Guest post by Giovanni Populo

The SEC has charged two major cryptocurrency exchanges: Binance and Coinbase. A common charge between both exchanges is that they offered unregistered securities on their platforms.

I. Understanding the Theory

1.1 Security vs. Commodity

A security is a financial asset that represents an investment and has an inherent value. It can be traded on a secondary market and its value is derived from a claim on assets or earnings. The Howey Test, established by the Supreme Court and very well-known by the market, is often used to determine whether an asset is a security. The test has four requirements:

1. Investment of Money: There must be an investment of money or some form of contribution.
2. Common Enterprise: The money must be invested in a common enterprise, meaning that the fortunes of the investor and the promoter are interlinked.
3. Expectation of Profit: The investor must have an expectation of profit.
4. Efforts of Others: The investor must enter into the investment with the expectation that they will receive a return or profit on their investment. This profit could come in the form of dividends, revenue share, price appreciation, or other financial returns. The key point is that the investor is motivated by the prospect of a financial gain from their investment.

A commodity, on the other hand, is a basic good that is used as an input in the production of other goods or services. Its value is derived from its inherent properties and usefulness. While there isn’t a specific test like the Howey Test for commodities, they generally have the following characteristics:

• Interchangeability: Commodities of the same type are identical to each other, regardless of who produced them.
• Used in Production: Commodities are often used as inputs in the production of other goods or services.
• Inherent Value: The value of a commodity comes from its inherent properties and usefulness, not from the efforts of others.
• Traded on Commodity Markets: Commodities can be bought and sold on commodity markets.

1.2 Easy-to-Understand Examples

An example of security could be a share of stock in Apple Inc. When you buy a share of Apple Stock ($A ), you are buying a piece of the company and have a claim on part of the company’s assets and earnings.

An example of a commodity could be the lithium used in the production process of the iPhone, which is later on transformed into batteries. Lithium from different sources is considered identical and interchangeable. Its price is uniform across the market, barring quality differentials.

II. Applying the Concept to Cryptocurrencies

Bitcoin and Ethereum were NOT mentioned by the SEC in any of the lawsuits, which suggests that their interpretation is more towards commodities than securities – or at least they are not sure about them. In recent hearings, SEC representatives have been inconsistent in their stance, raising concerns over its capacity to interpret digital assets.

But, what would be the technical interpretation of such assets, considering current market understanding and past rulings?

2.1 Bitcoin (BTC)

Bitcoin is a decentralized digital currency without a central bank or single administrator. It can be sent from user to user on the peer-to-peer Bitcoin network without the need for intermediaries.

Let’s see how the Howey Test looks would apply:

• Investment of Money? Check.
• Common Enterprise? Nope, Bitcoin’s value is not tied to the fortunes of a separate enterprise.
• Expectation of Profit? Check, many people buy Bitcoin with the expectation of profit.
• Efforts of Others? Nope, Bitcoin’s value does not come predominantly from the efforts of others.

What about commodities?

• Interchangeability? Check.
• Used in Production: Somewhat. Bitcoin is not used as a direct input in production, but rather energy is. However, Bitcoin is used for the production of the information registry that we usually call blockchain.
• Inherent Value: Check.
• Traded on Commodity Markets: Check.

General market interpretation tends to think of $BTC as a Commodity.
Note: This is not an official classification, but rather an opinion based on common sense and talks by SEC representatives that signal the same direction. As mentioned previously, the SEC is still debating such classifications, and as of now, there are no concrete answers by US government agencies.

2.2 Ethereum (ETH)

Ethereum is an open-source, blockchain-based platform that enables developers to build and deploy decentralized applications (dApps). Its native cryptocurrency is called Ether (ETH).

Let’s try the Howey Test again:

• Investment of Money: Check.
• Common Enterprise: Nope, Ether’s value is not tied to the fortunes of a separate enterprise.
• Expectation of Profit: Check, many people buy Ether with the expectation of profit.
• Efforts of Others: No, Ether’s value does not come predominantly from the efforts of others.

What about the commodity characteristics?

• Interchangeability? Check.
• Used in Production: Check.
• Inherent Value: Check.
• Traded on Commodity Markets: Check.

General market interpretation, in the case of $ETH, is split due to staking features, but considering just the checklists above, closer to a Commodity than Security.

Note: Same as the previous note, not a formal legal classification, but rather just market opinion.

Section 3: An Alternative Approach to Digital Asset Classification

It is important to understand that crypto assets are very new compared to traditional assets, and the classification guidelines covered above were built only for the latter – TradFi. As proposed by Gabriel Shapiro on Twitter, we should start discussing alternative classifications when dealing with digital assets, as to consider the new variables introduced by blockchain technology. As he proposes, digital assets could be a security and a commodity at the same time, depending on different requirements. His idea would work as below:

Security

• Insiders’ tokens (even if from end-user distributions)
• Tokens sold by insiders to third parties, if the relevant system is not yet functional and decentralized

Commodity

• Tokens from “end user distributions” (mining, airdrop, etc. for a functional system)
• Tokens intrinsically relating to a functional, decentralized system
• Stablecoins

In short, this would interpret tokens as security or commodity depending on how it was acquired (investors, ICOs), use case (e.g. utility vs. stablecoin), and ecosystem decentralization level.

Clearly, such a proposal makes a lot of sense to the crypto market, since it applies key features and characteristics to classify an asset as one or the other. This is just one example of an alternative approach, but that should serve as motivation for us to contribute to the discussion and create our own versions of it.

Section 4: Recent SEC Charges and Implications for Crypto Markets

The legal drama involving the U.S. Securities and Exchange Commission (SEC) and major cryptocurrency exchanges, Binance and Coinbase, has left the crypto world speculating on the potential implications and outcomes. The charges in question pertain to the alleged offering of unregistered securities, including but not limited to ADA, SOL, MATIC, and BNB. As it is critical to understand, these are currently just allegations and the legal process is yet to run its course. The final decision on these cases could serve as a regulatory beacon, profoundly impacting the crypto industry at large. So, what could these implications look like under different scenarios?

In one scenario, the SEC emerges victorious in its lawsuits, setting a precedent for stricter regulatory oversight of crypto exchanges. This would likely mean a redefinition of what constitutes security within the crypto domain, potentially based on parallels drawn from the projects the SEC has claimed to be securities. In this scenario, it’s plausible that we’ll witness an influx of enforcement actions against other platforms that fall within similar operational characteristics. A heavier regulatory environment could stifle innovation or push it offshore, leading to a challenging environment for U.S-based exchanges and Web3 projects. This scenario seems to be unlikely given the complexity of crypto assets and the evolving dynamics of the crypto market. Moreover, as some experts suggest, imposing traditional security laws on crypto assets could create more regulatory confusion rather than clarity.

The other sees the SEC losing the lawsuits, resulting in a much broader interpretation of cryptocurrencies as commodities. This could potentially loosen the grip of regulatory oversight, providing room for the crypto industry to flourish. Yet, the downside is that without proper guidelines, there could be an increased risk for investors, which could, in turn, affect the overall market stability.

Conclusion

Looking ahead, we find ourselves at a crossroads. The conclusion of these legal cases will significantly influence the regulatory landscape for crypto in the U.S. and likely globally. If I were to guess, I’d suggest that the degree of decentralization within networks could become a determining factor in classifying something as a security. Brand new regulation for digital assets also seems to be a likely outcome.

Looking beyond the immediate challenges, we need to continue fostering open discussions around digital asset classifications and encouraging innovation within the regulatory frameworks. We should support efforts that aim to find a balance between facilitating crypto’s immense potential and safeguarding the interests of all participants. After all, the goal is to ensure that the crypto industry thrives, regardless of the legal and regulatory environment it operates in.

Always forward-looking, always ahead of the game. Let’s keep the conversation going.