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Why Betting on the Ethereum Ecosystem is a Gamble

Liz Louw
Liz Louw
3 July 2019
 

In part 5 of our Bitcoin Myths series, we debunked the idea of Ethereum Ecosystem as a ‘Supercomputer Network’ or a ‘Decentralised World Computer’. Although the Ethereum blockchain copied some elements of the Original Bitcoin protocol, the non-existent barriers to entry (meaning: anyone can create an Ethereum-based token in as little as 4-minutes) combined with the absence of regulations mean that investors have little protection and peddlers of fraudulent projects mostly get off scot-free. These two elements alone make the Ethereum blockchain the perfect environment for scam artists to hustle unwary investors.

Perhaps you feel that none of this applies to you since you’re a seasoned cryptocurrency investor who follows a thorough process of evaluating cryptocurrency projects before you invest in them. You may even think, “scam or not; there’s money to be made by trading crypto coins for the short-term”. 

Whatever your position, it’s time that we talk about how Ethereum is positioned to compete as a blockchain technology, and how it’s positioned to stand up to regulatory enforcement that’s been brewing.

Ethereum is not Truly Decentralised

The concept of a ‘decentralised’ blockchain means different things to different people.

Some believe that the distributed nature of a blockchain’s ledger automatically qualifies it as a decentralised project. In other words, as long as there are multiple copies of the ledger existing in tandem operated by a significant number of independent operators, the network is decentralised.

For others, decentralisation is all about the distribution of mining power. This group warns against the infamous 51% attack scenario where a single mining operator has gained enough power to manipulate the consensus algorithm in their favour, e.g. by double-spending coins.

In the case of Ethereum, the network may well be based on distributed ledger technology, and the mining power may well be widespread across different operators, but the power to make protocol altering decisions is everything but decentralised.

A prime example occurred quite early in Ethereum’s history when one of the first Ethereum-hosted projects, the DAO (decentralised autonomous organisation) was hacked and tokens to the value of over $50m were stolen due to a poorly coded smart contract.

What transpired after the hack was discovered is a compelling counter-argument to claims that Ethereum is decentralised, or immutable, for that matter! Cryptocurrency Reporter, Amy Caster tells of the outcome:

The blockchain was supposed to be immutable, meaning that once a transaction was recorded on the ledger, that was that. You could not undo it. In 2014, Ethereum co-founder and lead developer Gavin Wood spoke about “allegality,” the idea that a system “cannot care” whether its actions are legal or not legal. “Decentralised software as a service has no operator,” he said.

But after some deep soul searching, the Ethereum Foundation, some of whom were curators of the DAO or had personally invested in it, decided to “roll back” the entire Ethereum blockchain to return the lost funds.

While the hard fork sure was good news for the impacted investors it revealed the willingness of the Ethereum Foundation to alter the so-called immutable Ethereum blockchain, when their own interests are at stake.

When a handful of developers have the ability to alter a particular protocol, they have the power to operate the network in a highly controlled fashion. This is a far cry from our definition of decentralisation.

Our Definition of True Decentralisation

Legitimate decentralisation is clearly about much more than claiming the title, and yet it’s not as difficult as abiding by everyone’s personal definition of the concept.

Blockchain Scientist, Craig Wright illustrates how the centralisation of power can be prevented by establishing the blockchain with some simple, yet steadfast criteria in place:

“For a cryptocurrency to be decentralised, it needs to be set in stone.

The same does not apply to just Bitcoin. Any cryptographic asset that can be altered by the protocol developers to change the nature of transactions such that it could alter the format making a transaction signed today become invalid some time within the next 20 years is centralised.

Creating something that is decentralised is very simple; you need to launch a cryptocurrency in such a way:

  1. Create a set fixed protocol.
  2. Allow no pre-mines or special benefits outside of time for the creator and other investors.
  3. Start the system with no value that is intrinsic in the system.
  4. Allow individuals to earn in securing the network and validating transactions.”

Is Ethereum an Unregistered Security?

“99 per cent of cryptocurrencies are going to fall on the wrong side of regulation. So we see this as massively clearing up the market," Bitstocks CEO, Michael Hudson

Another elephant stomping around the Ethereum blockchain is the matter of compliance with security laws.

A word of warning: you might not much care whether regulators give a blockchain project a thumbs-up or down, but you sure will feel the pain if a court of law orders miners to freeze all transactions associated with a particular coin or seizes the assets themselves as they’ve done in hundreds of cases.

As illustrated in our Bitcoin Myths series, Bitcoin was not created for crypto anarchy but to operate within the legal boundaries. Now, let’s take a look at the Ethereum Ecosystem.

Over the last three years, several contradictory statements have piped up from the ranks of the United States’ Securities and Exchange Commission (SEC). Their ‘conclusions’ have ranged from “all ICO’s are securities” (2017 SEC Report) to “'all ICOs are securities but Ethereum is not" ( 2019 Clayton's Senate testimony), leaving legal experts baffled.

Matthew Gertler, a senior analyst and counsel at Digital Asset Research, reportedly wrote the following note in an analysis of the 2019 Clayton's Senate testimony

"It is not at all clear to us how 'all ICOs are securities' and Ethereum is not”. Ethereum, after all, "conducted a token sale in 2014."

There is also a number of legally trained cryptocurrency professionals who have stated their belief that Ethereum passes all the criteria of being a security (and is, therefore, under law, required to be registered with the SEC or face penalties and/or criminal prosecution).

In conclusion to an in-depth analysis of Ethereum’s governance and economic model, Craig Wright (LLM International Commercial Law), states:

“The [Howey] test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value.

With proof of stake, Ethereum will move to fulfill all of the requirements of the test. Yet, it is not registered…”

In an article titled, “The SEC is wrong! Ethereum is a Security”, Blockchain Legal expert, Thijs Maas writes:

“The wording of the Howey-test’s fourth prong is whether an investor’s expectation of profits is ‘reliant solely on the efforts of a third party’. In the case of Ethereum, it is true that the value of Ethereum tokens is determined by many factors, parties and decisions — not solely the Ethereum Foundation.

However, further case law has shown that the word solely can be very loosely interpreted. After all, the Howey-test is concerned with the economic reality of a product. The economic reality here is that the Ethereum Foundation still plays a very significant role in the Ethereum ecosystem. Therefore information disclosure about the Ethereum foundation is of importance for the protection of investors.

Personally, I believe that the information asymmetries between retail investors and ‘insiders’ are bigger in the crypto space than in any traditional business, albeit partly due to the complicated nature of blockchain technology.

Getting rid of such information asymmetries is why securities laws exist in the first place and I believe that if it was up to a competent judge/jury, the only conclusion will be that Ethereum was, and still is, a security.”

What gives with all the confusion? Most blockchain professionals agree that the lack of clarity from regulators stems from their lack of understanding of the nature of Bitcoin and other cryptocurrencies. You can’t definitively categorise what you don’t clearly understand, as highlighted by David Case of CryptoFights in a recent Bitstocks podcast.

 

 

What is clear that under United States law, for one, any asset that qualifies as a security has to be registered or face the possibility of criminal punishment and/or financial retribution. Considering the SEC’s warnings about "potentially unlawful online platforms for trading digital assets" goes back to March 2018, nobody can say they weren’t warned and aware of the potential risks of investing in the Ethereum Ecosystem. 

Choosing a Blockchain with the Future in Mind

Perhaps, by now, you think me an Ethereum nay-sayer. Perhaps the regulatory uncertainty regarding Ethereum’s legal status and the centralised nature of its management are risks you are willing to take. Be that as it may, at Bitstocks we advocate a well-researched long-term investment strategy.

We undertake investments the way one might go about building your ‘forever home’ in a dreamy location:

Once you’ve researched the pros and cons of different areas in your chosen region, you’ll start viewing every available piece of land until you find a plot that suits your vision.

And then, because so many new homeowners have ended up in bitter court battles after buying a frog dressed up as a prince, you wouldn’t rush ahead and sign the deal on the spot. Instead, you’d have a land survey done to make sure the plot is stable enough to build on, and suitably zoned for the type of building you’ve designed.

If you’re particularly prudent, you’d get a lawyer to verify the terms of the agreement. Only then would you sign the deed, satisfied that you’ve done everything within your power to assure that your investment will deliver on your hopes and dreams.

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