ONE of the most prominent firms in crypto recently sent shockwaves through the industry by announcing it is suing the U.S. Securities and Exchange Commission (SEC). On April 25th, in a bitterly worded lawsuit filed in a Texas federal court, crypto giant Consensys accused the SEC of “regulatory overreach” in its bid to bring to heel the $380 billion cryptocurrency Ether (commonly referred to as ETH). The complaint is based on the grounds that “ETH bears none of the attributes of a security.” Consensys are wrong, and this lawsuit is doomed to fail. The reasons why stretch back nearly ten years to when Ethereum was first founded. But in order to understand them, we first need some context on what, exactly, Consensys does. Consensys is a major backer of the Ethereum blockchain; a “Layer 1” blockchain ledger, like Bitcoin, but on top of which other protocols and applications can be built. Ethereum users transact on the network using ETH, which acts as a form of payment made by users of the network to the individuals around the world who run it (known as “miners” - more on them shortly). Consensys has contributed significantly to Ethereum’s back-end infrastructure, as well as funding a lot of smaller projects within the ecosystem. However it’s best known as the developer of MetaMask; by far the most popular wallet used in the crypto industry, with around 30 million monthly active users as of February this year. The level of the firm’s contribution to the Ethereum ecosystem, and the huge adoption its products have seen, have enabled Consensys to become a colossus in the crypto world; in November 2021, it raised $200 million at a $3.2 billion valuation. In March 2022, it raised a further $450 million; this time, with a valuation of $7 billion. The success of Consensys is intrinsically tied to the success of the Ethereum network which it backs, however, the latter has been mired in controversy and plagued by regulatory scrutiny since its inception, on account of its token ETH. Specifically, the manner in which ETH was first launched onto the market. ETH was launched nearly ten years ago, in July 2014, through a process known as an Initial Coin Offering (ICO); essentially, the crypto industry’s version of an IPO, in which tokens are first sold to the public. In their heyday, ICOs were tremendously popular, with participation in them reaching a zenith in 2016-17; a period now referred to in the industry as the “ICO era.” Such was the exuberance around these sales that one token, EOS, raised almost $4.1 billion through a year-long ICO; more than the three biggest equity raises that year – Uber, Epic Games, and Juul – combined. With so much money flooding into ICOs, they soon caught the attention, and the ire, of regulators. The SEC produced an Investigative Report in July 2017, declaring that “offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.” Cryptocurrencies, the agency decided, were securities and were to be regulated as such. After issuing this decree, the regulators set about ardently pursuing and prosecuting ICOs that did not adhere to securities law. Which, unsurprisingly, was pretty much all of them. This brought about an abrupt end to the ICO mania, with token sales drying up virtually overnight. However, while the SEC was hell-bent on throwing the book at new ICOs, all the tokens that launched before the July 2017 report were effectively given a free pass. None of these token issuers were prosecuted because their sales had been conducted before the decree went out that ICOs fall within the boundaries of securities laws. This meant a lucky escape for ETH; had it launched after the report, then its developers would have been prosecuted. No registrations for the sale were filed with the regulator, meaning the ICO did not comply with the SEC’s securities laws. Yet, despite not actively pursuing ETH for securities violations, the agency resolved to keep both the network, which was skyrocketing in popularity, and the coin, which was skyrocketing in price, firmly on their radar. For the next five or so years, while some debate persisted around whether the SEC should in fact be going after ETH, the regulators’ main focus was to clamp down on the . many scams and frauds being conducted throughout the space All this was to change in 2022, however, when Ethereum made a major change to the way the network was run. The details around this change are quite technical, but essentially, Ethereum introduced a system called “proof-of-stake,” in which the network would operate by the aforementioned miners locking up (or “staking”) their ETH in exchange for the ability to receive payments from the network’s users. While this may sound like an innocuous technical update, comprehensible and interesting to only a handful of basement-dwelling obsessives, the switch to proof-of-stake changed everything for Ethereum. The network was now firmly within the SEC’s crosshairs. And the regulator, long since exasperated by the sheer number of scams unfolding in the cryptosphere, had the perfect excuse to go after the network that it saw as integral to the facilitation of so much fraudulent activity. Because to the SEC, staking constitutes an investment contract and falls firmly within the realm of securities law. Investment contracts are classified as such if they pass the “Howey Test”. Developed by the US Supreme Court in a landmark case in 1946, the Howey Test asserts that an investment contract is “a contract, transaction, or scheme whereby a person invests their money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Staking arrangements involve individual investors contributing crypto to staking pools with the expectation of receiving a reward while relying on the efforts and work of the team managing and operating the staking platform. A court using the Howey Test, therefore, would find staking does indeed constitute an investment contract, and therefore, falls under securities law. Since Ethereum’s move to proof-of-stake, the SEC has been vigorously and ruthlessly clamping down on the network and the companies within its ecosystem, unleashing a deluge of regulatory action against many of the major players in the space. In its lawsuit filing, Consensys even refer to the head of the agency, Gary Gensler, as “the crusading SEC Chair.” And, indeed, buried within that same lawsuit a diligent reader will discover, on reaching the 68th paragraph, that Consensys itself was recently served a Wells Notice by the SEC; a letter that informs firms about impending legal action, following the results of an investigation which the agency has conducted. It turns out, then, that prior to filing its lawsuit Consensys was staring down the barrel of imminent prosecution. The SEC’s grounds for this were that, amongst other things, the MetaMask wallet which Consensys built offers staking services within its product. With all of this considered, a very different picture begins to emerge around Consensys’ decision to sue the SEC, and its lawsuit starts to look very much like a preemptive blow. Knowing that prosecution was imminent, the firm decided to go on the offensive and sue the SEC before the SEC sued them. The problem is, however, that Consensys stands almost no chance of winning. Despite what Consensys may argue, ETH bears all the hallmarks of a security. Not only because of the staking mechanism which is central to the way the network operates, but also because the token was issued through an ICO; a process which the SEC has declared falls under securities laws. ETH simply got lucky and was given a pass because its ICO happened to have taken place prior to the declaration. It was good timing which prevented prosecution, and nothing else. And while the SEC can’t go after the token for the way in which it was launched onto the market, the incorporation of staking as a central feature of the network has given them all the ammo they need to initiate legal proceedings and take down ETH from a different angle. And, over and above the sheer weight of evidence against its case, Consensys also has the SEC’s track record of prosecuting crypto companies to contend with. The SEC website lists 238 lawsuits the agency has filed against crypto firms, and to date, it has never really lost a case that involves unregistered securities. Ripple, another cryptocurrency firm whose token , made a lot of noise around a purported court victory in July last year. However, this is misleading; XRP was deemed not to be a security when offered to the public in secondary sales on exchanges, but the court found it is indeed a security when sold to hedge funds and other institutions. At a push, it was a partial victory for Ripple, and certainly not a loss for the SEC. XRP the SEC claimed was a security With all of this in view, therefore, the decision by Consensys to sue the SEC over its alleged witch-hunt of the Ethereum ecosystem can best be regarded as something of a Hail Mary play; the firm knew it was going to get prosecuted, and likely very soon, so it decided to roll the dice and take on the SEC in court over a separate issue, perhaps in an attempt to shift attention away from itself and onto the legal uncertainties surrounding Ethereum and its token. In doing so, it’s also fast-tracking the resolution of one of the biggest open questions in crypto, which has long been looming over the industry: whether or not ETH is officially, and legally, a security. Up against such astronomically unlikely odds of victory, it seems the best Consensys can hope to achieve is to drag the court case on for as long as possible. The firm has vast financial resources and can afford to hire legions of the best lawyers in the business. In doing so, it’ll be able to keep the party going for a little longer. But sooner or later the court will, inevitably, come to a decision. And when that happens, it’ll be lights out for both ETH and Consensys.

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