What makes a crypto asset a security in the US?
Cryptocurrencies are digital assets that operate on a decentralized network of computers, using cryptography to secure transactions and verify records. They have attracted millions of users and investors around the world, but also raised regulatory challenges and legal disputes.
One of the most contentious issues is whether crypto assets are securities under US law, and therefore subject to strict rules and oversight by the Securities and Exchange Commission (SEC). The SEC has brought more than 100 enforcement actions against crypto companies, alleging that they violated securities laws by offering or selling unregistered digital tokens.
But what exactly is a security, and how does it apply to crypto assets? In this blog post, we will explain the legal framework, the recent court rulings, and the implications for the crypto industry and investors.
The Howey Test:
The SEC relies on a 1946 Supreme Court case, SEC v. W.J. Howey Co., to determine whether an asset is a security. The case involved investors who bought fractional land interests in Florida orange groves, along with a contract to share in the profits from the harvest. The court ruled that this arrangement was a kind of security called an investment contract, which is defined as:
> an investment of money in a common enterprise with profits to come solely from the efforts of others
This became known as the Howey Test, and it has been applied to various types of assets over the years, including cryptocurrencies. The SEC argues that many crypto assets meet the criteria of the Howey Test, because they involve:
- an investment of money (such as fiat currency or other crypto assets)
- in a common enterprise (such as a blockchain network or a platform)
- with profits to come solely from the efforts of others (such as the developers, promoters, or miners of the crypto asset)
The Ripple Case:
One of the most prominent cases brought by the SEC against a crypto company is the one against Ripple Labs, the issuer of XRP, one of the largest and oldest cryptocurrencies by market capitalization. The SEC sued Ripple in December 2020, alleging that it conducted an unregistered offering of $1.3 billion worth of XRP between 2013 and 2020.
Ripple denied the allegations, claiming that XRP is not a security, but a medium of exchange that facilitates cross-border payments. Ripple also argued that the SEC lacked clarity and consistency in its approach to crypto regulation, and that it failed to provide fair notice to market participants.
In July 2023, Ripple won a landmark ruling from a federal judge in New York, who said that some of XRP's sales were not subject to securities laws. Judge Analisa Torres found that Ripple's sales on public exchanges to retail investors were not offers of securities under the law, because purchasers did not have a reasonable expectation of profit tied to Ripple's efforts. She said that those sales were "blind bid/ask transactions", in which buyers "could not have known if their payments of money went to Ripple, or any other seller of XRP."
However, Judge Torres also ruled that Ripple violated securities laws when it sold XRP directly to sophisticated investors such as hedge funds. She said that those sales involved an investment contract, because they were based on "information asymmetry" between Ripple and its buyers, who relied on Ripple's disclosures and representations about XRP's value and potential.
The ruling was a mixed outcome for both parties, and the case is still ongoing. It could have significant implications for other crypto companies and assets that face similar allegations from the SEC.
The Coinbase Case:
Another major case brought by the SEC against a crypto company is the one against Coinbase, the largest US cryptocurrency platform. The SEC sued Coinbase in March 2023, alleging that it allowed users to trade at least 13 crypto assets that should have been registered as securities, including tokens such as Solana, Cardano, and Polygon.
Coinbase denied the allegation, claiming that those tokens are not securities, but utility tokens that provide access to decentralized applications and services on various blockchain networks. Coinbase also argued that the SEC has been vague and inconsistent in its application of the Howey Test to crypto assets, and that it has failed to provide clear guidance or feedback to market participants.
The case is still pending in court, and it could have far-reaching consequences for the crypto industry and investors. If Coinbase loses, it could face fines, penalties, injunctions, or even criminal charges. It could also be forced to delist or restrict trading of certain tokens on its platform, affecting millions of users and billions of dollars worth of transactions. On the other hand, if Coinbase wins, it could set a precedent for other crypto platforms and assets that challenge the SEC's authority and interpretation of securities laws.
The Implications:
The question of whether crypto assets are securities or not has profound implications for the future of the crypto industry and the innovation and adoption of blockchain technology. It also affects the rights and responsibilities of crypto investors, who may face different levels of risk, regulation, and protection depending on the legal status of the tokens they hold or trade.
The SEC's position is that crypto assets are securities, and therefore subject to the same rules and oversight as traditional securities, such as stocks and bonds. The SEC's mission is to protect investors, maintain fair and orderly markets, and facilitate capital formation. The SEC argues that by enforcing securities laws, it can prevent fraud, manipulation, and abuse in the crypto space, and ensure that investors have access to accurate and timely information about the crypto assets they buy or sell.
However, many crypto companies and advocates disagree with the SEC's position, and argue that crypto assets are not securities, but new forms of digital assets that have different characteristics and functions than traditional securities. They argue that applying securities laws to crypto assets would stifle innovation, competition, and growth in the crypto space, and create unnecessary barriers and costs for crypto entrepreneurs, developers, and users. They also argue that securities laws are outdated and ill-suited for the dynamic and decentralized nature of blockchain technology, and that new regulations or laws are needed to provide clarity and certainty for the crypto industry.
The debate is not likely to be resolved anytime soon, as both sides have strong arguments and interests at stake. The outcome of the ongoing court cases could have a significant impact on the legal landscape and the market dynamics of the crypto space. Ultimately, it may take legislative action or regulatory reform to create a more coherent and consistent framework for crypto regulation in the US.
References:
¹: Explainer - What makes a crypto asset a security in the US? https://www.investing.com/news/stock-market-news/explainer--what-makes-a-crypto-asset-a-security-in-the-us-3126238
²: Explainer: What makes a crypto asset a security in the US? https://www.msn.com/en-gb/money/technology/explainer-what-makes-a-crypto-asset-a-security-in-the-us/ar-AA1dSxbv
³: Five Things to Know in Crypto This Week: XRP Not a Security, Sometimes https://www.fxempire.com/forecasts/article/five-things-to-know-in-crypto-this-week-xrp-not-a-security-sometimes-1361530
⁴: US regulators continue crypto crackdown – but here's why the latest … – The Conversation https://www.inferse.com/616420/us-regulators-continue-crypto-crackdown-but-heres-why-the-latest-the-conversation/
⁵: Explainer - What Makes a Crypto Asset a Security in the US? https://money.usnews.com/investing/news/articles/2023-07-14/explainer-what-makes-a-crypto-asset-a-security-in-the-us
⁶: Why It Matters Whether Crypto Coins Like Ripple’s Are Considered Securities - The Washington Post https://www.washingtonpost.com/business/2023/07/14/are-crypto-coins-like-xrp-securities-here-s-what-s-at-stake-in-sec-case/a0259b98-2276-11ee-8994-4b2d0b694a34_story.html
(1) Explainer - What makes a crypto asset a security in the US?. https://www.investing.com/news/stock-market-news/explainer--what-makes-a-crypto-asset-a-security-in-the-us-3126238.
(2) Explainer: What makes a crypto asset a security in the US?. https://www.msn.com/en-gb/money/technology/explainer-what-makes-a-crypto-asset-a-security-in-the-us/ar-AA1dSxbv.
(3) Five Things to Know in Crypto This Week: XRP Not a Security, Sometimes. https://www.fxempire.com/forecasts/article/five-things-to-know-in-crypto-this-week-xrp-not-a-security-sometimes-1361530.
(4) US regulators continue crypto crackdown – but here's why the latest … – The Conversation. https://www.inferse.com/616420/us-regulators-continue-crypto-crackdown-but-heres-why-the-latest-the-conversation/.
(5) Explainer - What Makes a Crypto Asset a Security in the US?. https://money.usnews.com/investing/news/articles/2023-07-14/explainer-what-makes-a-crypto-asset-a-security-in-the-us.
(6) Why It Matters Whether Crypto Coins Like Ripple’s Are Considered .... https://www.washingtonpost.com/business/2023/07/14/are-crypto-coins-like-xrp-securities-here-s-what-s-at-stake-in-sec-case/a0259b98-2276-11ee-8994-4b2d0b694a34_story.html.
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