Guest post by John Populo
The SEC has charged two major cryptocurrency exchanges: Binance and Coinbase. A common accusation between the two exchanges is that they offer securities that are not listed on their platforms.
1.1 Security vs. Commodity
A security is a financial asset that represents an investment and has inherent value. It can be traded on the secondary market and its value is derived from claims on assets or income. The Howey test, established by the Supreme Court and well known to the market, is often used to determine whether an asset is a security. This test has four requirements:
- Investment Money: There must be an investment of money or some kind of contribution.
- Public Company: The money has to be invested in a joint venture, meaning the wealth of the investor and promoter is intertwined.
- Profit Expectations: Investors must have an expectation of profit.
- Efforts of Others: Investors should enter into an investment with the expectation that they will receive a return or profit on their investment. These advantages can come in the form of dividends, profit sharing, price appreciation, or other financial benefits. The key point is that investors are motivated by the prospect of a financial return from their investment.
A commodity, on the other hand, are basic goods used as inputs in the production of other goods or services. Its value comes from its inherent properties and uses. Although there is no specific test like the Howey Test for commodities, they generally have the following characteristics:
- Interchangeable: Commodities of the same type are identical to one another, regardless of who produces them.
- Used in Production: Commodities are often used as inputs in the production of other goods or services.
- Inherent Value: The value of a commodity comes from its inherent properties and uses, not from the efforts of others.
- Traded in the Commodity Market: Commodities can be bought and sold on the commodity market.
1.2 Easy to Understand Examples
An example of a security could be shares in Apple Inc. When you buy Apple Stock ($A ), you bought part of the company and have a claim on some of the company’s assets and income.
An example of a commodity is the lithium used in the iPhone production process, which is then converted into batteries. Lithium from various sources is considered identical and interchangeable. Prices are uniform throughout the market, except for differences in quality.
II. Applying Concepts to Cryptocurrencies
Bitcoin and Ethereum were NOT named by the SEC in any of the lawsuits, which suggests their interpretation is more towards a commodity than a security – or at least they weren’t sure about it. In recent hearings, SEC representatives were inconsistent in their stance, raising concerns over its capacity to interpret digital assets.
But, what is the technical interpretation of the asset, given current market understanding and past decisions?
2.1 Bitcoins (BTC)
Bitcoin is a decentralized digital currency without a single central bank or administrator. It can be sent from user to user on the peer-to-peer Bitcoin network without the need for intermediaries.
Let’s see how the Howey Test view would be implemented:
- Investment Money? Inspect.
- Public Company? No, the value of Bitcoin is not tied to the wealth of separate companies.
- Lucky Hope? See, a lot of people buy Bitcoins with the hope of making a profit.
- Efforts of Others? No, Bitcoin’s value does not primarily come from the efforts of other people.
What about commodities?
- Interchangeable? Inspect.
- Used in Production: Somewhat. Bitcoins are not used as direct inputs in production, but energy. However, Bitcoin is used for the production of information records which we commonly call blockchain.
- Inherent Value: Check.
- Traded in the Commodity Market: Check.
General market interpretation tend to think of $BTC as a Commodity.
Note: This is not an official classification, but rather common sense opinion and talks by SEC representatives indicating the same direction. As previously noted, the SEC is still debating the classification, and as of now, there is no concrete answer from a US government agency.
2.2 Ethereum (ETH)
Ethereum is an open-source, blockchain-based platform that enables developers to build and deploy decentralized applications (dApps). The original cryptocurrency was called Ether (ETH).
Let’s try the Howey Test again:
- Investment Money: Check.
- Public Company: No, the value of Ether is not tied to the wealth of a separate company.
- Expectation of Profit: See, many people buy Ether with the hope of making a profit.
- Efforts of Others: No, Ether’s value does not primarily come from the efforts of others.
What about commodity characteristics?
- Interchangeable? Inspect.
- Used in Production: Check.
- Inherent Value: Check.
- Traded in the Commodity Market: Check.
common market interpretation, in the case of $ETH, divided due to the staking feature, but just considering the above checklist, it is closer to Commodity than Security.
Note: Same as the previous note, not a formal legal classification, but only a market opinion.
It is important to understand that crypto assets are very new compared to traditional assets, and the classification guidelines discussed above were created for the latter only – TradFi. As suggested by Gabriel Shapiro on Twitter, we should start discussing alternative classifications when dealing with digital assets, to take into account the new variables introduced by blockchain technology. As he proposes, digital assets can be both a security and a commodity at the same time, depending on different needs. The idea will work as below:
- Insider tokens (even from end-user distributions)
- Tokens sold by insiders to third parties, if the related system is not yet functioning and decentralized
- Tokens from “end user distribution” (mining, airdrop, etc. for functional systems)
- Tokens are intrinsically related to functional and decentralized systems
In short, this will define a token as a security or a commodity depending on how it was acquired (investors, ICOs), use cases (e.g. utilities vs stablecoins), and the degree of decentralization of the ecosystem.
Obviously, such a proposal makes a lot of sense for the crypto market, as it implements key features and characteristics to classify assets as one or the other. This is just one example of an alternative approach, but it should be a motivation for us to contribute to the discussion and create our own version.
The legal drama involving the US Securities and Exchange Commission (SEC) and major cryptocurrency exchanges, Binance and Coinbase, has left the crypto world speculating about the implications and potential outcomes. The allegations in question relate to the alleged offering of unregistered securities, including but not limited to ADA, SOL, MATIC and BNB. As it is very important to understand, these are only accusations and legal proceedings have not run their course. The final decision on these cases can serve as a regulatory beacon, which greatly impacts the crypto industry at large. So, what are the implications of this in different scenarios?
In one scenario, the SEC emerged victorious in its lawsuits, setting a precedent for tighter regulatory oversight of crypto exchanges. This may mean a redefinition of what constitutes security in the crypto domain, potentially based on parallels drawn from projects that the SEC claims are securities. In this scenario, it is reasonable that we would witness an influx of enforcement action against other platforms that fall under similar operational characteristics. A more onerous regulatory environment can stifle innovation or push it overseas, leading to a challenging environment for US-based exchanges and Web3 projects. This scenario seems unlikely given the complexity of crypto assets and the dynamics of the evolving crypto market. Moreover, as some experts have suggested, imposing traditional security laws on crypto assets could create more regulatory confusion than clarity.
Others see the SEC losing lawsuits, resulting in a wider interpretation of cryptocurrencies as commodities. This could potentially loosen the grip of regulatory oversight, giving the crypto industry room to thrive. However, the downside is that without proper guidelines, there will be increased risks for investors, which in turn can affect the overall stability of the market.
Looking ahead, we find ourselves at a crossroads. The conclusion of this legal case will significantly influence the regulatory landscape for crypto in the US and most likely globally. If I were to guess, I’d suggest that the degree of decentralization in a network can be a determining factor in classifying something as security. New regulations for digital assets also appear to be a possible outcome.
Looking beyond the immediate challenges, we need to continue to encourage open discussion around digital asset classification and drive innovation within regulatory frameworks. We must support efforts that aim to find a balance between facilitating the enormous potential of cryptocurrencies and safeguarding the interests of all participants. After all, the goal is to ensure that the crypto industry thrives, regardless of the legal and regulatory environment that operates within.
Always looking ahead, always ahead of the game. Let’s continue the conversation.