Ever since Gary Gensler made a case for designating Ripple and Ether as non-compliant securities, debate has raged and speculation has run rampant like never before. Most notably, fear over the potential for SEC regulation has caused prices to fall for the affected currencies.
Unsurprisingly, both Ethereum's and Ripple's founders have emphatically denied that their cryptocurrencies should be labeled as securities, with Ethereum's Joseph Lubin telling TheStreet "We spent a tremendous amount of time with lawyers in the U.S. and in other countries, and are extremely comfortable that it is not a security; that it never was a security."
Similarly, Ripple chief marketer Corey Johnson told CNBC last month that its cryptocurrency, XRP, is not a security. In a development that puts Ripple's claim to the test, in May, one coinholder filed a class action lawsuit against Ripple and CEO Brad Garlinghouse, alleging securities law violations, including attempts to bribe cryptocurrency exchanges Coinbase and Gemini to list XRP.
For their part, the SEC and the Commodities Futures Trading Commission have each expressed differing opinions regarding the designation of cryptocurrencies, with the CFTC labeling them as commodities and the SEC giving the opinion that they should be designated as securities. The CFTC could treat Bitcoin and cryptocurrencies as futures, swaps, or spot transactions and subject them to the Commodities Exchange Act, which can include limits on margin and short sales.
While multiple news outlets pointed to a meeting between the SEC and CFTC this week, in a call with TheStreet, the SEC's Public Affairs Office denied that a meeting between the two agencies would take place.
The Howey Test
How will the debate play out? It will most likely come down to an interpretation of the Howey Test, the result of a 1946 Supreme Court decision that has since been used to determine whether a transaction should be labeled as an investment contract -- in other words, a security.
"The Howey Test essentially asks four main questions to determine whether something is a security," explains Enrique Souza, development specialist at SmartCash, a community-driven, decentralized cryptocurrency platform. "Are you investing money or assets? Do you expect to make a profit from your investment? Are you investing in a common enterprise? And is the profit the result of a third party's actions, rather than your own? If the answer is yes to all four questions, then the transaction is typically labeled a security."
What is noteworthy about the Howey Test is that an investment doesn't need to be a stock or bond to be considered a security.
As securities attorney Laura Anthony has noted, "Applying the Howey Test, courts have interpreted a security to include such diverse items as citrus groves, warehouse receipts, chinchillas, minks, diamonds, bullion, pay phones, real estate and equipment, and condominium units, when they were offered or sold under circumstances involving the investment of money and expectation of a return through the efforts of others."
Many feel, however, that the Howey Test doesn't necessarily apply to cryptocurrencies. "I think that the CFTC definitely has a right to decide if these currencies are considered securities or not," says Jose Rivas, former CEO of alternative asset investment company Sig Capitales and co-founder of SprintX, a blockchain platform for business idea development. "At the same time, they must be careful in making sure regulatory efforts are protecting investors and their investments, while staying friendly and open to the new economy that the cryptocurrency markets represent. The Howey Test is a solid legal framework, but we are now obligated to ask: Is this the best way to look at the cryptocurrency market?"
Shashank Sripada, former Vice President at private-equity firm Marcena Capital and CEO of Bubblo, a blockchain-powered discovery app, shares these sentiments. "The definition of whether something is a security or not is in itself the wrong way to approach the regulation of blockchain token offerings. Ripple is merely creating the keys for users to have access to their financial transaction system. If people decide to speculate on the value of a very utility-driven concept and idea, then it is not directly dependent on Ripple as a company or a token. Their token should not be labeled a security."
Though many involved in cryptocurrencies feel they have a solid argument, others are quick to dismiss these points. "I've always thought cryptocurrencies are securities," says Bart Chilton, a former CFTC commissioner who now advises cryptocurrency exchanges and blockchain-based companies.
In Chilton's view, as investments in a common enterprise being primarily used to gain a profit, cryptocurrencies check off all four points listed in the Howey Test.
"Too many folks out there have been relying upon either pretty poor legal advice or no legal advice whatsoever in an effort to do what they believe is staying under the regulatory radar," he continues. "I think that's not only a mistake, I wouldn't want to be involved in anything that skirts or plainly violates the law. Cryptos are securities. Full stop. To say they are not is the wrong reading and could end up causing some serious problems for people."
Awaiting an Outcome
Whether the SEC and CFTC agree on a final regulatory scheme any time soon appears unlikely and it's not a requirement that one or the other agency regulates an asset class exclusively. But in the end, regardless of how cryptocurrencies are defined, it is quite likely that they will be subject to some type of regulation.
On a case-by-case basis, cryptocurrencies could be deemed securities and required to register with the SEC to face strict rules against insider trading, along with regular reporting requirements. On the other, the CFTC could place limits on margins, transparency and enforce its own set of rules that limit insider trading on commodities spot markets.
Whether that regulation is predominantly the commodities-based rules of the CFTC or the securities regulations of the SEC, crypto investors and developers would be wise to consider how potential changes could disrupt the industry in the months ahead.
The author holds stock in investment holding company, Leucadia, and remains a partner in an emerging technology fund. He holds no positions in cryptocurrencies or in any companies that invest in them.