This year, a surge of legal actions coordinated by the U.S. Securities and Exchange Commission (SEC) has shaken the crypto space. Among the high-profile cases are Bittrex, Kraken, Celsius Network Limited, Binance, and Coinbase, all facing charges for unregistered security offerings (Read the full story here). This industry-wide regulatory showdown raises an important but long-unanswered question: Are cryptocurrencies securities?
As the SEC amplifies its regulatory efforts, the distinction between cryptocurrencies as securities or commodities becomes increasingly blurred.
This article delves deep into this ongoing debate, exploring how securities are classified, whether cryptocurrencies rightfully fit the securities category, and recent efforts addressing these issues.
What are Securities?
Securities, a cornerstone of modern financial markets, represent ownership or debt in a company or entity. But to fully understand what they are and how they are classified, we have to go back to the early 20th century.
President Franklin D. Roosevelt signed the Securities Act of 1933 to prevent fraud and ensure that investors have access to reliable information before investing in securities.
A year later, the president signed the Securities Exchange Act of 1934, which established the U.S. Securities and Exchange Commission (SEC) and outlined regulations for securities exchanges, brokers, and other market participants to ensure transparency, fair practices, and investor protection in the securities markets, while also addressing issues like insider trading and market manipulation.
While these two acts laid the foundation for regulating the securities market and ensuring safe and transparent investing practices, they didn’t provide an air-tight definition to classify securities. The actual guidelines to what constitutes a security came with the landmark SEC v. W.J. Howey Co. ruling, a pivotal moment in securities regulation that established the “Howey Test.”
The case involved an orange grove investment scheme, where the Supreme Court ruled that an investment qualifies as a security if it “involves an investment of money in a common enterprise with an expectation of profits primarily from the efforts of others.”
What is the Howey Test?
The Howest test led down the foundational four criteria for deciding if a transaction falls under an investment contract and, therefore, is a security or not:
Investment of Money: The first criterion is that investors must invest money or valuable consideration in the scheme. This can include cash, assets, or other forms of consideration.
Common Enterprise: The investment must be part of a common enterprise, meaning the enterprise pools together investors’ money to fund a collective endeavor. The fortunes of the investors are typically intertwined, and they share the success or failure of the enterprise.
Expectation of Profit: Investors must expect profits from their investment. This profit is usually in the form of returns on the investment, such as dividends, interest, or capital appreciation.
Primarily from the Efforts of Others: The most crucial criterion is that the anticipated profits should come primarily from the efforts of someone other than the investor. This often means that the success of the investment is dependent on the managerial or entrepreneurial efforts of a third party.
This test has been instrumental in defining what falls under the securities classification and is widely used to determine if various financial instruments and investment schemes, including cryptocurrencies, are subject to securities regulations.
Are Cryptocurrencies Securities?
Cryptocurrencies, often associated with decentralization and utility, challenge the traditional securities framework. While some crypto assets embody the characteristics of securities, many others do not fit neatly into this classification.
For instance, some Initial Coin Offerings (ICOs) and token sales, such as Ripple, Telegram’s Gram, OmiseGo, DASH, etc., are deemed as security offerings by the U.S. Securities and Exchange Commission (SEC) because the regulators believe they satisfy the Howey Test.
However, established cryptocurrencies like Bitcoin and Ethereum often escape the securities classification. Their decentralized nature, utility as mediums of exchange, and lack of dependence on third-party efforts differentiate them from traditional securities.
In an interview with CNBC and the former SEC chair Jay Clayton in 2018, Clayton clarified, “Cryptocurrencies: These are replacements for sovereign currencies, replace the dollar, the euro, the yen with bitcoin,” and that “That type of currency is not a security.”
Determining whether a specific cryptocurrency is a security requires a case-by-case analysis. If a token represents ownership in a company, provides dividends or a share of profits, is sold with an expectation of future returns primarily driven by the efforts of others (such as a development team or organization), and has a lack of utility, it might be considered a security.
And this brings us to the Ripple case…
Ripple’s Partial Win Against the SEC and its Significance
Before we discuss the final court verdict on the SEC V. Ripple lawsuit and what significance it has on the crypto industry, let’s take a brief look at the timeline and allegations made by the SEC in this case.
On December 22, 2023, the SEC charged Ripple and two executives for managing a $1.3 Billion Unregistered Securities Offering – their native token, XRP. The SEC raised several key points to support this claim:
Investment Contract: The SEC asserted that XRP’s initial distribution resembled an investment contract, arguing that XRP purchasers were investing money with the expectation that Ripple’s efforts would lead to the appreciation of XRP’s value.
Ripple’s Role: The SEC highlighted the significant role played by Ripple Labs in the development, promotion, and distribution of XRP. They claimed that Ripple’s efforts were crucial in driving the success of XRP, and therefore, the expectation of profits was tied to the company’s actions.
Market Manipulation and Control: The SEC also argued that Ripple and its executives had significant control over the supply and distribution of XRP, potentially leading to price manipulation. This control served as evidence of a common enterprise in which investors’ fortunes were intertwined.
Lack of Utility: The SEC claimed that XRP didn’t have a primary utility as a medium of exchange or a store of value, differentiating it from decentralized cryptocurrencies like Bitcoin and Ethereum. Instead, XRP was primarily used to fund Ripple’s operations and products.
In response to the SEC’s allegations, Ripple Labs disputed the characterization of XRP as a security. Ripple argued that XRP should be considered a currency and not a security, and they emphasized its usage in cross-border payments and its potential utility in financial transactions.
After a legal battle spanning over two years, the case finally reached its conclusion on July 13, 2023.
The ruling from the District Court for the Southern District of New York emphasized that the “offer and sale of XRP on digital asset exchanges did not amount to offers and sales of investment contracts.” This ruling signifies that the mere exchange of XRP tokens on cryptocurrency platforms doesn’t inherently fall under the securities classification.
However, it’s worth noting that Ripple’s institutional sales of XRP were deemed to violate Section 5 of the Securities Act, as they were considered unregistered offers and sales of investment contracts.
This came at a particularly crucial time when other crypto giants, like Binance and Coinbase, are also facing similar charges by the SEC, as Ripple’s partial win against unregistered securities offering charges can set a favorable precedent for the other platforms.
Crypto Oversight Bill
The new crypto oversight bill, introduced on July 21, 2023, following its initial drafting in June, successfully passed a pivotal congressional committee, marking a crucial advancement in the ongoing effort to define the regulatory landscape for cryptocurrencies.
But what exactly does this bill entail?
At its core, this legislative proposal serves a dual purpose: to provide long-awaited clarity around crypto regulations and to foster a more harmonious relationship between crypto enterprises and the regulatory bodies that oversee them.
Taking a more technical perspective, the bill aims to accomplish this by two primary means: extending the scope of oversight by the Commodity Futures Trading Commission (CFTC) into the cryptocurrency sector and concurrently establishing the jurisdictional boundaries of the Securities and Exchange Commission (SEC).
If executed properly, this bill can answer the “Are cryptocurrencies securities” question once and for all.
What cryptocurrencies are not securities?
Established cryptocurrencies like Bitcoin and Ethereum are often not considered securities due to their decentralized nature and primary use for transactions and smart contracts.
But other than that, any coin that is not marketed as an investment opportunity, does not promise future profits based on the efforts of others and primarily functions as a medium of exchange or utility tokens are less likely to be classified as securities.
Is crypto a commodity or a security?
Some cryptocurrencies, like Bitcoin and Ethereum, are often considered commodities due to their function as digital assets used for transactions, similar to traditional commodities like gold or oil.
On the other hand, certain cryptocurrencies or tokenized assets that meet the criteria of an investment contract and are marketed as opportunities for profit may be classified as securities under relevant securities laws.
Which cryptocurrencies are securities?
Below are some of many cryptocurrencies that the SEC has deemed as securities:
- Ripple (XRP)
- Telegram’s Gram (TON)
- DASH (DASH)
- Algorand (ALGO)
- Naga (NGC)
- Monolith (TKN)
- Rally (RLY)
- Rari Governance Token (RGT)
- DerivaDAO (DDX)
- Kin (KIN)
- DragonChain (DRGN)
- Tron (TRX)
- BitTorrent (BTT)
- Terra USD (UST)
- Luna (LUNA)
- Mirror Protocol (MIR)
- BitConnect (BCC)