Crypto vs. SEC: Part 1
In June 2023, the SEC sued the giant of the crypto industry Coinbase, alleging that some of the tokens listed on the exchange were securities and by not following regulations applicable to securities, Coinbase was acting illegally. At the heart of the dispute is whether some crypto token offerings fall within the definition of investment contracts, a catch-all legal term that includes any possible investment scheme that is not a known form of security (like bonds and equities). The definition of investment contracts was outlined by the US Supreme Court in SEC v Howey in 1946, the standard which is still applied today. This is not some arcane legal issue as it affects everyday investors holding crypto assets.
As per the Howey Test, a crypto asset would be a security if the answer is affirmative to each of the following four questions, when applied to the circumstances in which it was sold:
- Did the purchaser spend money to acquire the investment in question?
- Was the money invested in a common enterprise?
- Was the money invested with an expectation of profits?
- Were the investors relying on the effort of others for the generation of the expected profits?
The actual answers to the above questions are specific to the facts and circumstances pertaining to how a specific crypto token was offered to investors and beyond the scope of these posts. Instead, the purpose of this post series is to synthesize crypto asset taxonomies so that legal scholarship can be applied to them more thoughtfully . This series consists of four short posts, each of which presents a taxonomy of crypto assets tailored to the four Howey Tests.
Howey Test 1: Investment of money
This criteria simply means that money has been spent by purchasers to acquire a specified crypto asset. Money here is interpreted in the broadest sense to mean spending anything of economic value.
Crypto assets can be acquired in the following ways:
1A: Primary Market-Coinbase Rewards
The term coinbase rewards here is used broadly to refer to the award of new tokens by the token issuer as an incentive to reward certain defined behaviors.
The most well-known example of this is bitcoin mining. New bitcoin (BTC) tokens are issued to operators who run the Bitcoin platform. Public blockchains like Bitcoin do not have any entity like Visa or Mastercard administering the network. Hence, network administration is crowdsourced.
The volunteer administrators of the Bitcoin blockchain (called miners) are rewarded through issuance of new tokens as part of a competitive process called mining. The money invested here is the electricity expended in running computers for the network as well cost of expensive hardware. The Bitcoin coinbase reward is the decentralized counterpart of fees charged by card networks, the difference being that card fees are paid from existing money instead of new money (in fact, after the year 2140, Bitcoin will not mint any new coins and miners will be paid exclusively via transaction fees only).
A somewhat different example of a coinbase reward is the award of new COMP tokens to borrowers and lenders on the peer-to-peer lending DeFi app Compound. The COMP token allows the holder to vote on various aspects of how the Compound protocol works.
1B: Primary Market-Token Sales
While the primary market for bitcoin (BTC) is exclusively via coinbase rewards , many crypto assets (including ether) were issued via token sales. In a token sale, the token issuer is paid by the purchasers, either in fiat currency or crypto currency. In return, the issuer transfers the newly minted tokens to the blockchain address of the purchaser. In the past, some of these token sales have been called Initial Coin Offerings (ICOs)
1C: Primary Market-Organic Issuances
New coins can be issued organically as part of the token’s business purpose. For instance, a stablecoin issuer may sell tokens and invest the proceeds (hopefully!) in low risk investments like treasury bills. A unit of stablecoin (example Tether and USDC) is thus matched 1–1 against fiat currency. Hence, every time there is a net increase (net of redemptions) in stablecoin demand, new tokens will be issued.
Another example of this are DeFi lending apps like Compound and Aave. Just as an investor is issued a unit of an ETF or mutual fund in exchange of the fiat money being invested, DeFi lending apps mint and issue tokens that represents the loan made.
Unlike coinbase rewards and token sales, where new tokens are generated out of thin air, in organic issuances, new tokens are derived from a pre-existing source of value.
1D: Primary Market-Air Drop
In an air drop, the token issuer transfers tokens to users’ wallet addresses for free or for some minimal service (like retweeting a marketing post or being an early use of the token issuer’s platform). There is no meaningful investment of money here.
2A: Secondary Market-Exchange Trading
The most popular way to acquire crypto tokens in the secondary market is through an exchange. Most people use centralized exchanges like Coinbase but decentralized exchanges like Uniswap are popular with technically proficient users. Tokens are bought, either with fiat money or swapped with another crypto asset.
2B: Secondary Market-Transaction Fees
This is the secondary market analog of coinbase rewards. Like coinbase rewards, transaction fees are paid for incentivizing behaviors desired by a blockchain enterprise. However, transaction fees are paid from existing supply of tokens by the transaction initiator.
The most well known example is gas fees on the Ethereum blockchain. While in Bitcoin, the primary incentive for miners is the coinbase reward, in Ethereum, on the other hand, transaction fees (or gas fees) are the primary reward mechanism.
Unlike Bitcoin miners who invest money in the form of electrical power, the money invested by Ethereum network administrators (called stakers) is their existing holdings of ether (ETH). By staking their existing ETH and letting their computers run the Ethereum validation software, stakers get the opportunity to earn additional ETH. The gas fees paid by transaction processors are distributed to stakers in ratio of the amount staked.
More broadly, transaction fees can be paid for an array of services. For instance, traders on decentralized exchanges pay trading fees to the exchange just as they do to centralized crypto exchanges like Coinbase. Another example is the fees paid by blockchain application owners to oracles who procure data from off-chain sources (the LINK token of the oracle Chainlink is most well known).
Summing up
To conclude,
- The investment of money criteria of the Howey Test can be tested by classifying crypto assets into their method of acquisition.
- The criteria is likely to be met for most tokens except those that can exclusively be acquired via air-drops.
- A crypto asset, which can be only acquired via air-drops, is probably not going to gain any traction and the SEC would probably leave them alone.
The next post addresses the common enterprise criteria of the Howey Test.
