The New Paradox — Are Crypto Coins Securities?
The ongoing regualtory debate on crypto token classification.
The recent Ripple ruling stated that sales on public cryptocurrency exchanges were not offers of securities under the law because purchasers did not have a reasonable expectation of profit tied to Ripple’s efforts. But the sale to institutions was in violation of federal securities laws, as it constituted an unregistered offer and sale of investment contracts. Are cryptocurrencies securities, and how does this impact the future of crypto?
The battle to regulate the nascent crypto industry took another twist when a U.S. District Court ruled that Ripple Labs did not violate federal securities laws by selling its XRP token on public exchanges. However, the ruling was not a complete victory as Judge Analisa Torres also ruled that Ripple did violate federal securities laws by selling its token directly to sophisticated investors.
XRP’s Many Use Cases
Ripple was an early entry into the blockchain universe, designed to be faster, cheaper and more scalable than bitcoin. Its native currency XRP has been around since 2012 and today XRP is one of the leading cryptocurrencies by market capitalization as well as one of the top payment cryptocurrencies. In fact, XRP is used by major banks across the world to facilitate real-time international settlements at a lower transaction cost.
The case: The case against Ripple began in December 2020 when the Securities and Exchange Commission (SEC) filed a lawsuit against the firm and two of its executives for raising over $1.3 billion through an unregistered digital asset securities offering. The regulatory agency alleged that Ripple sold unregistered securities: roughly $728.9 million of XRP to institutions and some $757.6 million of XRP in programmatic sales on crypto exchanges.
The verdict: According to Torres, Ripple’s XRP sales on public cryptocurrency exchanges were not offers of securities under the law because purchasers did not have a reasonable expectation of profit tied to Ripple’s efforts. But the sale to institutions was in violation of federal securities laws, as it constituted an unregistered offer and sale of investment contracts.
What is a Security?
At the heart of the battle between the SEC and the crypto industry is the definition of a security and whether crypto coins match that description. To determine whether a not a transaction qualifies as an investment contract, and is therefore subject to U.S. securities laws, the Howey Test is used. Using the Howey Test, an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
While the first three components of the Howey Test are easily satisfied by most assets, the statement “expectation of profit to be derived from the efforts of others,” is where the Court decided that XRP is both a security and not a security.
Passing, and Failing, the Howey Test
U.S. District Court Judge Analisa Torres ruled XRP itself is not an investment that “embodies the Howey requirements of an investment contract.” Some other distributions of XRP were also deemed not to be securities offerings, including being algorithmically sold on exchanges to unknown buyers and used as compensation for employees and other parties. However, the institutional sales did constitute securities, as per the Howey Test.
What was the rationale behind institutional sales being illegal? According to the Court, many investors signed agreements not to sell their XRP until a specific period of time had passed. During this “lock-up” period, XRP was a speculative investment. Additionally, the court also cited investment contracts that explicitly stated the buyer was purchasing XRP “solely to resell or otherwise distribute.”
Carol Goforth is the Distinguished Professor and Clayton N. Little Professor of Law at University of Arkansas (Fayetteville) School of Law. She explained that an asset can be classified as an investment contract, and then lose that characteristic at a later point in time. Goforth stated, “When Ripple initially sold its XRP tokens to institutional investors, they were buying with the expectation of profits. Later on, when purchases occurred on the open market, the purchases could have been buying for the utility of the tokens or at most, with the expectation of profitability based on market factors rather than upon Ripple’s efforts.”
However, the significance of the ruling is not crystal clear. The case refers only to XRP, and Golforth believes that the case will add pressure to develop a legislative solution to the question of when cryptoassets should be classified as securities.
In fact, in a suit filed on Jul. 21, 2023, against Terraform Labs and its CEO Do Kwon, the SEC claims, “Respectfully, those portions of Ripple were wrongly decided, and this Court should not follow them.” The agency also stated it was looking into further review, including appealing the XRP decision.
What’s Next?
While the SEC has been attempting to reign in crypto, the industry largely lies outside of the realm of any regulatory agency — for now.
Last year, a bipartisan bill by Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) sought a number of provisions, including the elimination of reporting gains less than $200 to the IRS, a common taxonomy for digital assets and — granting the CFTC responsibility for the majority of cryptocurrencies and exchanges. The bill would also require digital asset providers to register with the CFTC. In comments shortly after the bill was introduced, SEC Chair Gary Gensler said it could “undermine” other market protections.
While the original bill failed to move froward, the Lummis-Gillibrand Responsible Financial Innovation Act was recently relaunched. Even as the question of who will govern the industry remains up for debate, the SEC recently filed lawsuits against both Coinbase, Binance and Terraform, and arrested Alex Mashinsky, founder and former CEO of Celsius.
While the United States grows increasingly hostile towards crypto, other countries are enacting regulation, but at the same time encouraging responsible innovation. Europe’s Markets in Crypto Assets Regulation (MiCA) will enable firms to obtain one license to trade across the 27-bloc region. The UK also sees new rules go into effect in October that recognize cryptocurrency trading as a regulated financial activity, and seeks to create the conditions for safe innovation.
Also at play is BlackRock’s application for a spot bitcoin ETF, seen by many as giving legitimacy to the crypto market in the United States. The application was formally accepted by the SEC, and will be one of the most closely watched applications. Notably, the SEC has so far rejected dozens of spot bitcoin applications, citing insufficient investor protection.
This content is for educational purposes only. It does not constitute trading advice. Past performance does not indicate future results. Do not invest more than you can afford to lose. The author may hold assets mentioned in this article.
If you found this content engaging, and have an interest in commissioning content of your own, check out Quantum Economics’ Analysis on Demand service.
