SEC may be forced to declare Ethereum a security after controversial new launch

So far, the Securities and Exchange Commission has avoided taking a position on Ethereum’s legal status even while declaring more than a dozen other popular cryptocurrencies to be securities. The latest gambit by New York–based Prometheum, which claims it has discovered a compliant path for crypto within existing laws, could force the agency’s hand. 

Legal experts have told Fortune that Prometheum’s plan to launch its custodial service may compel the SEC to resolve the long-running Ethereum question. If the agency does indeed proclaim Ether to be a security, Prometheum could be in a pole position when it launches its planned trading platform next quarter—even as the rest of the industry insists crypto can’t be viable without new laws.

A controversial new player

Longtime crypto exchanges like Coinbase and Kraken offer trading platforms in the U.S., allowing users to buy and sell popular cryptocurrencies like Bitcoin and Ether. While many of the firms have been around for more than a decade, they still operate outside the regulatory framework of the existing financial system, which has led lawmakers to propose new rules for the industry. 

SEC Chair Gary Gensler, who has stepped up enforcement after the disastrous collapse of FTX, has said existing rules are sufficient and filed lawsuits against exchanges for failing to register with the agency. In response, companies like Coinbase have argued that the existing rules are outdated. 

While much of the U.S. crypto industry has sided with Coinbase, Prometheum has taken a different—and contentious—approach.

Founded by two brothers, Aaron and Benjamin Kaplan, Prometheum received regulatory approval in 2021 to operate an alternative trading platform—similar to a stock exchange—where users can buy and sell different securities. The company went on to gain widespread attention in mid-2023 when it announced a first-of-its-kind approval from the Financial Industry Regulatory Authority (FINRA)—an industry oversight body that’s independent of the SEC—to operate as a special purpose broker-dealer for digital asset securities. The SEC first created the designation in 2021, but no other firm has succeeded in obtaining a license, though others, including Robinhood, have tried.

Prometheum’s claim to have found a compliant path for crypto trading immediately drew condemnation from legal figures in the crypto industry, who argued that even if the SEC and FINRA approved Prometheum’s structure, it would not have any assets available for trading. That is because, skeptics argue, the SEC has jurisdiction over securities, while cryptocurrencies like Solana and Ether are more like oil or gold—assets that don’t fit the legal definition of a security and so can’t be registered.

The Kaplan brothers, in contrast, agree with the SEC’s assessment that most cryptocurrencies are securities. They argue that Prometheum will be able to list different crypto assets as securities under an exemption called Rule 144, which is used to trade restricted stocks, and that they can use blockchain data to determine whether the assets have been in circulation for more than a year—a key factor for the exemption. As an alternative trading system (or ATS), Prometheum will not have to work directly with the issuers but instead can choose which assets to list.

Prometheum’s claims have not only riled the crypto industry but Republican lawmakers, who have argued that Gensler had propped up the little-known firm to further his own regulatory agenda. In a June appearance on CNBC, for instance, Gensler touted Prometheum’s registration as a special purpose broker-dealer as an example of a compliant path for the industry. And last June, the company received a prized invitation to testify at a congressional hearing about crypto despite having virtually no presence in the industry.

The debate over Prometheum’s proposal has until now been theoretical, but Wednesday’s announcement of Ether custodial services, which are slated to launch by late March for institutional clients, means the company is on the cusp of becoming the first crypto exchange to compliantly offer assets like Ether for trading.

“We want to work with the crypto industry,” Benjamin Kaplan said in an interview with Fortune. “Our goal is not to destroy, it’s not to harm, it’s not to undermine—it’s to help build.”

‘Move the ball forward’

In the traditional world of stock markets, the various steps that make up a trade are divided among different firms. For instance, a retail trader visits a broker like Fidelity to buy a share of Apple stock, leading Fidelity to turn to a broker-dealer like Citadel Securities to fill the order. Next, a firm called the National Securities Clearing Corporation, a subsidiary of the Depository Trust and Clearing Corporation, figures out who owes what in all the trades the broker has made that day—a process known as clearing.

At this point, another DTCC subsidiary called the Depository Trust Company steps in to oversee the funds and securities moving from one party to another—a process called settlement. Finally, an institution—either the original broker or a firm like State Street or BNY Mellon—serves as the custodian, meaning it holds the actual securities on behalf of the investors.

One of the reasons for separating these various functions is to prevent conflicts of interest. If Citadel, for example, was serving as both an exchange and a broker-dealer, it could digest customer trade information and front-run orders. Separating brokers into distinct entities also prevents markets from having a single point of failure, as happened with FTX.

James Angel, an associate professor at Georgetown focused on financial regulation, told Fortune that much of the separation is also historical—a convention that the crypto industry is seeking to disrupt with the help of blockchain technology.

Firms like Coinbase offer clearing, settling, custody, and trading services under one roof, an arrangement that provided partial fodder for the SEC’s lawsuit against the exchange. The agency’s primary complaint, though, was that Coinbase and others had not registered with the SEC to offer any of these services—even as it sold what the agency deemed to be securities. 

Prometheum, meanwhile, believes it has found a way to sell crypto without triggering any of these objections from the SEC, in part by dividing itself into two entities.

One, the alternative trading system, is a member of FINRA and registered with the SEC, and will provide a front-end platform for investors to buy and sell crypto assets. The other entity, Prometheum Capital, is the company that received the special purpose broker-dealer license and a final go-ahead from FINRA in January to offer the clearing, settling, and custody services necessary to complete the trades.

The upshot is that, while firms like Coinbase have been battling with the SEC, Prometheum has been getting approvals from FINRA, which is nominally independent of the agency but also works closely with the SEC and is ultimately subject to its oversight. It is also notable that, while other firms have applied to receive the special purpose broker-dealer license—the one created by the SEC in 2021 and issued by FINRA—Prometheum is the only one to receive it.

Now, Prometheum’s custodial services for Ether announcement suggests the company is on track to offer the popular cryptocurrency for trading to institutional investors later this spring. More consequentially, by offering custodial services for Ether, Prometheum is claiming that Ether is a security—a critical question that the SEC has yet to decide on—and doing so as a FINRA- and SEC-regulated business. 

“You have to be able to custody before you trade,” Aaron Kaplan told Fortune. “This is hopefully going to move the ball forward.” 

‘It’s a gamble’

Fortune spoke with four lawyers and academics with expertise in digital asset regulation who agreed that Prometheum’s custody launch could lead the SEC to finally rule on Ethereum’s legal status, especially because Prometheum prominently displays its registered status with the two organizations on its website—a decision that Boston University lecturer Mark Williams described as “marketing.” 

“It’s a gamble,” Williams told Fortune. “Maybe it’s part of their business strategy to force the hand of the SEC.” 

William Brannan, vice chair of the crypto practice at Lowenstein Sandler, said that Prometheum would be creating “unnecessary controversy” by announcing Ether as the first asset it would custody, given the SEC’s reluctance to take a stance on it. 

Even though Prometheum’s primary regulator is FINRA, which operates separately from the SEC, Brannan said FINRA likely would be working with the SEC on the question of Prometheum’s launch of Ether custodial services, owing to the decision’s magnitude.

“My hunch would be that, particularly for these types of issues, FINRA is in very close contact and consultation with the SEC, and would likely be liaising with them and seeking to get some clarification on their position,” Brannan told Fortune. 

According to a company spokesperson, since Prometheum received the special purpose broker-dealer license from FINRA, it doesn’t require further approval to make assets available for custody, but it has informed FINRA of its plans to offer services for ETH.

Spokespersons from FINRA and the SEC both declined to comment when reached by Fortune.

If the SEC took action to stop the offering, it would likely come after Prometheum launched its custodial services for Ether. Still, Ron Geffner, a partner at Sadis & Goldberg and a former SEC enforcement attorney, said that he does not expect the SEC to block Prometheum’s approach given Gensler’s stated desire to find a company that can operate under the SEC’s preferred guardrails. “The SEC, given their position on crypto being a security, wants successful registrants in the marketplace that are complying with federal securities laws and supporting their position,” he told Fortune. 

The question remains whether Prometheum can draw investor interest—and whether its approach will survive subsequent SEC administrations. The Kaplan brothers argue that creating a compliant approach will drive institutional participation in the crypto industry, although they haven’t specified if the trading platform has potential clients lined up. Williams expressed skepticism that Prometheum would pull off its bold move. “They’re not market-tested, so I would just have some caution in regard to their ability,” he told Fortune.

But even if Prometheum can’t drum up demand, or running the operation proves too expensive, a successful launch could upend the industry’s argument that crypto is incompatible with existing securities laws. And that clarity, Brannan said, wouldn’t be the worst thing.

“There’s a certain degree of value,” he told Fortune, “in just knowing exactly what the rules of the road are.”