in October 2023, well after Ethereum changed to Proof-of-Stake in September 2022. Any argument that Ethereum’s change from Proof-of-Work to Proof-of-Stake somehow changed it from a commodity to a security (which Gensler has suggested) is null and void by the SEC’s own actions.

Lastly, the SEC has brought enforcement actions against a number of crypto companies over the past several years for selling unregistered securities. In those lawsuits, the SEC named over 60 different cryptoassets as securities. However, the SEC never once named Ethereum in any of its legal filings. It seems odd that the SEC would leave out the second most traded cryptoasset if in fact it thought it was a security. That wasn’t an oversight by the SEC, Ethereum was a purposeful omission for a reason.

For all these reasons, it’s very unlikely the SEC could prove in a court of law that ETH is a security if it was to bring a lawsuit against the Ethereum Foundation for selling unregistered securities. Assuming the SEC did file a lawsuit and then lose, that puts us right back where we are today; with the SEC having no viable reason to deny an Ethereum ETF.

The SEC backed itself into a corner and is now grasping at straws to try and salvage any rationale to deny the Ethereum ETF. If the SEC does deny the applications in May as it appears they will, they will have an extremely difficult time defending that decision in court. And it’s not like the SEC has a good track record of winning court cases against crypto companies. Ripple, loss. Grayscale, unanimous loss. Debt Box, historically embarrassing loss.

If you have read this far and are thinking to yourself, isn’t Gary Gensler just wasting taxpayer’s dollars? Congress apparently has the same reaction. 48 members of Congress, including the Chairman of the House Financial Services Committee, signed a letter to Gensler, asking him to explain why he is trying to classify ETH as a security and expressing concerns about how listing ETH as a security could threaten the crypto industry.

The bottom line is that an Ethereum ETF will be approved…eventually. The question is whether the SEC approves it in May or is forced by a court to approve it at a later date.

In Other News

The new BlackRock fund that gives investors blockchain tokens representing investments in cash and T-bills has pulled in $240 million in its first week.

Why Blackrock’s first tokenized fund is a bigger deal than people think.

BlackRock’s new tokenized fund brings TradFi and crypto closer.

Goldman Sachs sees resurgence in clients’ interest in crypto assets.

The London stock exchange will start market for bitcoin and Ether ETNs.

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