The rate and reach of cryptocurrency adoption in recent years signals the dire need for modern regulations that simultaneously safeguards investors and enables innovation to flourish. As it stands, most crypto tokens fall within a regulatory gray area as they don’t fit within the confines of the traditional financial system — so why should they fall prey to inapplicable, outdated rules?
Presently, the SEC applies “The Howey Test,” a legal analysis based on a 1946 U.S. Supreme Court ruling, to differentiate between securities and non-securities. The SEC asserts that securities are an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
However, there is a glaring void of regulatory clarity on who determines this classification and how it applies to today’s constructs. The majority of digital assets resemble commodities and some were specifically designed to avoid securities laws.
Furthermore, in contrast to the citrus grove investors involved in SEC v. Howey, who had no intention of buying or eating the fruit they were backing, crypto enthusiasts are often looking well beyond the return on investment (ROI). Today’s crypto buyers see a future in which consumers use tokens to transact on the blockchain and for entry into decentralized apps, among other use cases.
I’d like to propose an alternative process to characterize crypto coins and tokens below.
Fully decentralized vs. fully centralized
There is a sliding scale when it comes to digital assets, ranging from fully decentralized to fully centralized. Where assets fall on this spectrum plays a huge role in whether both industry leaders and government officials see them as either a security or non-security. If a holder of a particular crypto token does not have the expectation of profit based on the efforts of a centralized team, then that crypto should not be considered a security.
For example, the SEC’s former Director of Corporate Finance, William Hinman, stated in a 2018 speech that based on his understanding of the Ethereum network’s decentralized structure, Ethereum offerings and its associated sales would not be considered securities transactions. The debate about whether Ethereum can be labeled a security has reemerged following the network’s switch to a proof-of-stake (PoS) model, which greatly changed how the blockchain functions. However, I’d argue that shifting to PoS should not affect the assumption that Ethereum (ETH) is effectively and directly decentralized, given the extensive holding of Ethereum.
Most blockchain startups initiate their projects with a native coin or create a native coin derived from their original ERC-20 offering. Native coins fall under the category of centralized currency because they have their own designation, and acquiring significant decentralization is hard to achieve.
Since the Howey Test is not a “3 out of 4 is not bad” test, if any of the four aspects are not met, then the asset in question is not a security. Given Hinman’s statement, any asset that can show that it is decentralized is clearly not a security.
You can read more about decentralization determination here.
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Additional categories
While an asset may not meet the requirements to be deemed a decentralized currency, it is not automatically deemed a security. The asset may contrarily fall into a number of other buckets such as centralized currency, contract or organization.
As more and more individuals lose faith in the U.S. Federal Reserve, some are placing trust in centralized stablecoins, like USDT or USDC, that keep reserves of cash off-chain to ensure that their coins are always valued at $1. Those holding these stablecoins are simply looking to protect the value of their money and not expecting significant profits. But because stablecoins like USDT and USDC are backed by securities, the SEC believes that they should be regulated.
Decentralized autonomous organizations (DAOs) are governed by smart contract algorithms without a centralized authority. Oftentimes, DAOs issue tokens so that users can participate in the decision-making of the organization. While many believe that these decentralized collectives don’t qualify as securities, lawmakers have issued stark warnings that crypto companies can’t hide behind DAOs to avoid regulation.
The solution: Transparent regulatory framework
The landmark case against Ripple underscores how different agencies within the U.S. government aren’t even in agreement on this issue, as FinCEN declared it was not a securitywhile the SEC argued that it was. All various modes of tokens and crypto coins should be analyzed by the SEC according to which unique category they’d fall under, as this dilemma isn’t black or white.
In the interim, there is a lot at stake for the future of crypto either way this case falls. If Ripple can prove that the SEC has taken an unclear, arbitrary approach to regulating crypto, then an important precedent is set that places the power back in the blockchain. If the SEC reigns supreme, then the governmental agency has legal say in the procession and development of regimenting decentralized finance.
Ultimately, digital assets are notoriously difficult to place into buckets, and until we have new guidelines for the crypto securities market, there will continue to be disagreement and confusion, which could, in tandem, stifle the industry.
The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.
Arie Trouw is the co-founder of XYO and founder of XY Labs.
This article was published through Cointelegraph Innovation Circle, a vetted organization of senior executives and experts in the blockchain technology industry who are building the future through the power of connections, collaboration and thought leadership. Opinions expressed do not necessarily reflect those of Cointelegraph.
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