Does the Merge change how Ethereum is regulated? (No.)

The Ethereum Merge is resurfacing questions about regulatory differences between proof-of-stake and and proof-of-work. As we’ve said many times, we do not believe that the technological differences between POS and POW warrant any different treatment.

The two major issues that folks tend to raise are securities law and OFAC policy, the latter especially now in light of Tornado Cash smart contract addresses being added to the SDN list of sanctioned persons and property.

On the securities law side, the SEC has always stressed that they look at the economic realities of transactions rather than the terms or technologies used to create those realites. The approach is substance over form, and it’s also the approach we’ve advocated in our framework for securities regulation going back as far as 2016.

As we’ve explained in past work, the economic realities of validating a chain through mining and validating a chain through staking are similar. In both cases validators are an open set of participants and the only precondition to participation is provably suffering some cost. In proof-of-work that cost is energy and computing resources, in proof-of-stake it is the time value of money (e.g. the opportunity cost of holding an asset needed for staking rather than spending it). Central to classification as a security is ongoing reliance for profits derived primarily from the efforts of others. Both consensus mechanisms are explicitly designed to avoid any such reliance by creating an open competition amongst strangers wherein any self interested participant can and will fill the gap left by any other unresponsive, corrupt, or censorious participant.

Now, of course, the SEC has lately been taking a very broad view of its jurisdiction, so there’s plenty of legal risk to go around potentially. Our analysis of the technology, however, suggests that there should be no differential treatment of projects based merely on the choice of one or another permissionless consensus mechanism. We also gave a comprehensive talk on this subject to the CFTC’s Technical Advisory Committee back in 2019. Otherwise decentralized cryptocurrencies that use proof of stake consensus are commodities, and, therefore, the CFTC has spot market policing authority and derivatives market supervisory authority.

On sanctions the issues are more novel and we’ll be publishing an in depth analysis soon. The short version, however, is that while miners and stakers in the US are subject to OFAC regulation (as are any other US persons), the activity of mining and staking alone (even mining or staking on top of a blockchain that includes some sanctioned transactions) is an exempted activity because it is covered by the Berman Amendment carve outs from OFAC jurisdiction (50 U.S.C. § 1702(b)). Those carve outs are intended to make clear that the President’s authority to block transactions should not extend to transactions merely involving the import or export of information.

As Congress found in 1994 while updating the Berman amendment language to strengthen its protections for the import or export (commercial or otherwise) of information of any sort:

[N]o embargo may prohibit or restrict directly or indirectly the import or export of information that is protected under the First Amendment to the U.S. Constitution. The language was explicitly intended, by including the words “directly or indirectly,” to have a broad scope. However, the Treasury Department has narrowly and restrictively interpreted the language in ways not originally intended. The present amendment is only intended to address some of those restrictive interpretations, for example limits on the type of information that is protected or on the medium or method of transmitting the information.

We will be publishing a more in-depth analysis soon. For now, it’s enough to note that miners and stakers, when they choose to add a block to a blockchain, are merely transmitting information related to already signed and valid cryptocurrency transactions. The type of information and the medium are unique, it’s true; but Congress and the courts have repeatedly found that even novel, commercial, or unconventional information types and media are included in the Berman Amendment exemption. In return for information transmission validators can claim block rewards and transaction fees, but the mere “commercial” nature of such a transaction does not obviate the fact that it is nonetheless a transaction in information, and therefore carved out of OFAC jurisdiction under IEEPA.

There are many further and more nuanced questions to answer on this topic and individuals should seek legal counsel if they are going to engage in these activities. As for the merge, however, we see no reason why the Berman Amendment carve-out from OFAC sanctions would apply any differently between proof-of-work or proof-of-stake validators.