For the most part, yesterday was a day of celebration for advocates and supporters of ethereum’s network. William Hinman, director of corporate finance at the SEC, told audiences at the Yahoo Finance All Markets Summit that he did not consider ether, the world’s second-most valuable cryptocurrency, to be a security. (See also: SEC Officially Declares Ether Is A Security).
Ether’s price spiked by as much as 10% in the hours following his speech. At 05:41 UTC, it was trading at $514.65, still up by 10% from the previous afternoon. Given that there are 519 ethereum tokens (as of this writing), it is interesting that the SEC chose to shine the spotlight on ether and absolve it of security status instead of making a blanket statement about ICO tokens. Why?
A Nuanced Assessment
There are two reasons for Hinman’s nuanced take on ether’s status.
The first one has to do with ether’s status within the ethereum network. While investors and traders commonly refer to it as a currency, ether is, in fact, the “gas” that powers the cryptocurrency’s network. This means that ether is necessary for each transaction that occurs within the cryptocurrency’s network, regardless of the decentralized app (DApp) in which it occurs.
On the other hand, tokens are specific to applications on ethereum and a token built for one app cannot be used in another. For example, the Populous coin, which is an ERC20 token to help small businesses with invoice financing, cannot be used in lieu of OmiseGO, which claims to provide financial inclusion to the unbanked. Tokens can also have a security or utility function associated with them. (See also: Why Crypto Users Need To Know: The ERC20 Standard).
Regardless of their status, however, tokens need ether to conduct a transaction. From the ethereum ICO document: A transaction specifies the amount of “gas” that it is allowed to consume and pre-pays a fee for it. In effect, each decentralized application on ethereum’s network requires ether to provide fuel for transactions occurring in its network. Keeping this use of ether in mind, the cryptocurrency would be classified as a utility token and not a security token. This may not be the case for other tokens which have yet to prove a similar transition in their worth.
The second reason for the SEC’s pronouncement on ether is the current decentralized state of ethereum’s network. Here it is important to parse the contents of Hinman’s speech because it purposely distinguished ether’s ICO from its decentralized status. That distinction is important, when you consider that ethereum’s 2014 ICO was styled as a security offering (although it was not advertised as such) with the backing of the Ethereum Foundation, a third party that actively promoted the ICO. Initial investors in ether have also benefited from a spike in the cryptocurrency’s price. Much has changed since 2014, however. The Ethereum Foundation’s role in channeling funds for further development on the platform has receded as startups, tech companies and financial institutions have taken over and formed their own consortiums. Other tokens on ethereum’s network are still dependent on self-styled non-profit foundations to fund future development. (See also: Governance: Why Crypto Investors Should Care?)
From Security To Utility?
As a corollary, ether’s current status and the SEC’s determination raise an important question for tokens. Can they similarly evolve from being a security issue at the time of their ICO to a utility token necessary to conduct transactions within an app or network?
SEC’s Chairman Jay Clayton indicated as much during a talk to discuss cryptocurrency regulation at Princeton University in April. “If a startup is offering something that depends on the efforts of others, it should be regulated as security,” he said and provided the example of a laundry shop using tokens for transactions within its branches or selling it to investors at a price to finance future expansion plans. “The use (of a utility token) can evolve toward or away from a security,” he said. “Just because it’s a security today doesn’t mean it’ll be a security tomorrow, and vice-versa.” His thinking on the matter is important because there already exists a regulatory path for security tokens to transition towards an eventual utility token designation. But the regulatory area during the transition from security token to utility token is still a gray area and allows the agency to crack down on startups and companies that market themselves as utilities but are, in fact, securities.
Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns 0.21 bitcoin and 1 Litecoin.