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Whilst Ethereum’s new proof-of-stake model is vastly superior to its proof-of-work predecessor, its centralised vulnerability is beginning to emerge (no pun intended) thanks to mighty America and its even mightier SEC.
Although new to Ethereum, proof-of-stake (PoS) is far from nasency. Already adopted by the likes of Polygon, Cardano and Solana, PoS has proven to be an efficent and scalable mechanism. Relying on validators rather than virtual miners and maths problems, PoS results in lower gas fees and a lower carbon footprint.
Furthermore, as RockX CEO and founder Zhuling Chen says, PoS is incredibly useful for internet applications and smart contract technology.
“This is where blockchain goes beyond just payment or storage of value,” Chen told Blockhead. “This is where we make things programmable and efficient…If we’re looking for something that can fit into the Internet, PoS is probably the better option in this case, which Ethereum has demonstrated.“
“We do see this trend that most of the blockchains will be more on PoS.”
However, Ethereum’s new PoS model has left it vulnerably exposed to regulation, particularly US regulation.
Over the past few weeks, the SEC has been loudly vocal about “all of Ethereum” falling under US jurisdiction. In a civil complaint against crypto influencer Ian Balina for failing to register a cryptocurrency as a security before its 2018 ICO, the SEC argued it had the right to sue him because Ethereum falls under the government’s watch.
“ETH contributions were validated by a network of nodes on the Ethereum blockchain, which are clustered more densely in the United States than in any other country. As a result, those transactions took place in the United States,” the SEC said in a filed complaint.
According to Etherscan, 48.31% of all Ethereum nodes operate from the United States, giving the US the highest density of nodes. The SEC believes that as America has the most nodes operating in the world, then all Ethereum transactions should be considered American, and thus all fall under American jurisdiction.
University of Kentucky law professor Brian Fyre told Decrypt that the SEC is essentially characterising “doing business on a US securities exchange, which, from their regulatory perspective, is convenient. It makes things so much simpler.”
This doesn’t sound very decentralised at all.
“It’s the SEC saying, ‘This entire body of financial activity is within the scope of the stuff that we regulate, and therefore we’re going to regulate all of it.’” Fay added.
The SEC is further applying the Howey Test to determine whether or not to treat the asset as a security, which would then fall under SEC scrutiny.
Qualification for a security under the Howey Test is extensive, but most recently SEC Chairman Gary Gensler said cryptocurrencies and intermediataries that allow “staking” may pass the test too.
“From the coin’s perspectivehe coin’s perspective…that’s another indicia that under the Howey Test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler said.
With the SEC claiming jurisdiction over the entirity of Ethereum, as well as being armed with the Howey Test, projects on the blockchain are becoming increasingly subject to American laws.
Not just a bluff
US regulators aren’t just vacuously flexing either. The Commodity Futures Trading Commission (CFTC) recently imposed a US$250,000 penalty against bZeroX and its founders Tom Bean and Kyle Kistner for developing a DAO. The CFTC stated that “bZeroX transferred control of the bZx Protocol to the bZx DAO, which subsequently renamed itself and is currently doing business as the Ooki DAO.”
“By transferring control to a DAO, bZeroX’s founders touted to bZeroX community members the operations would be enforcement-proof—allowing the Ooki DAO to violate the CEA and CFTC regulations with impunity, as alleged in the federal court action,” the CFTC argued.
Even BAYC creators Yuga Labs is under investigation by the SEC, which is attempting to determine whether their NFTs are securities.
And of course, we all know what happened with Kim Kardashian, who was fined US$1.26 million by the SEC for promoting EthereumMax.
Wrong kind of regulation
At this point you might be thinking – isn’t regulation just what we need after all this crypto anarchy? And yes you’d be correct. As RockX’s Chen says, clear regulations inspire institutional adoption.
“If we look at the success of Bitcoin nowadays, it’s in fact driven by institutional acceptance. Particularly with regulations becoming clearer, family offices and banks have started to get into BTC,” he said.
Indeed, crypto’s wild west nature is arguably what led to the intensity of crypto winter. However, the SEC’s iron grip on Ethereum is too overbearing and counterproductive to its entire concept. When Vitalik Buterin conceptualised Ethereum, his inspiration came from building a blockchain that had wider applications than Bitcoin.
“I came up with the idea behind Ethereum,” Buterin said in the past. “This idea of a blockchain with a built-in programming language as, kind of, what I thought was the simplest and kind of most logical way to actually build a platform that can be used for many more kinds of applications.”
Since its inception, Ethereum has been celebrated as global decentarlised blockchain, available to everyone and for everyone. Post-merge, Ethereum enthusiasts have been harbouring the same message too.
Dustin from Ethereum Foundation told Blockhead at the Ethereum Merge Party that he was particularly excited about how the merge will provide “building blocks to allow scaling such as EIP-4844.”
Raman Sha, founder of Crypto Jobs List, described the merge as “an exciting accomplishment.”
“We are now 99%+ more energy efficient and are looking forward to more scalability happening on chain,” he said. “In the long run, there will be more sustainability and people will be throwing fewer stones at the chain. Time will show. Being able to bridge between L2s and being able to move your assets across different chains – that’s what I’m looking forward to myself.”
Under SEC regulation, projects have less incentive to work on Ethereum and fulfill the Buterin’s concept. In fact, the SEC’s presence even serves as a deterrent for projects particuarly outside of America. If the draw of decentralisation inspires a developer to build on a blockchain, why would they pick one so heavily watched by the SEC? Developers from countries who are not exactly the biggest fans of the US would also be put off from the SEC-thereum.
Sure, the SEC will crack down on nonsense like Kim Kardashian pump and dumps, and the CFTC may be “right” in preventing companies from turning into DAOs to escape the law, but its ability to pick off validators around the world under the guise of “American Ethereum nodes” is rather scary.
This is particularly true when considering the technicalities of nodes and their geographical locations. As Bloomberg Law explains, “many protocol systems and node systems are supported programmatically by hosted and centralized server and hosting systems that maintain server and infrastructure farms in various locations.”
In English, blockchain transactions are hard to pin down geographically as the hosting providors may be different to where the nodes are located. A single ETH transaction “could have network nodes could be in seven or more different locatiosn across the globe.”
Ethereum security’s unsecured future
The SEC enforcing their unwelcomed presence based on questionable logic is damaging for Ethereum and it’s global blockchain utopia. When the SEC first made their claims, the price of ETH plummeted 20% to sub US$13,000, and has struggled to pick up since. Meanwhile, increasing hope that Ripple can win its battle against the SEC for XRP not being a security, has sent its price upward.
It’s a similar story for Ethereum. If Ethereum can shake off the SEC from regulating the entire chain, developers will continue to be attracted to it. However, if the SEC retains its dominance, and worse still, acts upon it by targetting validators and suing projects, developers will undoubtedly lose faith in Ethereum. Opportunities to develop on defi, even not for nefarious reasons, are diminished by the SEC’s reign, and developers who are drawn to decentralisation will value this.