Regulating Cryptocurrencies: Are you Investing in Securities?
Thought Leaders are articles that are contributed by respected members of the fintech & digital assets community. They may or may not necessarily reflect the views held by the Securities.io team.
There is an ongoing legal case between SEC and Ripple Labs. In December 2020, the San Francisco-based corporation and its current and former senior executives were sued by the SEC on charges that they had been selling unregistered securities worth $1.3 billion since the token’s inception. The commission declared XRP as a security. You should have heard of this case if you are in the crypto industry. Many questioned how this happened and will this have any affect on the rest of the cryptocurrencies. What is a security? How SEC determine what is a security? I will try to break it down in this article.
What is Howey Test?
The Howey test is used by the U.S. Securities and Exchange Commission (SEC) to determine whether a particular financial product or transaction qualifies as an “investment contract.” If a product or transaction is deemed to be an investment contract, it is subject to certain regulatory requirements under federal securities laws.
The test is named after the 1946 Supreme Court case SEC v. W.J. Howey Co., in which the Court established a four-part test to determine whether a transaction qualifies as an investment contract:
- It involves an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
If all four of these criteria are met, the transaction is considered an investment contract and is subject to regulation as a security.
What is a Security?
Before we look further, let’s look at what is a security. A security is a financial instrument representing an ownership position in a publicly traded corporation (stock), a creditor relationship with a governmental body or a corporation (bond), or rights to ownership as represented by an option.
There are several types of securities, including:
- Stocks: Stocks represent ownership in a company and entitle the holder to a share of the company’s profits.
- Bonds: Bonds are a type of debt security that involves borrowing money from an investor for a set period of time at a fixed interest rate.
- Options: Options are a type of derivative security that gives the holder the right, but not the obligation, to buy or sell a specific asset at a predetermined price within a specific time frame.
- Mutual funds: Mutual funds are investment vehicles that pool money from multiple investors and use that money to buy a diversified portfolio of stocks, bonds, or other securities.
- Exchange-traded funds (ETFs): ETFs are investment funds that are traded on stock exchanges, much like stocks. They typically track an index, such as the S&P 500, or a specific sector or theme.
- Derivatives: Derivatives are financial instruments that are derived from other assets, such as stocks, bonds, commodities, or currencies. They are used to hedge risk or speculate on the price movements of the underlying asset. Examples of derivatives include futures, options, and swaps.
Howey Test Applied to Cryptocurrencies
The Howey test is a well-established legal test used for decades to determine whether a financial product or transaction qualifies as an investment contract and is subject to regulation as a security. While the test was originally developed in the context of traditional securities, it has also been applied to cryptocurrency and initial coin offerings (ICOs).
The four-part test established by the Howey case has generally been applied to cryptocurrency in the same way as it has been used to traditional securities. However, there may be some nuances or specific considerations that apply specifically to cryptocurrency when applying the Howey test.
For example, the first prong of the test, which requires an investment of money, may be satisfied by the purchase of a cryptocurrency using fiat currency (such as U.S. dollars) or by the exchange of one cryptocurrency for another.
The second prong, which requires an expectation of profits, may be satisfied by the potential appreciation of the cryptocurrency’s value or by the ability to earn returns through the use of the cryptocurrency in a particular platform or network.
The third prong, which requires the investment of money to be in a common enterprise, may be satisfied by the pooling of resources or the use of a shared infrastructure or platform.
The fourth prong, which requires any profits to come from the efforts of a promoter or third party, may be satisfied by the involvement of a central authority or the use of a decentralized autonomous organization (DAO) to manage the cryptocurrency or ICO.
Modern-Day Version of Howey Test for Cryptocurrencies
The above pointers may sound familiar to you. You are a project owner and have spoken to a lawyer before; this is the same advice they gave you. My question now is, since the state of play in cryptocurrencies are changing rapidly, should there be an adapted version for the modern day?
The modern-day version might look something like this:
- Is there an investment of money?
If the crypto digital asset issuer has not sold any assets issued to build its project. It is most likely not considered a security.
- Is there an expectation of profits from the investment?
If the crypto asset is utility-based, for example, it is used for voting purposes. It is most likely not considered a security.
- Is the investment of money in a common enterprise?
If the project is decentralized, it is not controlled and operated by a centralized entity. It is most likely not considered a security.
- Are any profit comes from the efforts of a promoter or third party?
If the profit primarily comes from the community which has nothing to do with the issuance of the crypto asset. It is most likely not considered a security.
Reminding all again, when all four criteria are met, the investment is considered a security and is subject to regulatory requirements of the Securities Act of 1933. The application of the Howey test to cryptocurrency may involve considering the specific characteristics and features of the particular cryptocurrency or ICO in question, as well as the broader market and regulatory context in which it operates.
Take some time to do a self-evaluation based on the above thoughts shared. If you have time, you can ask yourself these questions about the tokens you invested. This is a good exercise for self-reference. I am not a lawyer, and none of the written content is formal advice.
“If you are a retail crypto investor- Do your crypto research. Learning about the regulation side of things can help you with your investment decision, avoiding unnecessary issues down the road.
If you are a project and you claim to be decentralized. Please stay decentralized. This will also avoid getting into any regulatory problems.” – Anndy Lian