Altcoins and Bitcoins

Most ‘cryptos’ are securities according to the Howey test

This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.

A vast majority of crypto assets (coins or tokens) are securities, and illegal ones at that, as they meet the Howey test and have not been issued/distributed in compliance with the securities law.

The only exception is one that satisfies both the following two conditions: (1) is based on genuine Proof-of-Work (PoW); and (2) has a locked base protocol according to the law.

The Howey Test

The present legal standard in the US for determining whether something is a security is summarized in the Howey Test. According to the Howey Test, if the thing meets all the following criteria, it is a security.

  1. It is an investment of money
  2. In a common enterprise
  3. With an expectation of profits
  4. Predominantly from the efforts of others

Most cryptos offered to the public meet all of them easily.

This is especially the case if the underlying blockchain uses Proof of Stake, or any other consensuses that use different names but are in essence still Proof of Stake.

Ripple, for example, argues that its XRP is a currency, and therefore isn’t a security. This argument is illogical. The Howey Test has nothing to do with whether it’s a currency or not. A currency is just a form of technology used for transmitting money (see Money & Currency). There are all kinds of possible currencies. The reason why a conventional fiat-based currency isn’t a security is not because it is a currency, but because it does not meet the Howey Test.

Specifically, (1) a conventional fiat-based currency is not issued by an enterprise, but by the government; and (2) obtaining a conventional fiat-based currency is not an investment, nor with an expectation of profits predominantly from the efforts of others, but rather a conversion of the fruits of one’s own labor into a convenient and reliable medium of value exchange.

Tokens like XRP meet the Howey Test. Arguing that XRP is not a security because it is a currency is to switch the subject matter.

The SEC has in the past indicated that it does not see Bitcoin and Ethereum as securities, as these assets have been sufficiently “decentralized.”

However, only the original Bitcoin (not BTC) meets the nonsecurity standard intended by the SEC. I would even argue that SEC has misapplied its own standard due to its misunderstanding of BTC.

BTC, a severely distorted version of Bitcoin, does not meet the nonsecurity standard, because it does not have a locked base protocol and and as a result is centrally controlled by a small group of Core developers, who in turn are subject to the control or influence of certain interest groups hidden behind the scenes. See, Decentralization – a widely misunderstood concept. Further, it has been deliberately transformed from the original bitcoin’s design of utility (a Peer-to-Peer cash system) to a purely speculative investment.

Ethereum is in a similar condition. In addition, Ethereum is in a process of moving to Proof-of-Stake (PoS), which makes it a security immediately according to the Howey test, as argued below.

Proof-of-Work, Proof-of-Stake and the Howey test

In the article Decentralisation, Dr. Craig S. Wright makes arguments that Proof-of-Stake (PoS) ensures the assets to be a security under the Howey test, while the true Bitcoin based on Proof-of-Work (PoW) and a protocol “set in stone” does not.

..the hash puzzle solution in Bitcoin can be solved using a separate system that only sees the block header and never validates transactions. This innovation was a key part of the invention within Bitcoin and allowed the specialisation of services. – Dr. Craig S. Wright, Decentralisation

The above clears up a big confusion over Proof-of-Work (PoW) and Proof-of-Stake (PoS) with respect to the question of securities law.

The genius of PoW is deeply and widely misunderstood. The PoW as originally designed by Satoshi maybe essentially described as follows:

A competitive economic system that requires nodes to each perform and demonstrate a signal-work in order to prove both its honesty and ability to perform a utility-work.

The bifurcation of work into two different kinds of work in PoW, namely a signal-work, and a utility-work, is critical not only to the overall design of Bitcoin as a scalable and secure system, but also to the question of Howey test. The bifurcation of work leads to specialization and labor division, which in turn, along with a locked base protocol, causes the nonexistence or disappearance of a common enterprise requisite according to the Howey test.

A crypto asset based on PoS is a security under the Howey test because the stakers are analogous to shareholders of a company, and the stakers (shareholders) bought the tokens (1) as an investment of money (2) in a common enterprise (3) with an expectation of profits (4) predominantly from the efforts of others.

In contrast, the original bitcoin that is based on PoW and has a locked protocol is not a security, because the buyers of bitcoin do not invest in a common enterprise.

Nexus required in Howey test

Concerning the Howey test, a focus has been on the existence or lack thereof a “common enterprise.”

However, there is an implicit nexus among the four elements required in the Howey test. The nexus is especially important between the first test element and the second one (“investment of money” and “in a common enterprise”), meaning that for the Howey test to be positive, investors must have invested the money into the common enterprise. If there is no common enterprise for investors to invest into, or, although a common enterprise does exist in the ecosystem, the asset purchasers have not invested into the identified common enterprise (but rather into something else), the asset does not meet the Howey test. The mere existence of both an investment and a common enterprise somewhere in the ecosystem does not qualify for the Howey test.

In other words, if the investors have invested money into something that’s different from the identified “common enterprise”, the Howey test would result in a negative and the asset would not be a security. The conclusion remains the same even if the actual investment target is somewhat related to but not identified with the common enterprise.

It is the absence or existence of this nexus that is the most important difference between PoW and PoS.

The common enterprise

It is clear both PoW and PoS satisfy the first element of the Howey test: investment of money.

It is also quite easy to identify a common enterprise working behind any crypto asset, be it PoW or PoS. The common enterprise may be the issuer of the asset, a group that maintains a consensus, a group of developers, a company that builds the common infrastructure, or the mining business as a collective whole in their effort of operating the blockchain according to the rules set by the issuer, etc.

If the above two are established, it is also fairly easy to establish the other two elements of the Howey test as well: investors also have an expectation of profits predominantly from the efforts of others.

Therefore, it may appear that even bitcoin with PoW meets the Howey test, is thus a security suspect.

One may argue on behalf of bitcoin that the above second element is not met, because there really is no common enterprise in bitcoin mining, due to the level of “decentralization” among the miners and also a clear competition among the miners. This is in fact the most common basis for many, including SEC itself, to justify a conclusion that bitcoin is not a security.

However, for the real bitcoin that is based on original PoW consensus, there is a stronger and more distant reason why it is not a security. The reason lies in a lack of a nexus between the bitcoin purchasers and any common enterprise. See below.

The requisite nexus exists in PoS

A PoS system has a more distinctive “common enterprise” than a PoW system does.

However, a much greater difference is in the existence of the requisite nexus, not in the existence or lack thereof a common enterprise itself in the first place.

With PoS, once a common enterprise is found to exist (which usually does), the nexus is inherently there, and it is quite obvious. There is no separation, not even an essential and substantive distinction, between possessing coins and performing validation by the validators in PoS. The validators derive their acting power and benefit directly from the very fact that they hold “shares” of this common enterprise. The shares in essence are non-distinguishable among all shareholders, except for a nonessential difference in the manner in which they receive a ‘dividend’.

Whether they are staking to become a validator or not, they are all investing into this same enterprise (the common enterprise). This makes the PoS coin holders essentially the same as any shareholders who have shares of a conventional enterprise, and therefore are holders of a security.

In other words, with PoS, coin purchasers effectively buy shares of a common enterprise which runs the PoS-based blockchain creation and validation business. They are all shareholders of the common enterprise. When some shareholders happen to also stake for validation using the shares and thus receive an extra benefit, they are nonetheless still shareholders of the same common enterprise and do not change the non-staking coin purchasers’ role as shareholders either. This is akin to a company’s equity shareholders who are also workers or employees of the company receiving an extra benefit in wage compensation, except that PoS ties the stakes even more directly with the compensation by not even requiring the “shareholder employees” to perform real work other than exercising voting rights proportional to each one’s shares.

No requisite nexus in genuine PoW

In contrast, with PoW, mining nodes derive their benefit by performing real work. The fact that a mining node may also own some coins (bitcoin for example) is merely incidental. The ownership of the coins does not constitute the business of mining. Performing the mining work does. There is a fundamental separation between possessing coins and performing mining work by the PoW miners.

In other words, even if one could characterize holders of bitcoin as some kind of investors who have invested in something, that ‘something’ is not an identifiable “common enterprise” in active operation. Rather, they just purchased a thing (a commodity), not the share of a common enterprise.

The case is particularly clear and strong with the real bitcoin based on genuine PoW.

First, the investors did not invest in an issuer to create more coins. The issuer of bitcoin, namely Satoshi, issued all the coins all at once in the beginning without having any coin purchasers’ participation. The bitcoin issuer isn’t a continuing enterprise that needs investment. In the case of bitcoin, the truth is that Satoshi the issuer would have received no money either directly or indirectly from the investments by others had he not himself mined coins as a miner on the exactly the same terms as the other miners. And the fact that the issuer did also do mining is coincidental and has no inherent relationship with the issuer identity. In this respect, any secret arrangement, such as pre-mining, that gives the issuer an unfair advantage makes the asset a suspect. The real bitcoin had no such arrangement.

Second, bitcoin purchasers did not invest in the mining business. It is the shareholders of the mining companies who have invested into the mining business, and these shareholders are a different category than the coin holders. The company shares of a mining business are clearly securities, and no one could honestly argue they are not, but there are different from bitcoin.

Third, bitcoin purchasers did not invest in a common infrastructure development business. Shareholders of the blockchain infrastructure development companies have invested into the development business, but again they are a different category than the coin holders. Likewise, the company shares of an infrastructure business are clearly securities, but they are different from bitcoin.

The spirit of the law

Lastly, looking beyond the letters of the law, it is relevant to consider the spirit of the law as well. The spirit of the securities law including the Howey test is to protect investors from issuers/sellers of certain things that have a strong speculative nature. There is a twofold reason why “securities” as a category are particularly risky: first, those behind securities are strongly motivated to get investors’ money; and second, the investors on the other hand are strongly drawn to a prospect of receiving a return without actually participating in the enterprise that is supposed to create the underlying return. When a common enterprise exists as a center of gravity to pull many investors in, you want some protection for the public.

The securities law does not make fundraising illegal per se. It just subjects fundraising process to certain regulatory requirements.

However, almost none of the existing crypto coins and tokens was issued and exchanged in a manner that satisfies such regulatory requirements. Therefore, to be legal, a crypto must pass a negative Howey test and be thus considered not to be a security.

For this purpose, a digital asset that runs on a genuine decentralized PoW consensus with a base protocol locked according to the law passes a negative Howey test and may not be a security, because such an asset has not a common enterprise that exists as the center of gravity.

Especially, if the digital asset is further designed to primarily serve as a nontrading utility, empirically there tends to be even less likely to form a center of gravity that is in itself speculative and also attracts speculating investors.

An example of a nonsecurity digital asset

One distinct example is Bitcoin Satoshi Vision (BSV).

BSV is the original Bitcoin according to the white paper “A Peer-to-Peer electronic cash system“. It is based on genuine Proof-of-Work (POW); and has a locked base protocol according to the law.

Not only the legal theory, but also the actual evidence supports the lack of a gravity center acting as a force to attract speculative investors.

Due to is designed emphasis of Peer-to-Peer (P2P) cash payment utility (versus “digital gold” and “store of value” narratives), BSV clearly has far less attraction to pure speculative investors. The way the market has treated BSV is in fact a harsh and bitter showing that BSV can only succeed on its having developed real utility, and not by merely selling a narrative. (But is it not what it should be like in a real world of business?)

But at the same time, this rather peculiar phenomenon is also circumstantial evidence that BSV is not a security but a commodity which lives or dies based on its utility.

As the BSV’s ecosystem further develops, coin purchasers are more and more purchasing the satoshi tokens for the utility (to actually use them) rather than with a mere expectation of profit.

In the case of BSV, the empirical behavior and the legal theory are in harmony. Both the lack of an investable common enterprise and the lack of nexus in an actually invested common enterprise, along with the asset’s being centered around utility, clearly demonstrated a nonsecurity asset.


A requisite “nexus” is found in PoS or even PoW that does not have a base protocol locked according to the law, but not in genuine PoW with a base protocol locked according to the law. The only digital asset that is not a security is one that satisfies both the following two conditions: (1) is based on genuine Proof-of-Work (POW); and (2) has a locked base protocol according to the law. Empirically, the asset should be essentially a utility asset rather than a speculative one.

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