The SEC filings today, filled with factual errors and misleading statements, show concretely that the agency's incompetence is endangering investors.
The most decentralized dApp on Ethereum is Rocket Pool - it has more home stakers than Solana, Gnosis, Polygon, Avax, everything but Ethereum itself.
In a sea of charlatans, Rocket Pool has pioneered true decentralization.
In this post, I will first explain why I believe $rETH is NOT a security by analyzing all of Howey, Reves, and the FIT21 criteria. Next, I will explain several factual errors that the SEC has made in its lawsuit against @Consensys with evidence. After this I will say why Consensys will likely win on summary judgment by analysing the Coinbase victory.
Finally, I will explain how, just like tornado cash, Rocket Pool is unstoppable. Neither the Rocket Pool DAO, nor Rocket Pool LTD., nor the SEC, nor any US or international court has the power to stop people from running nodes at home or holding $rETH in their wallet.
Permisionless. Decentralized. Censorship resistant.
By the end of this essay, I hope you walk away with the knowledge that the SEC is hollow, Ethereum is the future, and Rocket Pool is enabling it.
Security?
Let's start with the elephant in the room. The SEC has alleged in its complaint against @Consensys that the $rETH token is an unregistered security.
Before diving into why I think the lawsuit will be dismissed before it ever gets evaluated on its merits, I want to defend the tougher position and establish why $rETH ought not to be a security. This analysis will be broken into 3 sections: an analysis through the Howey test and each prong, an analysis through the Reves test and its prongs, then finally an analysis through the yet hypothetical FIT21 for good measure.
I will be using @TeamPOSA's analysis for the below section and will link to their full report. I highly recommend reading it.
Disclaimer: I'm a full-time medical student. I am not a lawyer and I have never studied law. The people who wrote the report are, and you should read the real report. This is just my interpretation of their arguments.
Howey Test
Prong 1 of Howey: Investment of Money
Liquid staking tokens operate akin to titles on staked assets such that "the holder possesses legal and beneficial ownership of the staked cryptoassets and any Network Rewards generated from (or slashing penalties deducted from) such cryptoassets."
Rocket Pool is fully noncustodial -- ETH is automatically allocated to a pool where it is used to launch validators across a many thousand strong node operator set.
In the context of Rocket Pool, the protocol does not "have any discretion as to how to use the funds, but instead the cryptoassets are required to be staked until the Liquid Staker makes the decision to redeem the underlying cryptoassets"
Prong 2 of Howey: Common Enterprise
None of Rocket Pool node operators, Rocket Pool DAO, nor Rocket Pool LTD form a vertical or horizontal common enterprise.
Horizontal commonality requires the pooling of assets and the entwinement of providers' and investors' fortunes. Neither of these bars is met in the case of $rETH.
First, assets are not pooled for investment. Users retain custody of their title and have ownership of the underlying ETH at all times. The SEC actually acknowledges this in a roundabout way in their suit.
"put up collateral..." is an incorrect view of what is really happening. Each and every Rocket Pool node operator only ever has custody over their own ETH. It is collateral in the sense that it is what node operators provide and may lose. There is no link between a node operator losing their ETH and $rETH holders writ large.
The situation does not even qualify as a bailment! There is no direct relationship between the fortunes of individual node operators and the $rETH holders. Custody is silo'd such that no liability is engendered.
From this, it is clear that the DAO and the Rocket Pool LTD are not engaged in a horizontal relationship as neither has any ability to claim custody over $rETH's underlying assets in a legal or practical sense at any point in the arrangement.
Vertical commonality requires providers and investors to share risk. As I explained above, this is not present for the decentralized automatic system that $rETH operates upon. Node operators have custody only over their provided ETH and $rETH holders only have custody over their supplied ETH.
The risk profiles of these two are distinct as exemplified by some node operators experiencing large losses due to slashing while $rETH holders feel no loss. In this way, the traditional managerial component of staking is fully absolved/removed/inapplicable.
To sum up this section: the profits and losses of $rETH holders are not tied to one another, nor are they tied to individual node operators providing ministerial services. Assets are silo'd thanks to smart contracts such that custody remains with each independent party and so no vertical or horizontal commonality can be established.
Prong 3 of Howey: Expectation of profit
This is nuanced. There is *some* expectation of profit from holding $rETH. However, I agree with @TeamPOSA that the Supreme Court's decision in United Housing Foundation, Inc. v. Forman is illustrative here.
"The Forman Court distinguished ancillary features of consumptive instruments that might generate “speculative and insubstantial” profits, which are insufficient to bring the entire transaction within the scope of the federal securities laws, from the core features of an instrument that are designed to return profits to the investor."
further: "[p]rice appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test."
I hold that staking is an ancillary feature of ETH that it provides 'insubstantial' profits. Just like growing a few plants on land for consumption and use is an inherent yet minor part of owning land, staking is an inherent yet minor part of owning ETH. In terms of USD, the average fluctuation of ETH massively outweighs the small return that one gets.
One might take another approach and argue that inflation paid to $rETH holders is compensation for work provided in defense of Ethereum rather than profit. The primary feature of staking is *not* profit seeking - it is providing security and functionality to the Ethereum blockchain. This role inherently requires cryptoeconomic incentives.
Thus, the argument is that there is not an expectation of profit, but a desire to make use of one's ETH and receive compensation from it. An analogy could be made to storing plants in a greenhouse - the plants will grow but the relationship is only that of warehouse bailment.
Prong 4: Efforts of others
For this prong, consider the case of gold storage.
In this case, gold is stored in a facility and a receipt is created. The individual who sold the future right to the gold did not have a security relationship with the gold storage facility. The storage facility provided non-essential services and were largely unrelated to the profit or loss realized. I say largely as it seems prima facie true that gold stored in a facility will retain value better than gold held in a closet and so some degree of value fluctuation is acceptable.
The same is true for $rETH. ETH is stored within the Rocket Pool contracts (more accurately within validators on the beacon chain) and users retain custody over it. As I explained in the previous section, the primary factor for profitability of $rETH in USD terms is the value of the underlying ETH. The services provided by the Rocket Pool contracts provide a minuscule fraction of the average yearly volatility.
Efforts are clearly not essential as users will experience largely the same profits if they choose to hold their ETH, stake with $rETH, or use one of many competitors. The ease of switching within metamask provides a strong argument that the efforts are not "undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise."
Reves Test
Now that the Howey test is out of the way, the other option the SEC has is the Reves test. While I hold that $rETH is not a note but rather a commodity, I want to analyze the arguments the SEC *could* make if it went this route.
After the Reves test, I will explore FIT21 and then the errors in the Consensys case.
Prong 1 of Reves: Motivations of the Seller and Buyer
The SEC holds that "If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a ‘security.’"
First off - $rETH is neither sold nor bought by the protocol. The concept of 'minting' is completely orthogonal to ideas of buying and selling. The non-custodial nature of $rETH is what enables minting rather than buying/selling.
Further, the ETH in Rocket Pool contacts is not being raised for general business use. It is automatically distributed in staking while $rETH holders retain custody.
Prong 2 of Reves: Plan of Distribution
The second prong of Reves says that a security is widely distributed for trading to the general public.
Fair enough - ultimately $rETH aims to be traded by any/all parties. That said, it is currently only available to those who hold ETH which is a relatively small subset of the general population. Over time, though, this will change.
Prong 3 of Reves: Expectations of the Public
If the general population views the asset as a security, the court is more likely to view it as one as well. On this topic, it is important to note that the SEC itself admits that Rocket Pool has separated itself from the pack and earned a perfect rating on Ethereum(.)org.
This high rating is one of the reasons the general investing public does *not* view $rETH to be a security.
In fact, in light of the recent SEC withdrawal of investigations into Consensys over ETH2.0, the prevailing sentiment has been that $rETH is a commodity receipt - especially due to its unparalleled decentralization.
Prong 4 of Reves: Alternative Regulatory Regime
The final prong of Reves holds that a note may not be a security if it is better regulated under an alternative regime. In my opinion, $rETH is best served under the CFTC as a commodity just like ETH.
@TeamPOSA writes: "the CFTC and federal courts have deemed certain “digital assets,” including bitcoin, ether, litecoin and tether, to be statutory commodities regardless of whether futures contracts may not presently or in the future be dealt in any particular type of cryptoasset (e.g., tether)."
It is worth also noting that the Supreme Court in Reves said that the uncollateralized nature of the note "an unfavorable fact when searching for risk-reducing factors to suggest the instruments were not securities."
$rETH is best served under the CFTC as the only overcollateralized staking option. As an aside, such a classification would enable the ETFs to hold $rETH. This is a win for ETF consumers as $rETH provides optionality and exposure to staking in a risk-minimized fashion.
FIT21
The last of the three tests is FIT21. Of the three, FIT21 is the only one that is still hypothetical. I am including it as I believe it to be a highly robust test of decentralization.
Prong 1 of FIT21: Power Rule
This prong asserts that no single person can alter the code or censor any individual from using the protocol.
With the recent Houston upgrade and passing of power to the pDAO with onchain voting, there is no person with this power.
Prong 2 of FIT21: Ownership and Voting
(i) - in the last year, no 'affiliated person' can own 20% of the asset ✅
(ii) - no 'person' had the power to direct 20% of voting power✅
(iii) - must give up power✅
$rETH is very distributed and governance is very egalitarian incorporating quadratic scaling.
Prong 3 of FIT21: Code Changes
(i) in the last three months no changes were made unless "adopted through the consensus or agreement of a decentralized governance system."
With the Houston upgrade the countdown begins to the fulfilment of this prong
Prong 4 of FIT21: No Marketing as an Investment
Doesn't get any simpler - don't market the asset as an investment within the past 3 months. ✅
Prong 5 of Fit 21: Inflation
Token issuance in the last 12 months must be an end user distribution - government talk for an airdrop that: 1 is broadly distributed, 2 relates to the nature of the chain, or 3 is based on the holdings of another asset.
$rETH is a non-rebasing token. This means that there are no airdrops of $rETH
In summary, $rETH does not meet any prong of the Howey test, Reves, or FIT21 bill.
Its decentralization and lack of managerial or custodial control have established Rocket Pool as a critical protocol for Ethereum.
The SEC's Folly
In the filings by the SEC against @Consensys regarding @MetaMask, @Rocket_Pool, and @LidoFinance, the @SECGov made several large and small errors.
The first error is below:
The flow described here is incorrect. The process of ETH being deposited to the beacon chain and users minting $rETH is related but distinct. This is important as it relates to the silo'd nature of the capital and lack of custodial cross-polination.
Second error:
The SEC, as I will go into more depth later, seems to have a poor grasp on reading smart contracts. The fee they are describing here is not applied to staking rewards!
They are conflating two completely different things here. There is a commission charged by node operators from $rETH holders. There is also a fee for minting $rETH which is 0.05%
It is *highly concerning* that the SEC doesn't know the difference between a trading fee and a commission in a published lawsuit!
Third error, largest, arguably a straight up lie:
Anyone who takes a look at the staking router contract will tell you that it is absolutely not true that the router contract temporarily holds (implying a state of custody) a user's ETH prior to the conversion to $rETH.
The transaction is atomic. At one point in time, there is ETH in the user's wallet. At the very next point in time, there will instead be $rETH in their wallet and ETH deposited with @Rocket_Pool. Consensys can take a fee and they would still never have provided essential support to the user or held custody of user funds.
Let's take a look at an example! You can see a version of the @MetaMask Lido contract in action here:
What you'll notice is that in the same block that the ETH is deposited, the $stETH is minted and it is deposited into the user's wallet. There is never an opportunity for Consensys contracts to take custody of user ETH except for taking a fee (also atomically)!
Summary Judgment
With these factual errors in mind, I will now posit why I believe @Consensys will win the suit in summary judgment. They do not need to argue that $rETH and $stETH are not securities when @coinbase recently won a very similar motion to dismiss.
Judge Falia ruled that the SEC could not sue Coinbase for being a broker through the CB wallet largely because the wallet is merely a tool to interact with the blockchain.
The Judge writes, "the SEC does not allege that Coinbase performs any key trading functions on behalf of its users in connection with those activities.
As the Complaint acknowledges, Coinbase has no control over a user’s crypto-assets or transactions via Wallet, which product simply provides the technical infrastructure for users to arrange transactions on other DEXs in the market...providing pricing comparisons does not rise to the level of routing or making investment recommendations...the fact that Coinbase has, at times, received a commission does not, on its own, turn Coinbase into a broker...
...the factual allegations concerning Wallet are insufficient to support the plausible inference that Coinbase “engaged in the business of effecting transactions in securities for the account of others” through its Wallet application."
All these same arguments hold true for @Consensys and @MetaMask as they did with @coinbase. With this precedence and the failed attempt at asserting Consensys holds custody, it is hard to see any other outcome but summary judgment for dismissal.
Immortan rETH
Finally, I want to end this thread/essay with a note on injunctive relief.
Even if Consensys somehow loses and even if the SEC goes after @Rocket_Pool directly, there is little that any court can do to stop the system from autonomously running.
Consider Tornado Cash. While yes volume through the dApp has slowed since it was put on the sanctions list, it has not died! It still runs! Truly decentralized applications will live on forever.
Rocket Pool was designed with decentralization as both a goal and a starting point. Once upon a time there was a consideration to launch Rocket Pool in a centralized state and decentralize with time. It is possible that $rETH would have a much larger market cap if that was true, however, the growth would've been fake.
Rocket Pool is immortal. The infinite garden will outlive most civilizations. No one can stop these protocols. The die is cast.
History will not look kindly on this SEC. However, history will experience $rETH.
If you made it this far, I encourage you to consider running a node at home. It's easier than you think. Also, check out all the incredible resources that I used to put this all together!
Sources:
@TeamPOSA essay on LSTs re Howey and Reves: https://static1.squarespace.com/static/62f147feb8108a08e666aea5/t/63f41766f6095b07bec7d1e8/1676941158721/U.S.+Federal+Securities+and+Commodity+Law+Analysis+of+Liquid+Staking+Receipt+Tokens+%28Willkie+Draft+02.14.23%29.pdf
https://www.proofofstakealliance.org/22123-posa-liquid-staking-legal-white-paper
Consensys vs SEC:
https://www.docdroid.com/YS1DSF5/sec-v-consensys-pdf#page=50
Coinbase vs SEC:
https://law.justia.com/cases/federal/district-courts/new-york/nysdce/1:2023cv04738/599908/105/
MM staking router contract: https://etherscan.io/address/0xc7bE520a13dC023A1b34C03F4Abdab8A43653F7B