To begin with, understanding crypto is a daunting task. The reason being it requires cross-disciplinary knowledge of cryptography, economics, philosophy and money in general. From a government standpoint, any industry which involves money cannot escape from the forces of fraud, manipulation and misconduct. So, naturally, regulations are introduced by the government to protect investors. Now, although the intent behind regulations is good, it shouldn’t hamper the industry’s growth when it especially proves to be something useful for the public. In the US, the Securities and Exchanges Commission (SEC) was formed to regulate the markets. With crypto reaching $1 trillion in market capitalization, SEC wants to classify crypto into a “security”. In this article, we will briefly understand what Securities mean, how it is classified and what the industry experts are reacting to it.
A security is a financial instrument that holds some type of monetary value and can be sold or traded in a financial market. The most common types of securities are stocks, bonds, EFTs (exchange-traded funds), options, and mutual funds. There are four types of securities mainly Equity securities, Debt securities, Hybrid securities and Derivative securities. In the US, all Securities must be registered with the SEC and failing to comply with SEC regulations will land in severe penalties. Before going any further, it’s worth clarifying how the SEC decides something as a security.
The Howey Test refers to the U.S. Supreme Court case for determining whether a transaction qualifies as an “investment contract.” If a transaction is found to be an investment contract, it’s considered a security. It’s then subject to registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934.
According to the SEC, an “investment contract" exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The test applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities.
Under the Howey Test, a transaction qualifies as a security if it involves the following four elements:
To be considered a security, a transaction must meet all four criterias of the Howey Test.
According to Jay Clayton, who was the SEC chairman during 2018, in an interview said Bitcoin (BTC) was found as a replacement for fiat currencies like the US dollar, EURO, Yen etc which obviously cannot be classified as a security.
While the first criteria is met by Bitcoin, it fails to satisfy the second and third criteria because it didn’t seek money from investors publicly. But it's not the same case with an Initial Coin Offering (ICO).
Here’s how the ICO process works. First, a company formulates a white paper, a document summarizing the company’s pitch to potential investors. A website is then dedicated to the new token. Then, after stimulating people’s interest, the company asks for financial contributions in exchange for some of the project’s crypto tokens. Now, the SEC has no problem defining ICOs as security as evident from the ongoing lawsuit with Ripple (XRP). In its latest crackdown, the SEC has made Kraken exchange close its staking services and pay a $30 million fine for not registering with them.
The bottom line is that there is no one-size-fits-all regulation when it comes to digital assets like Bitcoin, Ethereum and the likes of many. While the technology has been evolving rapidly, the laws like Howey test (which was formulated more than 30 years ago) haven’t thereby heavily hampering the progress of new technologies like blockchain. While protecting consumers should be one of the main priorities, cracking down without understanding it in a holistic way will do more harm than good. World’s second largest exchange Coinbase’s CEO Adam Grant has made a statement saying that staking as a service cannot be considered as a security and Coinbase will be considering fighting it out in court if necessary.
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Disclaimer: This article was authored by Giottus Crypto Exchange as a part of a paid partnership with The News Minute. Crypto-asset or cryptocurrency investments are subject to market risks such as volatility and have no guaranteed returns. Please do your own research before investing and seek independent legal/financial advice if you are unsure about the investments.