Cryptocurrencies and Securities - The Differences and Similarities
One of the most debatable arguments in crypto is whether cryptocurrencies can be classified as securities. To answer that question, we need to understand what exactly cryptocurrencies and securities are. Are cryptocurrencies a subset of securities, or are they different in design and function? This article will answer that question and clarify the stand of regulatory authorities on cryptocurrencies.
Cryptocurrencies vs. Securities
Cryptocurrencies are digital currencies that run on a blockchain network. With the aid of blockchain technology, cryptocurrency transactions can be verified transparently and without a central authority. Cryptocurrencies can be viewed as investments, too, since they can appreciate over time due to their volatility.
But what are securities? Securities are fungible financial instruments used to raise capital from investors. Bonds, stocks, and equities are all examples of securities. Securities have a monetary value and represent ownership. To perfectly define as asset class as a security or a commodity, we famously use the Howey test, which was brought to the limelight in 1946. According to the Howey test, an asset can be classified as a security if it meets the following conditions:
- There is an investment of money
- The investment is made into a “common enterprise”
- Investors hope to make profits
- Any expected profits are a result of the actions of a third party
This criteria for classifying securities was invented in 1946 following a court case between the Howey and the SEC. Thus, securities are not limited to the sales of stocks or bonds.
Notably, cryptocurrencies involve an investment of money, and investors hope to make profits. However, whether due to the design of most cryptocurrencies, the expected profits should not involve a third-party.
Bitcoin was designed as a financial tool that does not require third parties. Satoshi Nakamoto, the creator of Bitcoin, who has remained anonymous till date, emphasized in Bitcoin’s whitepaper that the cryptocurrency would serve as a peer-to-peer cash. Thus, Bitcoin cannot be classified as a security.
Altcoins – Securities or Not?
Crypto fans and regulatory authorities widely agree that Bitcoin is not a security. However, for some altcoins, the case has been very different. In 2020, the Securities and Exchange Commission sued Ripple, the company responsible for creating the XRP token, for illegally selling securities to the public. The case between the SEC and Ripple is yet to be settled, but it will greatly impact how many other cryptocurrencies are classified.
Ripple conducted an Initial Coin Offering (ICO), encouraging investors to buy XRP tokens. The SEC has held this against the company, since the investment strategy mirrors Initial Public Offerings (IPO) held by traditional companies trying to sell securities.
Admittedly, ICOs are usually conducted by new crypto protocols to boost liquidity or increase the number of holders or investors. Several crypto protocols have decided to conduct a Token Generation Event (TGE) rather than an ICO to prevent undue interest from regulatory bodies. A token generation event has the same goal with an initial coin offering – to draw investment from the public.
Ethereum – A Security or a Commodity?
Ethereum has been widely known as a commodity, since it’s blockchain used the proof-of-work (PoW) consensus mechanism for a long time. With the PoW mechanism, tokens are created through a process called mining. Miners use digital equipment to mine blocks on the Ethereum blockchain and secure the network.
However, late last year, the Ethereum blockchain transitioned from the Proof-of-work consensus mechanism to the Proof-of-stake consensus mechanism. Thus, Ether can no longer be mined, and stakers now secure the network. Users stake Ether and are rewarded with transaction fees from the staking pools.
With this new reward model on the Ethereum network, speculations have been flying regarding the SEC’s stand on Ether’s classification. At the moment, Ether is yet to be classified as a security by the SEC, despite its reward model for stakers or investors. This is largely because the Ethereum network remains a decentralized network. Interestingly, while Ether remains a commodity, the SEC recently penalized the Kraken exchange for offering crypto staking to its users. As you likely expect, Ether is was one of the cryptocurrencies available for staking on the platform.
Why the SEC is Against Kraken’s Staking Services
Not all details about the SEC and Kraken saga have been clarified at the moment. However, it currently seems the SEC is not against Ether staking itself. The regulatory body is against third-parties offering staking services to their customers without registering with the SEC.
Also, the SEC emphasize that Kraken exchange have failed to be completely transparent in informing investors of the risks and returns associated with crypto staking. Thus, the SEC still does not classify Ether as a security.
Kraken will not be the first recipients of criticism from the Securities and Exchange commission. The SEC have also battled with Binance and Coinbase exchange in the past.
Decentralization Plays a Key Role in the SEC’s Classification
While many crypto enthusiasts will argue against classifying cryptocurrencies as securities due to their decentralized nature, the SEC have a slightly different opinion. According to the SEC, a cryptocurrency may not be classified as a security if it is absolutely decentralized. This goes in line with the fourth criteria for classification above.
The SEC believes Bitcoin is not a security since it is decentralized. However, the regulatory commission have struggled to come to terms with classifying many other cryptocurrencies as non-securities.
Interestingly, the Commodity Futures Trading Commission (CFTC) classified all cryptocurrencies as commodities rather than securities in 2015. While this classification seems more acceptable for cryptocurrency users, it still leaves a lot of questions unanswered. If all cryptocurrencies are classified as commodities, they must be regulated by superior authorities. More so, how exactly do you regulate a decentralized code? This complex puzzle seems to have no perfect solution at the moment.
Based on the definition of securities and the boxes that need to be ticked for an asset to qualify as a security, cryptocurrencies are not securities. Since most cryptocurrencies are decentralized, they can easily be defined as non-securities.
However, whether a crypto asset is a security or not still slightly depends on the perspective of regulatory authorities. To the SEC, cryptocurrencies not absoluetly decentralzed are classified as securities. Additionally, while the SEC is the most widely known regulatory body, other regulatory bodies across the globe have classified specific crypto assets differently at one time or another.
For regular individuals, cryptocurrencies are better classified as commodities than as securities. However, for die-hard web3 fans passionate about decentralization and absolute freedom, cryptocurrencies are neither commodities nor securities. They are cryptographic digital assets that need no regulation from superior authorities.