New Technology Rarely Fits Into Old Laws
Are cryptocurrencies securities and how does the Howey Test apply? The largest barriers standing between cryptocurrency and mass-adoption by U.S. citizens is a lack of clear regulatory framework. U.S. Exchanges are reluctant to list most coins, investment institutions are prohibited from offering exchange traded products, and crypto taxes are a living hell. Does it have to be this way? Well…obviously not, but the reason for our frustration is rooted in the very specific definition of security.
Why a Security Designation Matters
In the United States, anything defined as a security is governed by a regulatory body known as the Security and Exchange Commission (SEC). This body is led by 5 appointed commissioners and has broad powers over how securities are allowed to be issued to investors.
The SEC was created in response to the 1929 stock market and the resulting Great Depression. The crash was primarily caused by debt driven investment by a massive number of non-educated investors. Since its founding the commission has been tasked with investor protection, regulatory compliance, and maintaining transparent markets¹. Anyone issuing securities in the United States is required register, and have their registration approved by the SEC. Failure to register may result in criminal charges.
The SEC also maintains standards for who can invest in private securities (those not traded on an exchange like the New York Stock Exchange). Currently you must either meet a certain income threshold or hold certain licenses in order to participate in private sales.
Cryptocurrency and public blockchains changed all this, allowing anyone to engage in commerce without the gatekeeping process. It created a legal grey area where regulators unevenly apply old laws to new technology, causing confusion for early adopters. At the center of everything is an archaic understanding of constitutes a security, and who has the authority to regulate products which don’t fit the old model.
The Howey Test, a Short History
To understand the current Security definition, we must take a trip back to 1945 and visit an enterprise known as W.J. Howey Co. This company had the brilliant idea to partition up orange groves it owned, sell those pieces to investors, then lease them back from the same investors. The investors would own the trees, but Howey would maintain them and split profits with the owners².
Unfortunately for Howey, the SEC didn’t appreciate the scheme, and sued them for selling an unregistered security. There was one small problem though. The Securities Act of 1933 defined a security as an investment contract, but the law didn’t was not clear on what constituted an investment contract³. The ambiguity allowed Howey to argue their orange trees were outside of the SEC’s authority and not securities. The case made it all the way to the U.S. Supreme Court in 1946.
The Court ended up ruling in favor of the SEC but acknowledged the unclear definition of investment contract. As a remedy, they looked to how individual states regulated investments and the wide range of investment types they covered. In their ruling, they offered a four-part test, affectionally referred to as The Howey Test¹, to determine whether something is a security. It reads as follows.
- An Investment of Money
- With a reasonable expectation of profit
- In a common enterprise
- To be derived from the effort of others²
Overall, the test is comprehensive. For something to be deemed a security, people must invest money into an entity and expect to make a profit from the operations of that entity. It works well for nearly all investment contracts and gives the SEC broad authority over registration/regulation of these contracts. Until the invention of Bitcoin, there was no reason to revisit the definition.
Bitcoin Fails the Howey Test
Bitcoin wasn’t taken seriously when it first launched in 2009, but the recent growth of the network exposed several holes in the Howey Test.
- BTC is mined, there is no cash investment into the network
- There is no common enterprise. Bitcoin mining is a solo effort
- If you profit from mining, its by your own effort, not others.
These these attributes also apply to Ethereum, however the network was bootstrapped by an initial investment of Bitcoin. Even still, decentralization of the network in the subsequent years seems to make the case for security exemption. This would put Bitcoin and Ethereum outside of the SEC’s authority, and spare the networks substantial amounts of regulation. To this point, no action has been undertaken to regulate either of these coins as securities.
While BTC and ETH may not be considered securities. They may yet be considered commodities due to the issuance of new coin from mining. This would put them under the umbrella of the Commodities and Futures Trading Commission (CFTC) which regulates raw materials like copper, oil, and wheat. As for other blockchains, most have yet to be scrutinized to the degree of BTC and ETH.
Tokens Built on Top of Blockchains Pose Unique Challenges
Many cryptocurrencies likely pass the Howey Test due to their more-defined ownership structures. Take Chainlink (LINK), for example. On September 18, 2018, The Chainlink team participated in an Initial Coin Offering (ICO) where ETH denominated value was exchanged for ownership of LINK tokens⁴. These investors exchanged value for shares in a specific enterprise, whose success would be derived from a team of developers. On the surface, this token meets the basic definition. Some notable exceptions exist, but most large-cap tokens/projects have a similar origin to Chainlink. It is thus reasonable to assume they would be considered Securities if their status was challenged by regulators.
The Howey Test for cryptocurrency is a poor standard for regulation
Up to this point, the United States has regulated crypto via a patchwork of different, individual rulings. SEC has claims many tokens are securities, but has refused to provide guidance⁵. They also have historically acknowledged Bitcoin and Ethereum as not being securities, but refused to allow exchange-traded funds for them.
At the center of all of this is the Howey Test. It’s track record for traditional assets does not fully translate to the blockchain and allowed unequal enforcement. Where it has been applied, it has caused confusion, inconsistencies, and chills otherwise interested American investors. As Dave Chappelle so aptly said, “Modern problems require modern solutions.” Cryptocurrency is a modern solution which requires modern, tailored, regulation.