Ryan Yosua's Blog

Problems with Regulating Ethereum in the US

March 31, 2018

There has been a lot of news recently around crypto regulation. I think there are a number of problems with regulating Ethereum in the US that will cause regulation attempts to fail in the long term. In this post, I will focus on Ethereum and the US, but much of this will apply to crypto as a whole, as well as other countries. The problems are:

  1. Ethereum based assets do not cleanly fit into the discreet categories that governments have created
  2. Ethereum moves much faster than governments
  3. Entrepreneurs will take advantage of legislative arbitrage
  4. Ethereum enables unstoppable organizations

The SEC published the DAO report which concluded that the DAO tokens where securities. The reasoning they use to categorize the DAO as a security is based on a case from 1946 called the Howey test. In short for something to be considered a security it has to meet these criteria (source):

  • It is an investment of money
  • There is an expectation of profits from the investment
  • The investment of money is in a common enterprise
  • Any profit comes from the efforts of a promoter or third party

If you know anything about the DAO, then you know that it pretty easily fits these criteria. But on a closer look, #1 may not be true because the IRS classifies cryptocurrencies as property. This brings me to the first problem of regulating cryptocurrencies - Ethereum based assets do not cleanly fit into the discreet categories that governments have created. The IRS calls crypto property for tax purposes. The SEC calls it money (I take this to mean a currency) so they can classify crypto as a security and pull it under their jurisdiction. More recently FinCEN was feeling a bit left out on all this regulatory action and made it clear that ICO issuers would be considered money transmitters and will need to register with FinCEN as well as comply with KYC. In a way, it makes sense that tokens on Ethereum fit all these categories because developers can program a smart contract to give a token whatever properties they want. The fact that tokens (and other Ethereum based assets) don’t fit cleanly into these categories is a problem because it is very expensive for entrepreneurs to comply with all these laws. Previously a college kid could start a crypto company over the weekend from their dorm, now they have to raise a seed round to pay for a council of lawyers and consultants who were probably ex-legislators.

So instead an entrepreneur will probably say fuck all of that and create 1,000,000 tokens, give away half of them to users as an incentive to start using a DApp. All of sudden the token is not a security because there was no investment - all the tokens were given away for free. And if the entrepreneur builds their app in such a way that the token has value, they can later sell the token on exchanges to fund their company. This illustrates the second problem of regulating Ethereum - Ethereum moves much faster than governments. By the time legislators come up with new laws to cover this new scenario, some developer or entrepreneur will just write a new smart contract that gives the token different properties that allow it to evade the laws. And most entrepreneurs would do this not because they are trying to do something illegal or fraudulent(current laws cover that), but because they can’t afford to start the business in the first place with the cost of compliance. Another option is to just move to a country that is more friendly to crypto and is open to entrepreneurship. This brings me to problem #3 - Entrepreneurs will take advantage of legislative arbitrage. If the regulatory climate of the US stays as inhospitable to innovation in the crypto space as it is, then entrepreneurs will be forced to move. We might see that the “silicon valley of crypto” ends up being in Switzerland or some other country that is more open to innovation in this space.

Going back to the DAO report, we see that the SEC claims that the DAO token was a security but states:

“In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants”.

Which brings me to the final problem of regulating Ethereum - Ethereum enables unstoppable organizations. Since The DAO, most ICO’s have been held by companies, swiss foundations, or individuals who the SEC can bring charges against. But what is the SEC going to do in the case when an anonymous individual or group (similar to Bitcoin) deploys a DAO, and the DAO holds an ICO? The SEC could charge, arrest, and imprison the person or people that wrote the code and deployed the smart contract if they could somehow track them down, but at that point, it is too late. People will still be able to invest money in the this DAO, and vote on how to money is used within the DAO. You can’t seize the funds from a DAO without performing a 51% attack on the network. Ethereum truly does enable unstoppable organizations which is the final problem of regulating Ethereum that I would like to highlight. In the case of The DAO, it was shut down in a way with the fork of ETH and ETC, but if it had been successful, the SEC could only go after the people that started it. They could not actually shut down the smart contract which would live on for the life of the Ethereum network.

Clearly, there are a lot of scammers creating fake ICOs, and there are a lot of companies that are using the ICO craze to make money when they have no real product. But with all these problems, regulating Ethereum will only result in a loss of taxpayer money, because the problems outlined in this post are not solvable problems for governments. Individuals will have to take responsibility for their own investments and use common sense before throwing money at a newly formed company with no product. People will lose money and the SEC will not have enough resources to go after all the bad actors. The other consequence is that governments will begin to have a lesser role in society. With the invention of cryptocurrencies, the monetary system and the government are becoming decoupled much like the government and the church were separated with the founding of the US. I believe that this is a positive change as the government will lose the ability to use inflation as a means of deficit spending.

Despite the bad actors in the space, there are many participants who want to use Ethereum to solve some of the worlds worst problems, to grow the economy by creating new companies, and to conduct business in an honest and open way. For that reason, I believe the problems with regulating Ethereum are not really problems, but protections for people who want to make a difference using this revolutionary technology.

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Ryan Yosua

I am a software engineer currently working as a contractor at Nutrien. At Nutrien I am working with a team to develop an e-commerce site built in JavaScript and React. I occasionally blog about technology and entrepreneurship.