Crypto vs. SEC Part 4

In June 2023, the SEC sued Coinbase alleging that some of the tokens listed on the Coinbase exchange were legally securities and by not following securities’ law, Coinbase was acting illegally. This series of posts synthesizes crypto asset taxonomies, which make it easier to apply the four Howey Tests, on which rests the definition of securities. Post 1, Post 2 and Post 3 covered the investment of money, common enterprise and expectation of profits criteria, respectively. This post covers the final effort of others criteria.

Howey Test 4: Effort of others

The fourth Howey Test evaluates whether the purchasers of the alleged security were relying solely on the effort of others for the generation of the expected profits. The thinking behind this fourth test is that investors who are participating in the management of an enterprise are less likely to benefit from the elaborate disclosures required for securities than those investors who are relying solely on the effort of the promoters. In the past, courts have taken a somewhat relaxed interpretation of solely to mean predominantly.

Crypto assets can be categorized into three categories based on the degree of reliance on centralized expertise for the generation of economic value:

Decentralized effort model

In this model, there is a founder (or founders) who leads the design and build of the blockchain enterprise but once up and running, the governance is decentralized. Post 2 of this series described this decentralized model of governance. Satoshi Nakamoto was involved with Bitcoin development till December 2010 and disappeared after that. While Vitalik Buterin continues to play an influential role in the Ethereum blockchain, he does not run it. The economic value of BTC and ETH arise from a diffuse ecosystem of developers and users.

Hybrid effort model

In this model, the promoters of the platform continue to play a lead role, often by pushing iterative version upgrades. However, the nature of their effort places greater emphasis on incentivizing users to participate in a marketplace rather than directing them. Hence, the economic value of the enterprise is also dependent on the choices made by the end users.

This hybrid model can be illustrated with the example of the decentralized exchange Uniswap:

Community Effort

Any issuer can list their token on Uniswap through an automated process, without being vetted against any specified listing requirements.

Any crypto asset holder can become a market-maker by depositing her tokens with Uniswap. These volunteer market-makers, known as liquidity providers (LPs), earn trading fees.

Traders buy and sell tokens on Uniswap, paying trading fees, which accrue to the LPs. The custody of assets is maintained by the traders and not by the exchange (as is often the case with centralized exchanges like Coinbase).

Finally, holders of Uniswap’s governance token (UNI) have a say in how the platform will function.

Leadership effort

Uniswap was founded in November 2018 by Hayden Adams. The founder and venture capital firms have a significant say in how Uniswap functions through their holdings of UNI tokens. The leadership effort in Uniswap centers around designing the software which enables a high level of decentralization.

An example of a top down functionality that impacts profits of LPs and traders is the algorithm by which bid-ask prices are set. Instead of being set by humans, the price of a trade is determined by an automated market maker (AMM) algorithm. The AMM used by Uniswap is different from its competitors and one can assume that this is a point of differentiation. In March 2021, Uniswap tweaked its AMM with the aim of increasing the returns accrued by LPs per dollar of assets deployed (a metric known as capital efficiency). The AMM function and its iterative improvements lie within the effort of others category.

Centralized effort model

Centralized models work like any traditional enterprise with a leadership team on whose expertise all investors are reliant. An example of this is the private permissioned blockchain XRP Ledger run by the blockchain based enterprise software company Ripple Labs.

In conclusion, the degree to which users rely on the effort of others varies by blockchain enterprise and requires a determination on how much of the economic value can be attributed to the ongoing efforts of a centralized management team.

Summing up

The suspicion that crypto assets are securities stems from the fact that regardless of their underlying purpose, they are easily tradeable and hence invite speculators. In traditional finance, assets that are not securities tend not to be easily tradeable (land, painting, an individual mortgage loan, physical oil). Of course there are exceptions like currency, which is traded but is not a security. But such exceptions are few.

Stepping away from the minutiae of the Howey Tests, conceptually there are two central questions:

First, the objective of securities regulation is to protect investors from unscrupulous promoters by relying on disclosures rather than caveat emptor. How would this objective be applied if the enterprise in question is operating in a truly decentralized manner, even though there was a founder at inception?

Second, should crypto tokens that are designed to be items of consumption be treated as investments simply because people are treating them as such?

Since crypto is such a rapidly evolving space, it is challenging for regulators to be prescriptive. However, regulators can promote greater innovation by providing safe harbor guidelines (like the one posted on Github by SEC Commissioner Hester Peirce) that are not overtly narrow but adhere to the spirit and letter of securities regulation. Finally, legislation can carve out a regulatory framework that is tailored for crypto assets.