The world of finance has undergone a significant transformation with the emergence of cryptocurrencies. These digital assets, built on blockchain technology, have completely revolutionized the ways in which we store, transfer, and invest value. According to CoinMarketCap, the estimated total market capitalization of the crypto market at the time of writing stands at $1.2 trillion, with over 20,000 different cryptocurrencies available for trading.
In recent years, we have witnessed a notable shift in the adoption of cryptocurrencies and non-fungible tokens (NFTs) as new investment and transaction methods. Numerous celebrities have either endorsed these digital assets or created their own projects and collections, expanding their influence and reaching new communities.
Blockchain technology offers more than just technological advancements; it brings about a fundamental shift in mindset and the way we can govern and organize ourselves without relying on a central authority or group of individuals to dictate our actions. This decentralization of assets, wealth, and work has created an alternative universe that more people are embracing and transitioning into.
However, like any burgeoning industry, blockchain is not immune to various forms of abuse and get-rich-quick schemes that harm and defraud many individuals. As the industry experiences rapid growth and more people become involved in building their own projects, regulators have shown an increased interest in this space. Currently, blockchain operates in a highly unregulated environment and faces numerous challenges in terms of regulation. However, these challenges do not stem from a lack of willingness or intention to defraud or scam people. Rather, the main issue lies in the significant regulatory uncertainty, which adversely affects ordinary individuals who are attempting to innovate and pursue different avenues.
Recently, we have witnessed cases of projects such as Ooki DAO and LBRY facing regulatory scrutiny and being targeted by regulatory bodies like the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) for allegedly violating securities laws. Unfortunately, these regulatory actions have not been accompanied by comprehensive guidance to help these projects comply with the law. Furthermore, it is important to note that this regulatory crypto crackdown is not limited to projects and individuals building within the blockchain space; it also impacts centralized exchanges and other platforms.
What Are Securities?
The term "security" is defined broadly to encompass a wide range of financial investments, including stocks, bonds, notes, debentures, limited partnership interests, and investment contracts. These instruments represent ownership, creditor relationships, or ownership rights through options.
Securities are typically issued by companies or organizations as a means to raise capital. When individuals invest money in a business with the expectation of making a profit through the efforts of others, it falls under the definition of a security.
Securities can take various forms, each with its own characteristics and conditions. Stocks, for example, represent ownership shares in a company and provide investors with a stake in its profits and voting rights. Bonds, on the other hand, represent debt obligations, where investors lend money to the issuer in exchange for periodic interest payments and repayment of the principal amount at maturity.
The classification of an investment as a security depends on factors such as the nature of the investment, the rights it confers, and the regulatory framework in a particular jurisdiction. Regulators, such as the Securities and Exchange Commission (SEC) in the United States, oversee the issuance, trading, and regulation of securities to protect investors and maintain fair and transparent markets.
It is important to note that the definition and regulation of securities may vary across jurisdictions, and it is essential to adhere to the specific laws and regulations in the relevant jurisdiction when dealing with securities.
What Makes an Asset a Security: The Howey Test and Securities Law in the US.
Securities are a very broad term, and rather than relying on a definition of what can be regarded as a security or not, it lays down the requirements for a transaction to be classified as an Investment Contract. The existence of an investment contract indicates the sale of a Security which triggers the applicability of Securities Laws.
This was outlined in the famous WJ V Howey Co. case in 1946 and with the establishment of the Howey Test.
The Howey Test traces its roots back to a case involving the Howey Company and its sale of citrus groves to buyers in Florida. In this arrangement, the buyers would lease the land to Howey, who would handle all the grove-related tasks and sell the fruit on their behalf. The buyers, who did not have any agricultural expertise, were not required to personally tend to the land. In this arrangement, the parties shared the generated revenue. These transactions were not registered with the U.S. Securities and Exchange Commission (SEC), prompting the SEC's intervention. The court ultimately ruled that these leaseback arrangements qualified as investment contracts.
With that it was established that:
“..for the existence of an investment contract, there needs to be an investment of money made in common enterprise with a reasonable expectation of profit from the efforts of others.”
In order to determine whether something can be classified as as a security, the Howey test “asks” four questions:
Is there an Investment of money?
Is it an investment in a common enterprise?
Is there a reasonable expectation of profit?
Are there marketing and other efforts from third parties?
The focus of the Howey Test is not dependent only on the nature of the instrument or asset being sold but also the circumstances and manner in which it is bought and sold. A security is not the asset, it is the contract or the transaction. For example, if somebody sells a crate of whiskey with the offer that the value of the crate will double in 10 years. Such a transaction will be considered to be an investment contract. The intention of the buyer is not to consume the asset, but to receive a return in the future. Even though the crate of wine is not traditionally a security, here it may be considered a security transaction.
Given that the Securities Law dates back to 1339 and the Howey Test to 1946, a pertinent question arises: Can these frameworks effectively apply to digital assets in the present day? While the Test primarily focuses on determining if something qualifies as an investment contract, it fails to consider the inherent nature of digital assets. Cryptocurrencies, by default, are speculative in nature. While some may function as investment vehicles, many others serve alternative purposes and are not designed for profit generation. Cryptocurrencies, by default, are speculative in nature. While some may function as investment vehicles, many others serve alternative purposes and are not designed for profit generation. Furthermore, the question arises regarding decentralized autonomous organizations (DAOs) that exist on the blockchain and are governed by smart contracts. Can they be considered a "mutual enterprise" when they often lack legal personality and operate solely through the execution of autonomous smart contracts?
Are ICOs (Initial Coin Offering) Security Transactions?
An Initial Coin Offering or ICO is the first token offering made by a Web3 project to raise funds. In its basic format, an ICO fulfills all the requirements of the Howey Test. A token offer is made for the purpose of raising money for a project in common enterprise, where the profit is dependent on the efforts of the project team, classifying it as a security transaction.
Complications arise when considering that all coin offerings may not be for the purpose of fundraising, so would only fundraising be considered a security transaction? When people are dealing in the token, or trading the token, if such transactions are labeled as securities transactions, it becomes problematic. All security transactions are required to be regulated by the SEC, and can only take place on regulated marketplaces. Regulating all token transactions can become extremely difficult, which makes it even more difficult to use the token. In addition to that, classifying all cryptocurrencies as securities would go against the very nature of these digital assets and the fundamentals of the technology itself.
Why is Bitcoin not a security?
The claim that Bitcoin is not a security because it is “sufficiently decentralized” is often cited but lacks clarity and substance. Decentralization itself is a complex concept, and its relevance to the classification of securities is not straightforward. Additionally, decentralization can be manipulated to mislead those who are not well-versed in its workings.
The primary reason why Bitcoin is not classified as a security is that it does not fulfill the requirement of a "common enterprise" as defined by the Howey test and securities laws. Moreover, there was no investment in the development of the technology with the expectation of profits, and promotional efforts by third parties. derived from the efforts of others.
The SEC has echoed this reasoning in their stance on Bitcoin. SEC Chair Jay Clayton explicitly stated that Bitcoin is not a security in his interview with CNBC: “Cryptocurrencies are replacements for sovereign currencies…[they] replace the yen, the dollar, the euro with bitcoin. That type of currency is not security,” . Gary Gensler and other Chairs seconded this claim, however, they still stay firm in classifying all altcoins as securities.
Is Ethereum a Security?
The question whether Ethereum is a security has been a Web3 hot potato for some time now. While the US regulatory bodies are battling over the throne of the crypto supervisory body, the community is really trying to understand what is going on and what the future may hold for Ethereum and its holders.
Following the transition from Proof-of-Work to Proof-of-Stake with the Merge, some argue that Ethereum has become more centralized due to the introduction of staking mechanisms, potentially categorizing it as a security. Additionally, Gary Gensler, the SEC's Chair, suggests that since a significant portion of Ethereum's validators are based in the US (over 45%), the network falls within the jurisdiction of the SEC.
Despite the absence of an official determination regarding Ethereum's status, many assert that it can be considered both a commodity and a security. Buyers invest in Ethereum with the expectation of its value appreciation over time, indicating a reasonable anticipation of profit. Moreover, acquiring the coin can be seen as an investment in the mutual enterprise, which is the Ethereum network. However, it is important to note that Ethereum operates in a highly decentralized manner, without reliance on a single entity. It’s worth noting that ast year, the CFTC declared cryptocurrencies such as Bitcoin, Ethereum and US commodities, and hopefully that will settle the status of Ethereum.
The SEC Crypto Crackdown.
In the past year, we had several cases of regulation by enforcement either by the SEC or CFTC without providing any clear answers or guidelines for this new class of assets to follow in order to comply. In the LBRY case, the project didn't fundraise through the ICO and there was no investment until the platform was launched. Despite high level transparency of the project, its activities and desire to collaborate with the regulators to come to a mutual solution, there is still a high level of uncertainty of what could have been done differently to be in compliance. Furthermore, the Ooki case brought new challenges to the industry: CFTC was granted the permission to serve the DAO and its members using a website chatbot and a Telegram group, and argued that all active voters on the governance and other project matters could be considered active participants in selling unregistered securities.
Kraken, the centralized exchange, allegedly was selling unregistered securities and paid a fine of $30M and had some of their operations seized. In the first months of 2023, Coinbase received Wells notice from the SEC claiming that Coinbase was also selling unregistered securities.
In the near future we will probably see more cases where projects, platforms and businesses are facing the same regulatory challenges.
So What Do We Do?
The intersection of digital assets, such as cryptocurrencies, with traditional securities laws and regulations raise important questions. The application of frameworks like the Howey Test, which originated decades ago, may not fully address the unique characteristics and purposes of digital assets in today's landscape. While the Test focuses on investment contracts, it overlooks the speculative nature of cryptocurrencies and the diverse range of purposes they serve beyond mere profit generation.
As the digital asset ecosystem continues to evolve, there is a need for regulatory frameworks that can appropriately address the complexities and nuances of these innovative assets. Striking a balance between investor protection and fostering innovation is crucial. It requires careful consideration of the unique features, functions, and governance structures of digital assets, as well as an understanding of the potential benefits they can bring to individuals and communities.
Embrace the Rise of DAOs with me and embark on a journey into the intricate realms of DAOs, Web3, and decentralization. To delve deeper into this remarkable space, I invite you to listen to my podcast, DAO Today, where we passionately explore its inner workings, challenges, and potential. Tune in to engage with insightful discussions that navigate various aspects, with a particular focus on the legal and regulatory challenges shaping this industry. Listen now!
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