Here is Why Most of The Cryptocurrencies are Not Securities and Howey Test is The Wrong Approach

June 11, 2023

Darko Simunovski content is written in English. Translations into other languages are automated and there may be minor text errors.

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On June 5th, the SEC filed a lawsuit against Binance and the next day the commission also went after Coinbase on similar grounds, alleging that popular cryptocurrencies offered by the exchanges are securities.

The regulation of cryptocurrencies with existing securities law is a complex and evolving topic and the question remains, whether existing securities laws can be applied to cryptocurrencies, because they are diverse and they represent NEW evolving asset class. Most of the cryptocurrencies doesn’t fit into the existing regulatory frameworks, such as Bitcoin and Ethereum, they are designed as decentralized digital assets and does not meet the definition of a security in any given way.
Securities represent ownership or investment in company that has owners, board of directors that jointly supervises the activities of an organization, earnings of the company, or cash flows of the company.
Securities can include stocks, bonds, investment contracts, and other financial instruments that have value and can be traded.
Cryptocurrencies, on the other hand, are digital currencies that typically use cryptography for security and operate on decentralized networks called blockchains. Their functions as mediums of exchange, store of value doesn’t fit with the securities law.

The absence of clear rules for the digital asset industry and the SEC enforcement-only approach, harms U.S. economic competitiveness and the compliance commitments of companies like Coinbase.
Let’s dive into current regulations in USA, in order to understand, why this isn’t the way to determine securities in crypto-industry.
For something to be classified as securities it needs to have the following criteria:

  • If individuals invest money with the expectation of earning profits, it can be considered as an investment contract.
  • If the fortunes of investors are tied to the success of a common enterprise or the efforts of others, it can indicate the presence of a security.
  • If investors anticipate or are promised profits from their investment, it can indicate a security, this is often associated with the efforts of the development team of the underlying project.
  • If investors profits depend on the efforts or actions of a third party, such as a development team, it can suggest the presence of a security.
  • If a cryptocurrency or token offering is marketed and sold to the public as an investment opportunity, highlighting potential returns and profit expectations, it may fall under the purview of securities regulations.

All above applys in to cryptocurrencies, but also if we look at the other standpoints of which assets are not deemed as securities, also show us that most of the cryptocurrencies, by definition of existing laws, are NOT securities, those factors are:

  • If cryptocurrency is purely designed to provide access to a decentralized network or platform, and it does not possess investment characteristics or promise profits, it may be considered a utility token. Utility tokens typically grant users access to specific functionalities or services within a decentralized ecosystem and are not treated as securities.
  • Cryptocurrencies that are primarily intended to be used as a medium of exchange for goods and services, similar to traditional currencies, are often regarded as payment tokens. These tokens are typically used for transactions and do not represent an investment in a particular project or enterprise.
  • Stablecoins are cryptocurrencies that aim to maintain a stable value by pegging their price to a fiat currency or other assets. They are designed to reduce price volatility and provide a stable medium of exchange.
  • Cryptocurrencies that operate on fully decentralized networks, where there is no central authority or organization responsible for the management or governance of the network, might have a lower likelihood of being considered securities.
  • If a cryptocurrency is primarily intended to be used for consumptive purposes, such as accessing a specific product or service within a decentralized ecosystem, it may not be considered a security. These types of cryptocurrencies are often designed to enable functionality within a particular network rather than serving as investment.
  • open-source communities, which do not involve profit-driven activities or investment schemes, may not be subject to securities laws. These cryptocurrencies are often focused on promoting a specific cause, facilitating community participation, or supporting open protocols.
  • Some cryptocurrencies are solely designed to facilitate community governance and decision-making within decentralized networks or blockchain platforms. If their primary purpose is to enable voting rights or governance functions within a protocol, they can’t be classified as securities.
  • Cryptocurrencies or tokens distributed through airdrops or giveaways, where no investment or consideration is involved, may not be considered securities. If the distribution is primarily for promotional purposes or to stimulate the adoption of a blockchain project, it may not trigger securities regulations.
  • Some cryptocurrencies are designed to incentivize specific actions or behaviors within a decentralized network. For example, tokens earned through participation in a decentralized application’s ecosystem or through contributions to a blockchain network may not be classified as securities if their primary function is to encourage user engagement rather than serving as investment contracts.
  • If a cryptocurrency or token has restrictions on transferability, such as being non-transferable or limited to a specific platform or ecosystem, it may not be considered a security.
  • And lastly, all cryptocurrencies that facilitate direct peer-to-peer transactions without the involvement of intermediaries or centralized entities can’t be considered as securities.

In my opinion, cryptocurrencies represents a new class of financial market, that possess unique characteristics and dynamics that set them apart from the existing financial markets, such as, stocks, bonds and commodities, and I strongly belive that other crypto experts share my opinion as well. The existing regulatory frameworks does not adequately address the complexities associated with these digital assets. Also creating new class for cryptocurrencies could offer several potential advantages, such as:

  • A new regulatory framework could be designed to address the specific attributes of cryptocurrencies, such as decentralized governance, transparency, and cryptographic security. This could provide clearer guidelines and standards for market participants, while also accounting for the unique risks and challenges associated with cryptocurrencies.
  • A distinct class for cryptocurrencies might foster innovation by providing a regulatory environment that supports the development of new technologies and business models. It could encourage entrepreneurs and developers to explore the potential of blockchain-based solutions without being subject to cumbersome regulations designed for traditional securities.
  • Designing regulations specific to cryptocurrencies could enhance investor protection by addressing issues such as fraud, market manipulation, and security vulnerabilities that are unique to the cryptocurrency space. This could help build trust and confidence among investors, potentially attracting more mainstream participation.
  • A separate classification could provide greater clarity for market participants, including exchanges, custodians, and other service providers. It could establish clearer guidelines on licensing requirements, reporting obligations, and compliance standards specific to cryptocurrencies, leading to a more transparent and stable market ecosystem.

In the United States the Securities and Exchange Commission (SEC) uses the Howey test to determine whether a particular investment, including cryptocurrencies, qualifies as a security, so if we take Howey test for all cryptocurrencies, probably all of them will fit in category of securities, except Bitcoin. The Howey test implemented in 1946, is a way to determine whether something is considered an investment contract or not. An investment contract is a type of agreement where people invest their money in something with the expectation of making a profit from the efforts of someone else. Let’s explained it in simple terms, for example you have a lemonade stand, and you want to raise money to make your lemonade business bigger. You decide to ask other people to give you money to buy more lemons and cups, in return, you promise to give them a share of the profits you make. There are 4 key takeaways on Howey test: Investment of Money, common enterprise, expectation of profits and effort of others.

Investment of Money: In the context of cryptocurrencies, this involves individuals purchasing or investing in tokens or coins using traditional fiat currency like US dollars.

Common Enterprise: This aspect evaluates whether the investors fortunes are tied together and depend on the efforts of others. In the case of cryptocurrencies, it usually involves investors relying on the efforts of the development team or individuals managing the project to create value for the cryptocurrency.

Expectation of Profits: This element examines whether investors have an expectation of profits from their investment. In the context of cryptocurrencies, it often relates to investors anticipating the value of the cryptocurrency to increase over time, allowing them to sell it at a higher price and make a profit.

Efforts of Others: This element evaluates whether the profits are derived primarily from the efforts of others. In the context of cryptocurrencies, it focuses on whether the success and profitability of the cryptocurrency depend on the ongoing efforts, developments, or management of the team behind the project.

The application of the Howey test to cryptocurrencies has been totally wrong approach, here are a few reasons:

Technological Differences: Cryptocurrencies are built on decentralized blockchain technology, which distinguishes them from traditional securities. The Howey test was developed long before the emergence of cryptocurrencies, in 1946 and its criteria are not fully accounted for the unique features and functionalities of blockchain-based digital assets.

Utility and Functionality: Unlike traditional securities, their primary purpose is to facilitate access to a product, service, or ecosystem, rather than serving as a passive investment. The Howey test primarily focuses on the expectation of profits.

Lack of Centralized Control: Most of the cryptocurrencies operate in a decentralized manner, with decision-making distributed among network participants, this contrasts with the traditional securities where profits are expected from the efforts of a centralized entity.

Regulatory Challenges: The Howey test was designed to address traditional securities regulations and provide investor protection. Applying the test to cryptocurrencies can be challenging due to the global and borderless nature of these digital assets. Different jurisdictions have already different regulatory approach like UAE, EU, UK, Japan, Indonesia, Switzerland and El Salvador.

SEC chair Gary Gensler has faced tough criticism after his agency sued cryptocurrency exchanges Binance Holdings Ltd, Coinbase Global Inc and Bittrex for securities law violations, but the regulator remains steadfast in his belief that noncompliance in the crypto industry is widespread and threatens the publics trust in U.S. financial markets. It is obvious that Gary Gensler is working for the interests of bankers and he is paving the way for CBDC, with the same fake narrative “investors protection” and it is clear that we can expect a wave of lawsuits against other cryptocurrencies.

it is ok to regulate cryptocurrency companies and how they manage the investors funds, but totally wrong to sue them for listing cryptocurrencies that he claims are unregistered securities. His lack of proper understanding of the crypto-space can destroy USA free crypto market, when he started last year an all-out war against crypto companies, affiliated banks and exchanges, in what was called “Operation Choke Point 2.0“. Widely condemned even within the SEC, this operation has been recognized as an attempt to drive cryptocurrency out of the U.S. and protecting the entrenched interests of the existing financial system. He also had disagreements with CFTC over the classification of Ethereum, as securities or commodities. Just for reminder Gary Gensler refused to say whether ether (ETH), the second-largest cryptocurrency by market cap, was a security or not, during congressional hearing almost 2 months ago, which is ironical the chair SEC couldn’t answer a simple question.

Coinbase CEO Brian Armstrong insists that the claim against his exchange is unfounded because there’s no clear methodology for classifying assets as falling under the Securities Act, and the agency has not responded to a request to formulate criteria for assessing that affiliation. Coinbase CEO Brian Armstrong already stated “We will not delist tokens deemed securities by the SEC and has no plans to phase out staking services”

According to a new filling from Binance’s lawyers, that was filed at the U.S. District Court of the District of Columbia, on June 6, revealed that Gensler himself was the one who offered to serve as an advisor to the crypto exchange platform in several conversations that happened in March 2019. Gensler allegedly met with CZ in Japan for lunch, where both talked about the platform’s Binance Coin (BNB) and the company’s plan of opening an exchange in the U.S. Gary Gensler and CZ remained in touch even after that lunch meeting in Japan, who was at the time teaching at Massachusetts Institute of Technology and even offered to serve as the company’s informal advisor.

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