One of the hot topics in the crypto community recently has finally found its answer. The US Securities and Exchange Commission (SEC) ruled earlier in June that the world’s second largest cryptocurrency Ethereum (ETH) is not a security because it is sufficiently decentralized. Now, how much decentralization is sufficient for a virtual asset to stay out of the regulatory radar?

The phrase “sufficiently decentralized” is described by William Hinman, head of SEC corporate finance division, as a case “where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts”.

Sufficiently decentralized

The terminology given in the statement, although vague, means that if there is a group operating a crypto asset, the purchasers/buyers would no longer reasonably expect that group to carry out essential managerial efforts. It is unclear whether that means that the developers, or mining pools, or the nodes have to be decentralized. Also, how many pools are sufficient to be considered decentralized, or how many developers is the minimum requirement for being considered a decentralized project. Hinman gives seven legal items to help with the analysis of whether a token is a security. It is not meant to serve as a ruling and not all points need to be present in order to make a decision. According to Hinman, the list is only meant to “prompt thinking by promoters and their counsel… it is not meant to be a list of all necessary factors in a legal analysis.” He states that this list is not “intended to be exhaustive” and he does not believe “each and every one of these factors needs to be present to establish a case that a token is not being offered as a security.”

Is Ethereum really decentralized?

In a recent blog post by StopAndDecrypt, he explains with many examples and arguments why he finds Ethereum centralized and why it is only going to become more centralized. The main argument that he provides is that Ethereum’s blockchain is exponentially growing, because of its uncapped blocksize limit, thus creating demand for hardware and bandwidth that far exceeds average users’ capabilities. As a result, only certain parties are able to run full nodes thus creating а premise for a more centralized network. The bandwidth problem with Ethereum is bigger than the problem with the size of the blockchain because it makes full nodes of average users impossible to sync with the network. So, almost nobody is running full nodes anymore because it is very expensive to maintain an Ethereum node. Mostly exchanges and miners run full nodes.

Also, the other implementations of Ethereum do not sync. Bitcoin in comparison has multiple full node implementations which means that different teams are developing for Bitcoin, so the protocol development is decentralized. In Ethereum, there is a creator who dictates when to have a hard fork and whether it should go proof-of-stake, for example.

The aftermath of the DAO hack can be seen as another argument about the central control in Ethereum. June 2018 is the second anniversary of the DAO hack. This can serve as a reminder of how Ethereum was two years ago. After the hack, Ethereum founder Vitalik Buterin instructed exchanges to halt trading of Ether and DAO tokens. There are recorded conversations with the exchanges.

Those arguments are important to consider when evaluating the decentralization of Ethereum but in the end, the Ethereum blockchain the way it is now is decentralized. We can only speculate how it will be in future.

Ethereum ICO

According to Hinman, if there is a centralized third party, and the purchasers expect a return, then it is a security. Even though technically Ethereum’s Initial Coin Offering (ICO) was a security offering (the Ethereum team was centralized and there was no Ethereum blockchain at the time), and its investors were not accredited, it still required some technical knowledge to participate. It did require some technical expertise from the investors because they had to purchase Bitcoin and setup a wallet. So, not everyone could participate because back then there was very limited infrastructure, no hardware wallet support, just JSON files and no UI (User Interface). And most people were not expecting any return because it was one of the first ICOs. Also, the sale was a long time ago, so there might be an issue under some statute of limitations.

A contributing factor for the SEC decision was the fact that Coin Center was lobbying for Ethereum and there was no lobbying from the other side. Coin Center is a “non-profit research and advocacy center focused on the public policy issues facing cryptocurrency and decentralized computing technologies like Bitcoin and Ethereum.”

It is unclear from Hinman’s statement, whether the SEC will deal with the Ethereum ICO. The crowdsale and the Ethereum blockchain are two different things. So, we are yet to see whether the founders of Ethereum will get any punishment.

The Ethereum ICO and the ICOs of today

An important distinction should be made between the ICOs (crowdsales) of today and those back in 2014. Betting on Ethereum in those early days was a very risky bet. Nobody would have expected it to go that far. The industry was immature and expectations of profit were unrealistic to think of. It was more of a donation and a gamble than anything else. Investing in Tezos or EOS, for example, is a completely different thing because now there are examples that investing in an ICO could be profitable. Therefore, soliciting money from investors will require KYC/AML, as we see with most new ICOs.

The people who invested in the Ethereum ICO deserve to be rewarded for the risky bet they have taken. There was no infrastructure and it was not easy for anyone to invest in an ICO.

All in all, this is good news for the cryptocurrency market because the main actors now have a better clarity regarding the regulations of ICOs, even though it is not written in stone yet. The news is bad for some of the ICOs from 2015-2016 which were not KYC compliant or did not create networks for the utility token they offered. They will likely have problems with the regulators in the coming years. And possibly those tokens will have to register as securities. Regulators also like to take their time.

Ethereum started as a security, and then Ether became a utility token (gas). Most of the ICOs today do not start as a utility. All ERC-20 tokens are investment contracts. If during the sale there is no network where the utility token can be used, then it is a sale of a security. Even if the underlying is not a security itself.

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