Regulation is far from the flashiest topic when it comes to Ripple and cryptocurrencies generally. That being said, though, I think it’s pivotal to understanding how Ripple will grow — what bigger obstacle than a blanket ban on cryptocurrencies? In terms of understanding how XRP is regulated, I’ll explore specifically how the SEC should look at it: as a security or not.
In order to determine whether XRP is a security, I will look at technical aspects of Ripple and XRP, such as how tokens are generated. I will then turn to the foundations of American securities law — what core characteristics do all securities share? I will conclude by evaluating the potential consequences of designating XRP as a security. Overall, I argue that XRP should be designated by the SEC as a security.
Part 1: About Ripple, XRP, and Securities Law
What is Ripple?
At its core, Ripple is a remittance network: it facilitates international payments and currency trades. Their goal is to minimize the delays and high transaction costs characteristic of international transactions today. Ripple’s value proposition to banks and other financial services firms is evident in its mission: it aims to lower their costs and help them potentially serve new customers that were formerly economically unviable. Ripple today has 100+ partners, including the likes of Santander Bank, American Express, Standard Chartered and Crédit Agricole.
Delving more concretely into what Ripple does, there are three main services that Ripple offers: xCurrent, xRapid, and xVia. xCurrent is an enterprise solution that executes instant cross-border payments for a negligible transaction cost — Ripple’s $0.00001 transaction fee merely serves to prevent DDoS attacks. xVia is a similar solution, essentially functioning as an API that plugs into standard interfaces, allowing payments to be made efficiently and be tracked as it is processed. xRapid is a liquidity solution: payments are instantly converted into XRP, Ripple’s native currency, thereby cutting down on the high liquidity costs characteristic of emerging markets.
About XRP and the XRP Ledger
Now that we have a concrete understanding of what Ripple does, let’s home in more specifically on XRP. XRP is a cryptocurrency; it is the native currency of the Ripple network. Its primary application is to serve as a bridge currency between currencies or assets while making a transaction. For instance, there likely isn’t a conversion rate from United MileagePlus Frequent Flyer Miles into Philippine Pesos directly. As such, XRP serves as a bridge, so the miles will be converted to XRP and those XRP will in turn be converted into pesos.
To understand how XRP works from a technical standpoint, one must turn to the ledger behind it. The XRP Ledger refers to the distributed ledger on which the XRP operates. Much like a standard distributed ledger, there is no one central server, rather transactions are distributed across nodes. However, a closer look reveals a number of differences between the XRP Ledger and more popular networks like Bitcoin and Ethereum. Perhaps most striking among them is the way XRP is obtained and distributed. Unlike Bitcoin, where even the very first Bitcoins required proof-of-work and had to be mined, XRP is simply distributed by the company Ripple. Ripple claims that 100 billion XRP were created initially. Out of those, over half are in escrow. While they claim the number of XRP is permanently capped, there’s theoretically nothing stopping Ripple from creating more.
Since there is no proof-of-work or even proof-of-stake on the XRP Ledger, the way obtaining consensus works is also distinct. When a node wants to validate a transaction, it receives input from peers called validators. From there, a subset, or “chosen validators”, are trusted — no one individual validator is believed to be truthful, but there’s trust in the fact that all of the chosen validators are not collectively malicious. From there, when a supermajority is obtained, the transaction is validated. The chosen validator system thus differs from other distributed ledger systems. However, by consequence of this consensus system, the ledger requires minimal electricity to confirm a transaction and only takes 4–5 seconds to do so, both clear comparative advantages.
What Do Oranges Have to do with This?
In order to figure out whether XRP qualifies as a security, we must turn to oranges. By oranges, I mean (of course) SEC v. W. J. Howey Co (1946), the landmark securities law ruling that gave rise to the Howey Test. The Howey Test is the current legal standard today to check if a contract or agreement is an “investment contract”, or security, and therefore should fall under the Securities Act.
In the case, Howey Co. owned vast citrus groves in Florida. He decided to sell tracts of his property to prospective investors, promising them great profits on the groves. Cognizant of the fact that most of his investors wouldn’t be picking the oranges themselves, he also recommended another firm who could be contracted to tend to and harvest the land. The SEC filed suit, contesting that the plots of land that were sold should constitute a security and as such should be regulated under the Securities Act.
The court ultimately found that Howey’s small orange plots were in fact securities. As Justice Murphy argued in the majority opinion,
“The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value”
In applying Justice Murphy’s standard to the facts of the Howey case, we note that any profits derived from investing in Howey’s plots would be form a third-party’s labors: it was Howey who planted the trees and it would be another contractor maintaining and harvesting the fruit, as all the investors had little to no experience in agriculture. Thus, it met the criteria to qualify as a security.
Subsequent sections of this paper will apply doctrines from this case to cryptocurrency, assessing whether XRP should be considered a security under this precedent.
Part 2: Is XRP a Security?
The Howey Test, Applied
To determine whether XRP should be considered a security, this article will apply the standard laid out in Howey and will also analyze the SEC’s approach to other cryptocurrencies like Bitcoin and Ether.
As mentioned earlier, the legal standard to consider a given asset a security is the Howey test. For an investment to be considered a security under Howey, the scheme needs to involve (1) an investment of money (2) with an expectation of profits (3) in a common enterprise and (4) profits derived from the effort of others. I will break these down sequentially.
Applying these criteria to XRP, the first standard is quite evidently met. Any purchase of XRP would require money. The second criterion — the expectation of profits — is a slightly subjective, as it points to the unarticulated beliefs and intents of investors. However, it is not unreasonable to conclude that anyone purchasing the XRP token today has some intention of profits; the XRP is likely to appreciate considerably as Ripple’s xRapid’s network grows. In terms of a common enterprise, the XRP is the digital asset behind the XRP Ledger, and as such multiple people owning small amounts of XRP would meet the “common enterprise” standard.
The last criterion — profits derived exclusively from the efforts of others — is slightly less evident. Obviously, what “effort” entails in this context has vastly evolved from the times of Howey. I contend that the most accurate way to describe effort in this context is in terms of how XRP are obtained and distributed. While most cryptocurrencies like Bitcoin need to be mined, as trust on the Bitcoin network is established through proof of work, the XRP has a different system. XRP’s unique consensus algorithm, as discussed earlier, does not require proof-of-work or even proof-of-stake. XRP is instead simply generated by Ripple and distributed. While it does have utility on the network, the Howey test indicates that this test is the standard regardless of intrinsic value. As such, any capital gains that result from the appreciation of XRP will be through third-party effort, as XRP was never earned through mining. As such, the Howey test indicates that XRP should be considered a security.
The Howey Test, Crypto Makeover
Obviously, as precedent from the 1940s, the Howey test lays out general guidelines that aren’t specifically tailored to cryptocurrency. As such, to find a better tailored test, I will turn to a speech made by William Hinman, the Director of the Division of Corporate Finance at the SEC, in June 2018. The speech specifically addresses how to interpret the doctrine from Howey in the context of cryptocurrencies and ICOs.
Apart from reaffirming the doctrine from Howey, Hinman called attention to the common counterargument that dubbing a currency as a “utility token” would mean it must not be a security. This is an argument made frequently by those who don’t regard XRP as a security. Hinman pointed out that “the economic substance of the transaction always determines the legal analysis, not the labels.” As he reminded us, even the oranges in Howey had utility, however the nature in which it was sold made it a security. As such, merely dubbing XRP as a “utility coin” does not in and of itself exempt it from securities law.
Going beyond Howey, Hinman also talks about how decentralization can be a potential way of making a token not covered under Howey. This is because in a highly decentralized network, there is no clearly identifiable third-party that brings about the appreciation of the currency. As he notes, a network is sufficiently decentralized when “purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.” He goes on to note that decentralization makes regulation cumbersome and unnecessary as “the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.”
As to whether XRP rises to this level of decentralization, I believe that it has not yet, however greater distribution of ownership of XRP and validators could easily rise to that level soon. The fact that the value of XRP is driven almost entirely by the success of the company Ripple and xRapid, coupled with the fact that Ripple is the only organization capable of distributing coins, leads me to believe that it is insufficiently decentralized to meet Hinman’s standard. Therefore, the SEC’s latest interpretations of Howey further my belief that XRP is a security.
Building upon the discussion from Hinman’s speech, comparing regulatory approaches to XRP to those of Bitcoin and Ether will offer a more thorough perspective on how cryptocurrencies are regulated. The extent of decentralization and proof-of-work are key concepts that distinguish XRP from Bitcoin and Ether. In the case of Bitcoin for instance, Hinman notes that he “does not see a central third party whose efforts are a key determining factor in the enterprise.” He goes on to note that applying “the disclosure regime of the federal securities laws to…Bitcoin would seem to add little value”, given how decentralized it is. He also indicates that, distinct from Ether’s initial fundraising, “the present state of Ether” and its “decentralized structure” indicate that current sales of Ether aren’t securities transactions. XRP differs from Bitcoin on both counts. Ripple would be a central third party and a “key determining factor” that drives XRP’s value, and customers could ostensibly be better protected by federal securities law disclosures. Overall, comparing XRP to Bitcoin and Ether reinforces the conclusion that the SEC should classify it as a security.
Part 3: What Happens if XRP is Deemed a Security?
XRP being deemed a security could have a range of implications for Ripple. This is because the sale and trade of the XRP will now be subject to SEC regulations, specifically the Securities Act of 1933. In the short run, the most immediate implication could be relating to the sale of unregistered securities. If XRP is deemed to be an unregistered security, then past sales of XRP can be viewed as violations of the Securities Act. This could result in heavy penalties for the company.
Unregistered securities apart, in the longer term, there are implications regarding information disclosure and consumer protection. The overarching purpose of the Securities Act is “To provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes.” While the part about the securities through the mail is a bit dated, the Securities Act mandates parties to periodically disclose matters of potential relevance to investors. As touched upon earlier, the SEC doesn’t regulate Bitcoin because it believes there’s no one third-party that can offer this information, whereas with XRP, the fingers point squarely at Ripple. Disclosures may hurt the health of Ripple as a company, however greater information sharing could help the overall industry of blockchain-based payment systems progress.
However, there are some potential adverse implications of labeling XRP as a security. Turning to industry-wide implications, if Ripple is deemed a security while Bitcoin and Ether have been deemed not, that will have lasting implications on how future blockchain networks are structured from a technical standpoint. As discussed earlier, Ripple’s distributed ledger does not rely on proof-of-work or proof-of-stake, instead using their own consensus algorithm to ensure throughput stays high. If the SEC decides to regulate XRP and not Bitcoin, it’s possible that subsequent entrepreneurs in the space will prefer a proof-of-work system to establish trust, thereby minimizing regulatory hassles.
One key implication of this, as the Ripple CTO points out, is the energy-intensive nature of proof-of-work blockchains. He contends that the energy required to verify a single Bitcoin transaction can power a full American house for a day. At scale, this could be a potential problem. Furthermore, Ripple’s XRP ledger is designed to have a throughput comparable to VISA, and processing times in seconds, compared to Bitcoin taking over an hour to process a transaction. If networks continue to rely on proof-of-work, the consequent lower throughputs would mean that centralized networks like VISA stay competitive. This could considerably slow the rate of adoption of decentralized solutions in the payments and remittance space.
This article contends that the SEC should classify XRP, Ripple’s native cryptocurrency, as a security. From a technical standpoint, it is clear that the XRP Ledger functions very differently than the Bitcoin and Ethereum networks, especially with respect to proof-of-work. The Howey test indicates that since capital gains would be the direct consequence of an identifiable third-party (Ripple, in this case), it must be classified as a security. This is bolstered by the speech given by Director Hinman of the SEC in June, as Ripple is not adequately decentralized to qualify for the exemption that Bitcoin and Ether have used, and its tokens are not mined. In terms of the impact branding XRP as a security would have, it is likely to increase transparency via disclosures and thereby bolster consumer protection. However, it could also result in the shunning of non-proof of work network architectures. That could increase the energy intensivity of future distributed ledgers and also reduce throughput relative to non-proof-of-work consensus algorithms.
Ripple, “Process Payments”, https://ripple.com/ripplenet/process-payments/ Accessed on Sept. 23, 2018
Ripple, “The Inherently Decentralize Nature of the XRP Ledger”, https://ripple.com/insights/the-inherently-decentralized-nature-of-xrp-ledger/ Accessed on Sept. 23, 2018
Ripple, “XRP”, https://ripple.com/xrp/ Accessed on Sept. 23, 2018
SEC v. Howey Co., 328 U.S. 293 (1946)
US SEC, “Laws that Govern the Securities Industry”, https://www.sec.gov/answers/about-lawsshtml.html#secact1933Accessed on Sept. 23, 2018
US Securities Act of 1933, http://legcounsel.house.gov/Comps/Securities%20Act%20Of%201933.pdf
US Securities and Exchange Commission, “Digital Asset Transactions: When Howey Met Gary (Plastic)” https://www.sec.gov/news/speech/speech-hinman-061418 Accessed on Sept. 23, 2018
US Securities and Exchange Commission, “Statement on Cryptocurrencies and Initial Coin Offerings”, https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11 Accessed on Sept. 23, 2018
XRP Ledger Dev Portal, “XRP Ledger Overview”, https://developers.ripple.com/xrp-ledger-overview.html Accessed on Sept. 23, 2018