The Securities and Exchange Commission (SEC) is suing Binance and Coinbase over their supposed failure to register tradable assets as securities according to the SEC Act. Though each case is multifaceted, they both relate to a decade-old question: are crypto-assets securities?
Since the SEC’s inception, it has been tasked with protecting investors from fraudulent assets and market manipulation. Unlike the Commodity Futures Trading Commission (CFTC), which deals with commodities like minerals and food supplies, the SEC only deals with an asset class called “securities.” Initially limited to mostly stocks and bonds, the definition of a security developed legal methods for classification over time.
The Howey Test, developed from SEC v. W.J. Howey Co., became the standard for determining what was a security. In the case of crypto, the Howey Test determines if these assets constitute “investment contracts,” which are legal securities and require registration and regulation under the agency. To be an “investment contract,” there needs to be an investment of money, into a common enterprise, with the expectation of profit derived from the efforts of others.
Under this definition, it’s clear how stocks, bonds, preferred shares, etc. constitute securities. You pay money for stocks that have the potential to earn profits depending on the efforts of others in a common enterprise. Simple enough.
The issue with crypto assets is that, on their face, they share similar characteristics as known securities. Money (or a digital money derivative) is commonly exchanged for crypto assets, usually with the expectation of future profit. Furthermore, based on SEC v. Int’l Loan Network, Inc., the SEC has deemed most crypto a “common enterprise” since the fortunes of asset holders are linked. The crux of the issue is generally not with these facts but with whether an investor is profiting from the efforts of others.
If the SEC can’t prove that profits result from the efforts of others, the entire case falls apart. This is because commodities (such as gold and silver) can be speculative assets that result in profits too. The difference is these profits result from outside market forces, not the asset’s “promoter.” Bitcoin is the only crypto asset to comfortably have the label “commodity” precisely because there is no known “promoter” or team, and Bitcoin has never changed due to the actions of a third party or investor. All profits are a result of market forces.
Most other crypto assets have entities that update and maintain the product, resulting in asset value fluctuations. These are groups like the Ethereum Foundation. Since the crypto asset is not directly controlled by the entity working on it, theoretically all crypto assets are “decentralized.” And this lies the standard on which crypto security status hinges. If it is “sufficiently decentralized” to the point that its value is independent of actions by its initial “promoters” then it is not a security.
Determining what constitutes “sufficient decentralization” has been challenging for entrepreneurs in the crypto industry since the SEC only gives a list of points that make an asset “decentralized” and no guide on how these points are weighted. Additionally, the status of a crypto asset can change over its lifetime in what the SEC calls “morphing.” This is why assets that are part of an Initial Coin Offering (ICO) are a security, but after this, it has generally been viewed as no longer a security.
The hardest part about these rules is that because there is no method for weighing decentralization outside of the SEC deeming an individual crypto asset a security or not, there is no way for companies to know if they violate securities law. Reforms to this system are required if the US hopes to maintain a domestic crypto industry. Ambiguity is not helpful for consumers or entrepreneurs. The SEC needs to issue a measurable and objective guideline for determining classification.
Isaac Schick is a policy analyst at the American Consumer Institute, a nonprofit education and research organization. For more information about the Institute, visit www.TheAmericanConsumer.Org or follow us on Twitter @ConsumerPal.