The Securities and Exchange Commission potentially could deliver some fairly dire news to Ethereum (ETH -0.62%) investors. The agency is sending intensifying signals that it considers it to be a security rather than a cryptocurrency. Most recently, SEC Chairman Gary Gensler suggested that Ethereum's recent transition to a proof-of-stake blockchain is further proof that the second-largest cryptocurrency in the world is a security and should be regulated as such.
Obviously, any change in the regulatory stance of the SEC would have profound implications not just for Ethereum but also the entire crypto industry. Since 2018, there has been a general consensus that Ethereum is a cryptocurrency. As a result, it has never run afoul of federal securities laws. But then came The Merge in September. So what would happen if the SEC decided to regulate Ethereum as a security?
The bearish scenario
In a worst-case scenario, the SEC would bring some sort of enforcement action against Ethereum, in the same way that the SEC has gone after other players in the crypto industry. For example, the SEC has gone after cryptocurrency trading platform BlockFi for its crypto lending practices, and it has gone after Coinbase (COIN 5.68%) for allegedly listing some securities (and not cryptocurrencies) on its platform. Back in 2020, the SEC also went after high-flying crypto XRP (XRP -1.65%), alleging that it is a security and not a cryptocurrency.
Image source: Getty Images.
Most likely, the SEC would target the new staking opportunities for Ethereum investors made possible by the blockchain's transition to a proof-of-stake consensus mechanism as part of The Merge. In a traditional staking mechanism, investors agree to lock up their crypto investments for a specified period of time, as a result of which they receive staking rewards. From the SEC's perspective, this sounds an awful lot like an "investment contract." And that means the SEC might decide to make an example of Ethereum. Obviously, this could have disastrous consequences for the future price of Ethereum. Would you invest in a crypto that is facing SEC action? As we have seen in the case of XRP, any legal case can drag on for years, placing a pall over the cryptocurrency and making it toxic for institutional investors.
The bullish scenario
In a best-case scenario, this might just turn out to be saber rattling by the SEC. Although the SEC has been beefing up its resources of late, including the establishment of a new Office of Crypto Assets in September, it clearly does not have the resources to go after the entire crypto industry. After all, if Ethereum is a security, then so is almost every other crypto, with the possible exception of Bitcoin (BTC -2.05%). Moreover, it now looks like the Commodity Futures Trading Commission (CFTC), and not the SEC, will get to regulate crypto, so maybe this entire argument is moot.
But even if the SEC does decide to expand its "regulation by enforcement" approach in the coming months, a growing number of voices within the crypto industry say that more regulation, no matter what form it takes, might actually be bullish for crypto. Most notably, it would legitimize crypto, and help to eliminate many of the hacks, shills, and grifters who exist today. That might be the reason the SEC went after a high-profile social media influencer like Kim Kardashian -- from now on, any other social media influencer is going to think twice before shilling for a crypto on social media. Kardashian's sin was promoting a crypto without disclosing she'd been paid to do so.
From this perspective, the SEC might decide to take a closer look at staking on the Ethereum blockchain simply as a warning to others. Eventually, it might find that staking does not violate any securities laws, which could give a green light for Ethereum to continue business as usual. That might lead to a huge relief rally for Ethereum.
Is Ethereum a buy now?
Regulatory risk has always existed within the crypto industry. But now it looks like regulatory risk has suddenly coalesced around Ethereum. If you are thinking about investing in Ethereum, you certainly have to take this risk into account along with other risks such as volatility.
The big question now is: What will big institutional investors do when presented with this new risk profile for Ethereum? That's why I think the specter of enhanced regulation of Ethereum will be an important factor that influences its price in the near term. While I'm still bullish on Ethereum in the long run, it's hard to see Ethereum rallying until regulators have figured out what they are going to do with it.
